What are 'Excess Reserves'

Excess reserves are capital reserves held by a bank or financial institution in excess of what is required by regulators, creditors or internal controls. For commercial banks, excess reserves are measured against standard reserve requirement amounts set by central banking authorities. These required reserve ratios set the minimum liquid deposits (such as cash) that must be in reserve at a bank; more is considered excess.

BREAKING DOWN 'Excess Reserves'

Financial firms that carry excess reserves have an extra measure of safety in the event of sudden loan loss or significant cash withdrawals by customers. This buffer increases the safety of the banking system, especially in times of economic uncertainty. Boosting the level of excess reserves can also improve an entity's credit rating, as measured by rating agencies such as Standard & Poor's.

The Federal Reserve has many tools in its monetary normalization toolkit. In addition to setting the fed funds rate, it now has the ability to change the rate of interest that banks are paid on required (interest on reserves — IOR) and excess reserves (interest on excess reserves — IOER).

New Laws, New Rules Increase Excess Reserves

Prior to Oct. 1, 2008, banks were not paid a rate of interest on reserves. The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay banks a rate of interest for the first time. The rule was to go into effect on Oct. 1, 2011; however, the Great Recession advanced the decision with the Emergency Economic Stabilization Act of 2008. Suddenly, and for the first time in history, banks had an incentive to hold excess reserves at the Federal Reserve.

Excess reserves hit a record $2.7 trillion in August 2014 due to the quantitative easing program. In mid-June 2016, excess reserves stood at $2.3 trillion. Proceeds from quantitative easing were paid out to banks by the Federal Reserve in the form of reserves, not cash. However, the interest paid on these reserves is paid out in cash and recorded as interest income for the receiving bank. The interest paid out to banks from the Federal Reserve is cash that would otherwise be going to the U.S. Treasury.

The IOER Is the Fed Funds Rate

Historically, the fed funds rate is the rate at which banks lend money to one another and is often used as a benchmark for variable rate loans. Both the IOR and the IOER are determined by the Federal Reserve, specifically the Federal Open Market Committee (FOMC). As a result, banks now have an incentive to hold excess reserves, especially when market rates are below the fed funds rate. In this way, the rate on excess reserves now serves as a proxy for the fed funds rate. The Federal Reserve alone has the power to change this rate, which increased to 0.5% on Dec. 17, 2015, after nearly a decade of lower bound interest rates.

RELATED TERMS
  1. Bank Reserve

    Bank reserves are the currency deposits which are not lent out ...
  2. Reserve Ratio

    The portion (expressed as a percent) of depositors' balances ...
  3. Fractional Reserve Banking

    A banking system in which only a fraction of bank deposits are ...
  4. Reservable Deposit

    A bank deposit subject to reserve requirements. Reserve requirements ...
  5. Net Borrowed Reserves

    A statistic released in weekly Federal Reserve data showing the ...
  6. Adjustment Credit

    A short-term loan made by a Federal Reserve Bank to a smaller ...
Related Articles
  1. Personal Finance

    What's the Federal Funds Rate?

    The federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements.
  2. Investing

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  3. Insights

    Regional Banks Give The Fed A National Perspective

    We all know that the Federal Reserve utilizes monetary policy to control the economy, but what do the 12 regional Federal Reserve Banks do?
  4. Insights

    What Do the Federal Reserve Banks Do?

    These 12 regional banks are involved with four general tasks: formulate monetary policy, supervise financial institutions, facilitate government policy and provide payment services.
  5. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
  6. Insights

    How The Federal Reserve Manages Money Supply

    Find out how the Fed manages bank reserves and this contributes to a stable economy.
  7. Trading

    Explaining the Federal Reserve System

    The Federal Reserve System is the central bank of the United States. It regulates monetary policy and supervises the nation’s banking system.
  8. Personal Finance

    Explaining the Federal Discount Rate

    The federal discount rate is the rate at which eligible banks or other depository institutions can borrow funds from a Federal Reserve bank.
  9. Investing

    Are The Markets Ready For an Interest Rate Increase?

    Learn why the bond market may not necessarily see an interest rate increase soon. Read about how the Federal Reserve will slowly raise interest rates.
RELATED FAQS
  1. How are bank reserve requirements determined and how does this affect shareholders?

    Learn how bank reserve requirements are determined and how bank reserves affect shareholders through improved bank stability ... Read Answer >>
  2. Why would the Federal Reserve change the reserve ratio?

    Understand the Federal Reserve's monetary policy and the tools it uses to change that monetary policy. Learn about the reserve ... Read Answer >>
  3. How do central banks acquire currency reserves and how much are they required to ...

    A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign ... Read Answer >>
  4. Who decides when to print money in the US?

    Learn who decides to print money in the United States. Many people relate credit creation, which is the Fed's job, with printing ... Read Answer >>
  5. How does the Federal Reserve's set discount rate affect my personal finances?

    Discover how the Federal Reserve implements its chosen monetary policy through its discount rates, and how these actions ... Read Answer >>
Trading Center