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. Free Reserves

    Free reserves are the reserves a bank holds in excess of required ...
  2. Bank Reserve

    Bank reserves are the currency deposits which are not lent out ...
  3. Reserve Requirements

    Requirements regarding the amount of funds that banks must hold ...
  4. Working Reserves

    Reserves held by banks above the required minimum level - or ...
  5. Reservable Deposit

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

    A statistic released in weekly Federal Reserve data showing the ...
Related Articles
  1. Investing

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  2. Trading

    Why Interest Rates Have Been Low for So Long

    Learn of several competing explanations about why the Federal Reserve has kept interest rates so low in the United States since 2008.
  3. 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.
  4. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  5. Insights

    A Primer On Reserve Currencies

    For nearly a century, the U.S. dollar has served as the world's premier reserve currency, but the future is uncertain.
  6. 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.
  7. Investing

    What's the Salary of the Chairman of the Federal Reserve?

    The chairman of the Federal Reserve oversees the U.S. banking system.
  8. Trading

    Emerging Market FX Currency Reserves Growing

    Are emerging markets preparing for a period of volatility?
RELATED FAQS
  1. 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 >>
  2. What are the implications of a high Federal Funds Rate?

    Learn the implications of a high federal funds rate, which include constriction of the money supply, a stronger dollar and ... Read Answer >>
  3. What are the implications of a low Federal Funds Rate?

    Find out what a low federal funds rate means for the economy. Discover the effects of monetary policy and how it can impact ... Read Answer >>
  4. How do open market operations affect the overall economy?

    Understand how open market operations affect the overall economy. Learn how the Federal Reserve uses open market operation ... Read Answer >>
  5. How is money supply used in monetary policy?

    Learn about the three components of the Federal Reserve's monetary policy. Understand how these three components use the ... Read Answer >>
Trading Center