What Are Excess Reserves? – How Do Excess Reserves Work?

Do you want to know What Are Excess Reserves? And also some other things attached to it? If your answer is yes, then you are welcome on this page. I am going to tell you all you need to know about this topic, but you need to do something. When you are reading this article, you will need to do so in a step-by-step process to be able to understand the article.

What Are Excess Reserves?

What Are Excess Reserves?

Anytime a bank simply keeps more money on hand than is required by regulation, it is usually known to have excess reserves. Banks simply hold excess reserves in times of financial uncertainty or if they believe interest rates will fall.

Here is a closer look at how the excess reserves work, why they are held, and also what they mean for you as a banking customer.

Definitions and Examples of Excess Reserves

Excess reserves simply refer to the surplus of cash a bank simply holds in its vault or Fed account beyond what is required by the Federal Reserve to be on hand.

For instance, suppose a bank is required to keep 10% of its deposits in reserve. If a bank has 12% in its reserves, then it has an excess reserve of 2%. The bank is then free to use these funds for any purpose.

How Do Excess Reserves Work?

Banks simply make money by taking in deposits from customers and then lending that money back out to others at even a higher interest rate. They cannot lend out all their money, though, because they need liquid cash on hand to pay their bills and fulfil withdrawal requests from customers.

The Federal Reserve then tells depository institutions the minimum amount of money they must then keep available for financial obligations. This minimum is simply known as the reserve requirement. Any money the banks keep over this limit is then considered excess reserves.

Banks do not lend excess reserves to businesses or consumers. Rather, they then hang onto them in case of an emergency.

The excess reserves formula looks like this:

Excess Reserves = Total Reserves -Required Reserves

In essence, a bank’s excess reserves are any cash it simply keeps over the required minimum. For instance, suppose a bank has $20 million in deposits. If its reserve ratio is 10%, then it is simply required to keep at least $2 million on hand. However, if the bank has $3 million in reserves, then $1 million of it is in excess reserves.

On the other hand, if a bank has $2 million in reserves and is required to keep $2 million on hand, then it has zero excess reserves.

Why Do Banks Hold Excess Reserves?

You might then be wondering, “What’s the significance of excess reserves? Why do banks use them? ” At their core, the excess reserves act as a safety net for banks during times of economic uncertainty. The bank can then fall back on this buffer if loans default or a lot of customers withdraw money at once.

Think of it like this: If you knew a hurricane was simply headed your way, you would stock up at the grocery store and then fill your pantry with all types of necessities to prepare for the unexpected. Banks also do the same thing when they hold excess reserves.

As a banking customer, you may not usually know when your institution has excess reserves. All you need to know is that you can easily withdraw or transfer money whenever you need it. In a sense, this is what having excess reserves is all about—simply making sure you always have a smooth banking experience, no matter what’s going on in the world.

Required Reserves vs. Excess Reserves

Required Reserves

Excess Reserves

The minimum amount of cash a bank must keep on hand, as dictated by the Federal Reserve,

The additional cash a bank keeps on hand over the Fed’s required minimum

Ensures banks have enough cash on hand to fulfil financial obligations and withdraw requests during regular economic times.

Used as a buffer in times of economic uncertainty to protect the bank from unexpected financial losses.

Banks must then keep a certain percentage of their deposits on reserve in a vault or simply with their local Federal Reserve branch. This minimum is the required reserve. If the bank chooses to hold onto additional money over this threshold, then it has excess reserves.

Just as you simply earn interest on your savings account balance, banks also simply earn interest on their required reserves and also excess reserves. The Federal Reserve even sets these interest rates.

Interest on Excess Reserves (IOER)

There are several interest rates that are related to excess reserves. Before 2008, banks in the U.S. were not paid with interest for simply holding excess reserves. The 2008 Global Financial Crisis then accelerated the decision that the Federal Reserve is simply authorised to pay a rate of interest to banks on their holdings of excess reserves. This is then known as the Interest on Excess Reserves (IOER), which can then give banks an incentive to increase their liquidity buffer.

The central bank can even use the IOER rate as a tool of monetary policy. By simply raising the IOER rate, the central bank can even give commercial banks more incentives to hold excess reserves, which then reduces the money supply. The central bank can then lower the IOER rate to conduct an expansionary monetary policy. This will then lead to commercial banks reducing their excess reserves.

Excess Reserves and Interbank Rates

The interbank rate is simply an interest rate on short-term borrowing and also lending between banks. The Federal Funds rate is then set by the Federal Open Market Committee (FOMC) as a target rate for the borrowing and even lending of excess reserves between commercial banks on an overnight basis. If a commercial bank then sees its cash and deposit holdings falling below the minimum requirement at the end of the day, it can then borrow from another bank that has excess reserves overnight to meet the reserve requirement.

The Federal Reserve can even impact the interbank rate by simply adjusting the money supply. Increasing the money supply then reduces the demand for overnight borrowing between banks, leading to a lower rate. Conversely, contracting the money supply can even lead to a higher interbank rate.

London Interbank has been The London Interbank Offered Rate (LIBOR) is a widely accepted benchmark rate for international interbank short-term loans between major global banks. The Intercontinental Exchange (ICE) then queries the major banks for their interest charges on lending to other banks. Unlike the Federal Funds Rate, which only covers borrowing in the United States dollar, the LIBOR includes a currency basis in the United States dollar, Japanese yen, euro, British pound, and Swiss franc.

Excess Reserves vs. Free Reserves

The free reserves are then the portion of excess reserves that are not borrowed from the central bank. A higher level of excess reserves does not necessarily mean a higher level of free reserves. A commercial bank’s free reserve is simply the amount that the bank can lend out. If commercial banks have more free reserves, greater amounts of credit are simply available to businesses and individuals. It then means a lower cost of financing and may lead to inflation.

The mechanisms of excess reserves and free reserves as tools of monetary policy are very similar. During economic downturns, the central bank can then implement a lower IOER rate and also a Federal Funds rate to encourage commercial banks to lower their free reserves and free up more money supply in the economy.


Do Excess Reserves Increase Money Supply?

You want to know about: Do Excess Reserves Increase Money Supply? When a bank does either or makes loans out of excess reserves, the money supply increases. We can then predict the maximum change in the money supply with the money multiplier.

How Do You Calculate Excess Reserves on Quizlet?

The bank’s excess reserves can even be calculated by simply subtracting the bank’s required reserves from the bank’s actual reserves of $12 million. The bank’s required reserves are an amount of $10 million (= reserve ratio of 10 per cent (0.10)  $100 million in checkable-deposit liabilities).

Can Excess Reserves Be Negative?

When a bank’s excess reserves are simply negative, then the bank would simply need to secure additional cash to meet the reserve requirement. A bank could even borrow from other banks at the federal funds rate or simply go to the Federal Reserve’s discount window and borrow at the higher discount rate.

Can Banks Lend Out Excess Reserves?

Banks do not lend out deposits; nor do they lend out reserves. They simply lend by creating deposits. And the deposits are also created by government deficits. Reserves can then play a pivotal role in money creation, but not in the way often envisaged.

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