Excess Reserves

Excess reserves are the funds that banks keep in their accounts at the central bank, together with cash in their vaults where that counts, over and above the amount the central bank requires them to hold. Total reserves equal required reserves plus excess reserves. A bank with deposits that attract a requirement of 100 and a balance at the central bank of 130 has excess reserves of 30.

For most of the twentieth century, excess reserves were small, because they earned nothing and banks lent out or invested any surplus. That changed after the 2008 financial crisis, when central bank asset purchases created reserves on a vast scale and central banks began paying interest on them. Excess reserves are now a permanent and very large feature of the banking systems of the major economies, and the way they are managed is central to how monetary policy is carried out.

Reserves are a liability of the central bank, and only the central bank can create or destroy them. An individual bank can reduce its reserves by lending them to another bank or buying an asset, but the reserves simply move to the account of another bank. The total held by the banking system is therefore determined by the central bank's own balance sheet: its asset purchases and lending add reserves, while its asset sales, maturing holdings, and growth in banknotes or government deposits remove them.

Under quantitative easing, central banks bought government bonds and other assets and paid for them by crediting banks' reserve accounts. Since the reserve requirement did not rise in step, nearly all the new balances were excess. In the United States, excess reserves rose from a few billion dollars before 2008 to well over two trillion dollars within a few years. The reverse process, quantitative tightening, drains them.

When reserves were scarce, central banks steered short-term rates by making small daily adjustments to their supply through open market operations. With abundant excess reserves that method no longer works, since banks with surplus funds would push the overnight rate towards zero. Central banks instead pay interest on reserves. No bank will lend at much less than it can earn risk-free at the central bank, so the rate paid acts as a floor under market rates.

The Federal Reserve began paying interest on reserve balances in October 2008 and in 2019 confirmed that it would continue to operate with ample reserves. In the euro area, banks can hold surplus funds in their current accounts or place them in the standing deposit facility of the European Central Bank, whose rate became the effective policy interest rate. When that rate was negative, the ECB for a time exempted part of banks' excess holdings from the charge through a two-tier system.

In March 2020 the Federal Reserve reduced reserve requirement ratios to zero. Since then no reserves are required, so in a strict sense every dollar of reserves is excess, and the distinction has lost its practical meaning there. In 2021 the Fed replaced its separate rates on required and excess reserves with a single interest rate on reserve balances. Analysts now speak of whether reserves are abundant, ample or scarce in relation to banks' demand for them, which is driven by payment needs, internal liquidity targets and rules such as the liquidity coverage ratio, under which central bank balances count as top-quality liquid assets.

Judging that level is difficult. In September 2019, after two years of balance sheet reduction, overnight repo rates in the United States spiked sharply, a sign that reserves had become scarcer than expected, and the Fed resumed adding them.

Textbook accounts of the money multiplier suggest that banks lend out excess reserves, so that a rise in reserves leads to a multiplied rise in the money supply. The experience after 2008 did not fit this picture: the monetary base grew several times over while broad money and prices grew modestly. Banks do not lend reserves to customers; they create deposits when they lend, and their willingness to do so depends on capital, credit demand and the profitability of loans, not on the quantity of reserves. With interest paid on reserves, holding them is also no longer costly. Central banks, including the Bank of England, have published explanations of money creation along these lines.

Large excess reserves raise several issues. Interest paid on them is a cost to the central bank, and when policy rates rose sharply after 2021 several central banks recorded losses, because their bond holdings yielded less than they paid to banks. Some economists have proposed paying no interest on a portion of reserves, in effect a higher unremunerated requirement; the ECB has paid no interest on minimum reserves since 2023. Others ask whether an abundant-reserves system weakens the interbank market and gives the central bank too large a footprint in finance, or whether a return to scarce reserves would bring back the volatility that the floor system removed.

• Federal Reserve Board: reserve balances
• European Central Bank