Excess Reserves
Key takeaways
- Excess reserves are funds a bank holds at its central bank above the required minimum.
- The U.S. effectively eliminated reserve requirements in 2020 by setting required reserve ratios to zero, removing the regulatory definition of “excess” reserves for U.S. banks.
- Central banks can still pay interest on voluntary reserve balances (e.g., IORB), which influences banks’ incentives to hold reserves.
What are excess reserves?
Excess reserves are the portion of a depository institution’s reserves held at the central bank that exceed mandated reserve requirements. Required reserves are the minimum liquid balances a central bank requires banks to hold; anything above that minimum is considered excess. A related term, free reserves, is typically defined as excess reserves minus any borrowing from the central bank’s discount window.
How excess reserves are used
Reserves (required and excess) serve as a liquidity buffer to cover withdrawals, interbank settlements, and unexpected loan losses. When central banks pay interest on reserves, banks may choose to leave additional funds on deposit rather than lend them, because holding reserves becomes a low-risk, interest-earning alternative.
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Programs that pay interest on reserves create a direct incentive for banks to hold balances at the central bank and can help set a floor under short-term market interest rates.
History (U.S. overview)
- Reserve requirements have been part of U.S. banking practice since the 1800s and evolved through reforms responding to banking crises.
- The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to pay interest on reserve balances. Implementation accelerated during the 2008 crisis.
- Quantitative easing (QE) after the 2008 crisis boosted reserve balances sharply; excess reserves peaked at trillions of dollars (around $2.7 trillion in 2014).
- QE and subsequent policy actions again raised reserve balances during the COVID-19 recession (surpassing $3 trillion).
- In 2020 the Federal Reserve reduced required reserve ratios to zero. That removed the formal distinction of required versus excess reserves for U.S. banks, though banks may still hold voluntary reserve balances and receive interest on them under the Interest on Reserve Balances (IORB) framework.
Factors that influence excess reserve balances
- Interest on reserves: A higher interest rate paid by the central bank makes holding reserves more attractive relative to lending.
- Monetary operations: QE and large-scale asset purchases inject reserves directly into banks’ accounts.
- Bank liquidity needs and risk management: Banks balance liquidity buffers against opportunities to earn higher returns by lending or investing.
- Opportunity cost: If lending offers higher expected returns (adjusted for risk and funding needs), banks are less likely to hold large voluntary reserves.
Common questions
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What’s the difference between required and excess reserves?
Required reserves are the mandated minimum held with the central bank; excess reserves are any balances above that minimum. -
What happens if banks keep excess reserves?
If interest is paid on reserves, banks may prefer to hold them for safety and guaranteed return. Otherwise, holding reserves has an opportunity cost compared with lending the funds. -
Are excess reserves a liability?
On a central bank’s balance sheet, reserve balances are recorded as liabilities because they represent deposits owed to commercial banks. Interest paid on those balances is an expense of the central bank.
Bottom line
Excess reserves represent liquidity that banks hold beyond regulatory minimums. In the United States, reserve requirements were set to zero in 2020, removing the formal regulatory distinction; nonetheless, central banks can and do influence banks’ reserve holdings through interest payments and monetary operations. Globally, reserve requirements and interest-on-reserve policies remain practical tools for managing bank liquidity and short-term interest rates.
Further reading
- Federal Reserve — Interest on Reserve Balances (IORB)
- International Monetary Fund — Guidance on reserve requirements and monetary operations