how excess reserves are used
reserves are designed to be a safety buffer for banks who might not anticipate the need for extra capital in their daily operations the idea of excess reserves was created alongside an incentive called interest on excess reserves in which the federal reserve paid banks interest on funds that exceeded reserve requirements financial institutions that carry excess reserves are thought to have an extra measure of safety in the event of sudden loan loss or significant cash withdrawals by customers history of excess reserves in the u s reserves have been a part of banking in the u s since the 1800s state laws enacted after a real estate bubble and bad banking practices caused a crash in 1837 began requiring reserves 1 these requirements changed over time to deal with other financial industry and economic circumstances eventually leading up to the monetary policies of the late twentieth and early twenty first centuries the financial services regulatory relief act of 2006 authorized the federal reserve to pay banks a rate of interest for the first time suddenly and for the first time in history banks were incentivized to hold reserves with a central bank 2 the rule was to go into effect on oct 1 2011 however the great recession advanced the decision following the passing of the emergency economic stabilization act of 2008 in the years following excess reserves hit a record 2 7 trillion in august 2014 due to quantitative easing qe payouts after the great financial crisis and the recession it caused 3 between january 2019 and february 2020 excess reserves ranged between 1 3 trillion and 1 6 trillion proceeds from qe were paid to banks by the federal reserve in the form of reserves not cash banks kept this money in reserve to allow it to gain interest the image below demonstrates the increase in reserve balances after qe and ioer were implemented note the sudden steep climb in excess reserves in the shaded area that indicates a recession where qe was used levels remained elevated after qe was discontinued in 2014 although it did decline suggesting that banks continued to take advantage of the interest offered by the fed on excess reserves federal reserve bank of st louisthe mini recession caused by the covid 19 pandemic and qe implemented by the fed once again increased the excess reserve balance to more than 3 2 trillion although interest rates on reserves had dropped from a high of 2 4 in april 2019 to 0 1 in march 2020 4in 2020 the federal reserve eliminated requirements for u s banks to hold reserves by dropping the required reserve ratio to zero when the fed removed reserve requirements it implemented a program in which voluntary reserve balances would be paid interest this is called interest on reserve balances iorb which is used to help create a floor for the rates that banks charge each other overnight 5factors that affected excess reserve balancesmany factors affected banks use of excess reserves one of the main factors is the interest paid on excess reserves when the fed implemented ioer the interest it paid on the excess reserves reduced the forgone interest costs banks incurred for holding funds in reserve the fed was pumping money into the economy via quantitative easing into reserve accounts which increased the amount banks held instead of using the money to issue loans to consumers and businesses the banks left the money in reserve to act as a cost buffer another factor that determined how much banks kept in excess reserves was their bottom line a bank needs to manage its reserves to maintain liquidity and cover the transactions it anticipates in the short term so banks kept as much as they were required to in reserve and then determined if they benefitted financially from keeping amounts above that requirement 6