What it means
Banks must keep a portion of customer deposits as reserves rather than lending them out. Anything held above that legal minimum is excess, and the bank is free to decide what to do with it.
For most of banking history excess reserves were small, because idle cash earned nothing and every dollar left at the central bank was a dollar not earning a lending margin. That changed once central banks began paying interest on reserve balances, which turned holding reserves into a genuine investment choice rather than a wasted opportunity.
The size of the system's excess reserves is driven far more by central bank policy than by individual bank decisions. Large-scale asset purchases push newly created reserves into the banking system, and reserve requirements have in several countries been cut to zero, so almost all reserves held are technically excess.
Excess reserves matter to people outside banking for two reasons. They shape how willing banks are to extend credit, which feeds straight into loan availability for businesses, and the rate paid on them sets a floor under short-term market rates, because no bank will lend to another below what it can earn risk-free at the central bank.
It is a mistake to read a high level of excess reserves as banks refusing to lend. Individual banks can pass reserves to each other but cannot make them disappear from the system as a whole, so the aggregate total is largely fixed by the central bank rather than by lending appetite.
In practice
Real-world examples
Example 1
A mid-sized commercial bank builds excess reserves ahead of a quarter-end regulatory reporting date, because supervisors assess its liquidity position on that date. Its treasurer accepts a slightly lower return for two weeks in exchange for a cleaner reported liquidity ratio.
Example 2
After a wave of deposit withdrawals hits a competitor, a savings bank raises its excess reserves from $40,000,000 to $180,000,000 as a precaution. The cost is real, roughly $6,160,000 of forgone lending margin over a year at a 4.4% spread, but the board treats it as insurance against a run.
Example 3
A central bank launches an asset purchase programme and buys $50,000,000,000 of government bonds from banks. The banks receive reserves in exchange, system-wide excess reserves jump, and short-term interbank rates settle close to the rate paid on those reserves.
Think of it
Imagine driving a car with a fuel tank that is legally required to be at least one-quarter full. If you fill it to three-quarters, that extra half-tank is your excess reserve. It gives you peace of mind for unexpected detours, even though you do not strictly need it to reach your immediate destination.
Formula
Calculation
Excess reserves = Total reserves held - Required reserves, where Required reserves = Reservable deposits x Required reserve ratio.
A bank holds $850,000,000 on deposit at the central bank. It has $6,000,000,000 of reservable customer deposits and the required reserve ratio is 3%, so required reserves are $6,000,000,000 x 3% = $180,000,000.
Excess reserves are therefore $850,000,000 - $180,000,000 = $670,000,000. If the central bank pays 4.4% a year on reserve balances, that excess earns $670,000,000 x 4.4% = $29,480,000 of interest over a full year. That figure is the hurdle any new lending has to beat, since a loan book yielding less than 4.4% after expected credit losses would leave the bank worse off than doing nothing.Case study
Seen in the real world
Harbourline Savings Bank is an illustrative and clearly fictional example used to show how the trade-off is argued in a real treasury committee. It held $850,000,000 of reserves against $6,000,000,000 of deposits with a 3% requirement, leaving $670,000,000 of excess earning 4.4%, or $29,480,000 a year.
The lending team wanted $300,000,000 of that redeployed into small business loans yielding 7.2%, an extra 2.8 percentage points, or $8,400,000 of additional annual income before credit losses. The treasurer's counter-argument was that expected losses on the portfolio ran at about 1.5% a year, or $4,500,000, and that the loans could not be sold quickly if depositors left.
The committee compromised on $150,000,000, keeping the rest liquid until deposit behaviour stabilised. The illustrative point is that excess reserves are not idle by accident, they are the price a bank pays for being able to survive a bad fortnight.
Watch out
Common mistakes
- Reading high excess reserves as proof that banks are hoarding cash and refusing to lend, when the aggregate level is mostly determined by central bank operations.
- Confusing excess reserves with a bank's capital, since reserves are an asset held in cash while capital is the shareholders' stake on the other side of the balance sheet.
- Assuming a bank can lend out its excess reserves and thereby reduce system reserves, when lending simply moves reserves between banks.
Questions
People also ask
Do excess reserves earn interest?
In most major economies yes, since central banks pay an administered rate on reserve balances, and that rate anchors short-term money market rates.
What is the difference between required and excess reserves?
Required reserves are the legal minimum calculated from deposits, while excess reserves are everything held above that minimum.
Why would a bank hold more reserves than it needs?
For liquidity insurance against deposit outflows, to satisfy internal or regulatory liquidity ratios, and because the return on reserves may compare well with risky lending once credit losses are allowed for.