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. 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
Just as you earn interest on your savings account balance, banks also earn interest on their required reserves and excess reserves. The Federal Reserve sets these interest rates.
