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.

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).

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.

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.