Excess Reserve
Excess reserves are the reserves that a depository institution holds at the central bank in excess of the amount that it is required to hold. Required reserves are the minimum balances that institutions must maintain against their deposits, and any holdings above that minimum are excess reserves. Excess reserves are the source of additional lending capacity, and their level reflects the balance between the return on holding reserves and the return on alternative uses of funds.
The reserve requirement
The reserve requirement is the fraction of deposits that institutions must hold as reserves, either as balances at the central bank or as vault cash. The requirement is set by the central bank and serves several purposes: it provides a buffer of liquid assets, it supports the stability of the banking system, and it was historically the main instrument for controlling the money supply. Many central banks have reduced or eliminated reserve requirements in recent decades, relying instead on interest rate policy.
Institutions that hold more than the required amount hold excess reserves, while those that hold less must obtain reserves from other institutions or from the central bank. The market for reserves, in which institutions with surplus reserves lend to those with deficits, determines the short-term interest rate that the central bank targets. The demand for excess reserves therefore influences the operation of monetary policy.
Determinants
The level of excess reserves depends on several factors. The interest rate paid on reserves is central: if the central bank pays an attractive rate on reserves, institutions have an incentive to hold more. The cost of obtaining reserves and the return available on alternative assets, such as loans and securities, also matter. When lending opportunities are scarce or risky, institutions may prefer to hold reserves even at a low return.
Uncertainty and liquidity preference influence excess reserves. During periods of stress, institutions hoard reserves to meet unexpected withdrawals and to reassure counterparties, and the demand for excess reserves rises sharply. Regulatory requirements, including liquidity rules, can also increase the desired level of reserves. The supply of reserves, determined by central bank operations, interacts with these demands to determine the observed level.
Role in monetary policy
Excess reserves are central to how monetary policy operates in the modern framework. When a central bank purchases assets, it creates reserves, which appear as excess reserves if the required level is unchanged. Under a system of ample reserves, the central bank controls the policy rate by adjusting the interest rate it pays on reserves, rather than by managing the quantity of reserves. This framework, adopted by many central banks, allows the policy rate to be steered even when reserves are abundant.
When reserves are abundant, the traditional relationship between reserves and lending weakens. Institutions may hold large excess reserves without expanding lending, if demand for loans is weak or if lending standards are tight. This decoupling, observed after periods of large-scale asset purchases, illustrates that reserves are not automatically lent out, and that the money multiplier is not a fixed relationship but depends on the behaviour of banks and borrowers.
Implications
High levels of excess reserves have several implications. They indicate ample liquidity in the banking system, which can support stability, but they may also signal weak lending and subdued economic activity. They affect the central bank's balance sheet and its exposure to interest rate risk, since paying interest on large reserves has fiscal consequences. They also influence the conduct of policy, requiring the central bank to use new instruments to manage short-term rates.
The level of excess reserves is therefore a useful indicator, but it must be interpreted with care. It reflects the interaction of central bank operations, regulatory requirements, and the preferences of financial institutions. Understanding why reserves are high or low requires examination of the underlying demand and supply, and of the broader conditions in credit markets, rather than the level alone.
Ample reserves and the corridor system
Under an ample reserves framework, the central bank supplies enough reserves that small changes in the supply do not move the policy rate, and it steers the rate by adjusting the interest it pays on reserves. This framework, adopted by many central banks, replaced the earlier system of scarce reserves, in which the central bank managed the quantity of reserves to target the rate. The change reflects the large balance sheets created by asset purchases and the desire for a robust method of policy implementation.
The corridor system, in which the policy rate is bounded by the rate paid on reserves and the rate charged on borrowing, provides the mechanism. The interest on reserves sets a floor, because institutions will not lend below the rate they can earn risk-free, and the lending facility sets a ceiling. Between these bounds, market rates reflect conditions in the reserve market. The system allows the central bank to control the rate even as the quantity of reserves varies with its other operations.
Quantitative easing and balance sheets
Large-scale asset purchases, often called quantitative easing, create reserves on a large scale and expand the central bank's balance sheet. These purchases are used when the policy rate is near its lower bound, to provide additional stimulus by lowering longer-term interest rates and by supporting asset prices. The resulting excess reserves are a by-product of the policy, and their level reflects the size of the purchases rather than a separate decision about reserves.
The unwinding of these balance sheets, through the redemption of assets or their sale, reduces reserves over time. The process must be managed carefully to avoid disrupting markets, and central banks communicate their plans in advance to avoid surprises. The experience of large balance sheets has changed the understanding of how monetary policy operates, and it has shown that the quantity of reserves is a less central instrument than once thought, with the policy rate and its communication taking precedence.
Monitoring and interpretation
The level of excess reserves is monitored as an indicator of liquidity conditions and of the stance of policy implementation. Very high levels suggest ample liquidity, while a decline toward the required level may indicate tightening. However, the interpretation is complicated by the fact that reserves reflect the interaction of central bank operations, fiscal flows such as tax receipts and government spending, and the preferences of financial institutions.
Analysts therefore examine a range of indicators, including money market rates, the dispersion of rates across institutions, and the volume of trading in the reserve market, to assess conditions. They also distinguish between reserves held for regulatory purposes and those held voluntarily, since the two have different implications. Careful interpretation of reserve data is essential for understanding the transmission of monetary policy and for anticipating how the central bank will respond to changing conditions.