What are excess reserves?
Excess reserves are the funds a bank holds beyond the minimum reserves required by its central bank, regulators or internal liquidity rules. For commercial banks, required reserves are a fixed percentage of certain deposit liabilities; any balances above that percentage are “excess.” Excess reserves act as a liquidity buffer and — when central banks pay interest on them — can also earn a return while remaining immediately available.
Key takeaways
– Excess reserves = reserves held above regulatory (or internal) requirements.
– They serve as a liquidity/safety buffer and can be a monetary policy tool when a central bank pays interest on them.
– The U.S. historically had positive reserve requirements, but in 2020 the Federal Reserve set reserve requirements to zero and now remunerates voluntary reserve balances (IORB).
– Large increases in excess reserves have followed Fed asset purchases (QE); at their peak they ran into the trillions of dollars. (Fed and St. Louis Fed data)
– For a commercial bank, reserve balances are assets; on a central bank’s balance sheet, reserve accounts are recorded as liabilities.
How excess reserves are used
– Liquidity management: Banks keep excess reserves to meet unexpected withdrawals or payment outflows and to satisfy intraday/overnight liquidity needs.
– Safety buffer: Excess reserves reduce the risk of shortfalls from sudden loan losses or deposit runs.
– Monetary policy transmission: Central banks can influence banks’ willingness to lend by paying interest on reserve balances (IOER or IORB). Paying interest reduces the opportunity cost of holding reserves, which can keep short-term market rates near the central bank’s target and provide a floor for interbank rates.
– Sterilization and balance-sheet management: When central banks buy assets (QE), they typically credit banks’ reserve balances; those reserves can be held as excess rather than circulating into broader credit creation. (Federal Reserve; St. Louis Fed)
History of excess reserves in the U.S.
– Reserve rules trace back to the 19th century: state laws requiring reserves emerged after banking instability in the 1800s. Over time, reserve requirements and how they were used evolved to address different economic and financial conditions. (International Journal of Central Banking)
– 2006: The Financial Services Regulatory Relief Act authorized the Fed to pay interest on reserve balances. The initial implementation date was scheduled for 2011.
– 2008–2009 Great Financial Crisis: Implementation of interest on reserves was accelerated after the Emergency Economic Stabilization Act of 2008. The Fed began significant asset purchases (QE), which added large amounts to bank reserve balances.
– Post-crisis peaks: Excess reserves grew massively — reaching roughly $2.7 trillion in August 2014 (during QE). Between Jan 2019 and Feb 2020 they were between ≈ $1.3–1.6 trillion. The COVID-19 period and associated policy responses again pushed reserve balances above $3 trillion. (St. Louis Fed)
– 2020: The Federal Reserve set required reserve ratios to zero, removing statutory reserve requirements in the U.S. and shifted to paying interest on voluntary reserve balances (IORB) to help control short-term interest rates.
Factors that affected excess reserve balances
– Interest paid on reserves (IOER/IORB): Higher interest reduces the opportunity cost of holding reserves and tends to increase the amount banks keep as excess. (Federal Reserve)
– Quantitative easing and central bank asset purchases: When the Fed buys assets it credits banks’ reserve accounts, raising reserve balances. Whether those reserves circulate into lending depends on banks’ demand for credit and the return on alternative assets. (St. Louis Fed)
– Bank profitability and balance-sheet management: Banks weigh the return on lending versus the return (and safety) of holding reserves. If lending prospects are weak or risky, banks may hold more excess reserves.
– Liquidity needs and stress expectations: In uncertain times, banks may increase excess reserves as a precaution.
– Regulatory environment and alternative liquidity requirements: Liquidity coverage ratios, supervisory stress tests and internal risk limits all influence reserve behavior.
– Market interest rates and credit demand: When market rates are higher (relative to IOER), banks have more incentive to lend rather than hold reserves.
What is the difference between excess and required reserves?
– Required reserves: the minimum a bank must hold (historically set as a percentage of certain deposits). Required reserves are a regulatory floor designed to ensure short-term liquidity.
– Excess reserves: any reserves above that required minimum. They are discretionary and reflect a bank’s liquidity preference and market incentives.
Note: Because the Fed removed reserve requirements in 2020 (set reserve ratios to zero), the distinction in the U.S. between “required” and “excess” reserves is no longer operational in the same way. Instead the Fed remunerates voluntary reserve balances (IORB) to help control overnight rates. (Federal Reserve)
What happens if banks keep excess reserves?
