Excess reserves

In banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank (in the United States, the Federal Reserve System, called the Fed; in Canada, the Bank of Canada). They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount. Therefore, many banks minimize their excess reserve amounts by putting them to more productive use.

For banks in the Federal Reserve System, this is accomplished by making short-term (usually overnight) loans on the federal funds market to banks who may be short of their reserve requirements. However, some banks may choose to hold their excess reserves in order to facilitate upcoming transactions or meet contractual clearing balance requirements.

File:EXCRESNS.jpg

Excess reserves in the U.S., 1930-2009

Emergency Economic Stabilization Act of 2008

On October 3, 2008, Section 128 of the Economic Stabilization Act of 2008 allowed the Fed to begin paying interest on excess reserve balances as well as required reserves. They began doing so three days later. Banks had already begun increasing the amount of their money on deposit with the Fed at the beginning of September, up from about $10 billion total at the end of August, 2008, to $880 billion by the end of the second week of January, 2009. In comparison, the increase in reserve balances reached only $65 billion after September 11, 2001 before falling back to normal levels within a month. U.S. Treasury Secretary Henry Paulson's original bailout proposal under which the government would acquire up to $700 billion worth of mortgage-backed securities contained no provision to begin paying interest on reserve balances.

The day after the change was announced, on October 7, Fed Chairman Ben Bernanke expressed some confusion about it, saying, "We're not quite sure what we have to pay in order to get the market rate, which includes some credit risk, up to the target. We're going to experiment with this and try to find what the right spread is." The Fed adjusted the rate on October 22, after the initial rate they set October 6 failed to keep the benchmark U.S. overnight interest rate close to their policy target, and again on November 5 for the same reason.

Beginning December 18, the Fed directly established interest rates paid on required reserve balances and excess balances instead of specifying them with a formula based on the target federal funds rate. On January 13, Ben Bernanke said, "In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors. However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate."

Also on January 13, Financial Week said Mr. Bernanke admitted that a huge increase in banks' excess reserves is stifling the Fed's monetary policy moves and its efforts to revive private sector lending. On January 7, 2009, the Federal Open Market Committee had decided that, "the size of the balance sheet and level of excess reserves would need to be reduced." On January 15, Chicago Fed president and Federal Open Market Committee member Charles Evans said, "once the economy recovers and financial conditions stabilize, the Fed will return to its traditional focus on the federal funds rate. It also will have to scale back the use of emergency lending programs and reduce the size of the balance sheet and level of excess reserves. 'Some of this scaling back will occur naturally as market conditions improve on account of how these programs have been designed. Still, financial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the financial turmoil,' he said."

At the end of January, 2009, excess reserve balances at the Fed stood at $793 billion but less than two weeks later on February 11, total reserve balances had fallen to $603 billion.