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.

Excess reserves may also be known as secondary reserves.

Understanding Excess Reserves

Excess reserves are a safety buffer of sorts. 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).

Key Takeaways

  • Excess reserves are funds that a bank keeps back beyond what is required by regulation.
  • As of 2008, the Federal Reserve pays bank an interest rate on these excess reserves.
  • The interest rate on excess reserves is now being used in coordination with the Fed funds rate to encourage bank behavior that supports the Federal Reserve's targets.

2008 Rule Change Increases 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.

Interest on Excess Reserves and 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 had an incentive to hold excess reserves, especially when market rates are below the fed funds rate. In this way, the interest rate on excess reserves served 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 December 17, 2015, after nearly a decade of lower bound interest rates. Since then, the Fed has been using the interest on excess reserves to create a band between the Fed funds rate and the IOER by setting it purposely below to keep their target rates on track. For example, in December 2018, the Fed raised its target rate by 25 basis points but only raised IOER by 20 basis points. This gap makes excess reserves another policy tool of the Fed. If the economy is heating up too fast, the Fed can shift up its IOER to encourage more capital to be parked at the Fed, slowing growth in available capital and increasing resiliency in the banking system. As of yet, however, this policy tool has not been tested in a challenging economy.