Anytime a bank keeps more money on hand than is required by regulation, it is known to have excess reserves. Banks typically hold excess reserves in times of financial uncertainty or if they believe interest rates will fall.
Here’s a closer look at how excess reserves work, why they are held, and what they mean for you as a banking customer.
Definition and Examples of Excess Reserves
Excess reserves refer to the surplus of cash a bank holds in its vault or Fed account beyond what is required by the Federal Reserve to be on hand.
For example, suppose a bank is required to keep 10% of its deposits in reserve. If a bank has 12% in its reserve, then it has an excess reserve of 2%. The bank is free to use these funds for any purpose.
How Do Excess Reserves Work?
Banks make money by taking in deposits from customers, then lending that money back out to others at a higher interest rate. They can’t lend out all their money, though, because they need liquid cash on hand to pay their bills and fulfill withdrawal requests from customers.
The Federal Reserve tells depository institutions the minimum amount of money they must keep available for financial obligations. This minimum is known as the reserve requirement. Any money banks keep over this limit is considered excess reserves.
Banks don’t lend excess reserves to businesses or consumers. Rather, they hang onto them in case of 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 keeps over the required minimum. For example, suppose a bank has $20 million in deposits. If its reserve ratio is 10%, then it’s 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 may be wondering “What’s the significance of excess reserves? Why do banks use them?” At their core, excess reserves act as a safety net for banks during times of economic uncertainty. The bank can 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 headed your way, you’d stock up at the grocery store and fill your pantry with all types of necessities to prepare for the unexpected. Banks do the same thing when they hold excess reserves.
Excess reserves in the U.S. doubled early in the pandemic, soaring from $1.5 trillion in February 2020 to $3.2 trillion in May 2020. This is a prime example of how banks prepared for the financial uncertainty of the sweeping event.
As a banking customer, you usually don’t know when your institution has excess reserves. All you know is that you can withdraw or transfer money whenever you need it. In a sense, this is what having excess reserves is all about—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 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 fulfill 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 keep a certain percentage of their deposits on reserve in a vault or 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.
- Excess reserves are the additional amount of money a bank keeps on hand over the reserve requirement.
- Excess reserves are important because they act as a safety net during times of economic uncertainty, ensuring the bank has enough money on hand to pay bills and honor withdrawals.
- You can calculate excess reserves by subtracting a bank’s required reserves from its total reserves.
Federal Reserve Bank of San Francisco. “I Noticed That Banks Have Dramatically Increased Their Excess Reserve Holdings. Is This Buildup of Reserves Related to Monetary Policy?” Accessed Jan. 26, 2022.
Federal Reserve Bank of St. Louis. “Excess Reserves of Depository Institutions.” Accessed Jan. 26, 2022.