Positive effects
– Greater short-term liquidity and reduced risk of funding shortages.
– During stress, excess reserves provide immediate capacity for payments and settlement.
– If remunerated by the central bank, banks earn risk-free interest on otherwise idle balances.
Potential drawbacks
– Opportunity cost: funds held as reserves normally earn less (or equal if IOER equals market rates) than funds lent out; high excess reserves can reduce bank interest income and loan supply.
– Monetary stimulus dampening: If central banks inject liquidity but banks hold it as excess reserves rather than extending credit, the intended stimulus to the real economy is muted.
– Lower money multiplier: When banks hold more reserves instead of creating loans, the expansion of deposits through lending (the money multiplier effect) is reduced.
Are excess reserves a liability?
– For commercial banks: reserves (vault cash and balances at the central bank) are assets on the bank’s balance sheet. They are highly liquid assets used for payment settlement and liquidity management.
– For the central bank: reserve balances are liabilities. When a commercial bank’s reserve account at the central bank is credited, the central bank records a deposit liability. If the central bank pays interest on reserves, that interest is an expense/liability for the central bank’s operations. (Federal Reserve)
The bottom line
Excess reserves are the additional liquid funds banks hold beyond any required minimum. They play an important role in liquidity management, financial stability and monetary policy transmission. In the United States, reserve requirements were eliminated in 2020 and the Fed now uses interest on reserve balances (IORB) to help control short-term rates; large-scale asset purchases (QE) and policy choices have driven reserve balances into the trillions in recent cycles. Central banks in other countries may still operate formal reserve requirements, so excess reserves remain a global policy instrument.
Practical steps — what different users should do or watch
For bank treasury/liquidity managers
– Monitor IORB/IOER and short-term market rates: compare the interest the Fed pays on reserve balances to potential lending or investment yields.
– Run liquidity stress tests: quantify how much excess reserves you need under various outflow scenarios and regulatory requirements.
– Optimize portfolio allocation: if reserves are remunerated but provide lower return than short-term securities, consider short-dated, high-quality liquid assets to manage yield vs. liquidity tradeoffs.
– Use intraday liquidity management tools: manage payment and settlement timing to minimize idle reserves while keeping safe buffers.
For regulators and central banks
– Use the interest rate on reserve balances as a policy tool to help set a floor for short-term rates.
– Monitor bank reserve holdings as a signal of banks’ willingness to lend and of stress conditions in the banking system.
– Coordinate reserve policy with other liquidity and macroprudential measures to avoid unwanted credit contractions or excessive risk-taking.
– Communicate clearly: banks’ incentive to hold reserves depends critically on remuneration and expected future policy.
For investors and analysts
– Watch Fed balance sheet trends and reserve-account data (St. Louis Fed FRED series) as indicators of excess liquidity and central bank accommodation.
– Track IORB/IOER and the spread between remunerated reserve rates and market rates — a widening gap influences banks’ lending decisions.
– Consider the implications of large reserve balances for loan growth, inflation and bond market dynamics.
For policymakers
– Evaluate whether remunerating reserves or using reserve requirements better suits the regulatory and monetary framework of your jurisdiction.
– Assess the trade-offs: remunerating reserves can stabilize interbank rates and avoid liquidity strains, but could reduce credit flows if banks’ risk appetite or lending demand stays weak.
Sources and further reading
– Federal Reserve Board — Interest on Reserve Balances (IORB) and historical IOER materials.
– Federal Reserve System — The Fed Explained: What the Central Bank Does.
– Federal Reserve Bank of St. Louis — Data and analysis on interest rate on excess reserves and reserve balances (FRED).
– Federal Reserve Bank of Cleveland — “Excess Reserves: Oceans of Cash.”
– International Journal of Central Banking — Lessons from the Historical Use of Reserve Requirements in the United States to Promote Bank Liquidity.
– International Monetary Fund — Monetary Operations and Domestic Market Development: Reserve Requirements.
– Investopedia — “Excess Reserves” (source summary provided).
If you’d like, I can:
– Pull the latest Fed and FRED series values for reserve balances and IORB, or
– Build a short decision checklist for a bank deciding how much reserve to hold vs. lend, or
– Summarize how reserve policy differences in other major economies (e.g., ECB, BoE, Bank of Japan) compare with the U.S.