Excess Reserves vs Required Reserves

A bank’s reserve position is split into two categories: required reserves, the minimum balance mandated by the central bank, and excess reserves, any amount held beyond that minimum. The distinction matters because the two serve different purposes — one is regulatory, the other is a business decision. Understanding why banks voluntarily hold excess reserves reveals how modern central banks influence lending behavior without relying on reserve-requirement rules.

Required Reserves: The Regulatory Minimum

A central bank sets a required reserve ratio, typically expressed as a percentage of a bank’s deposits. Historically in the United States, the Federal Reserve required depository institutions to hold 10% of checking and savings deposits as reserves. These reserves must be held in non-lending form — either as physical cash in the bank’s vault or as a balance with the central bank (called a “reserve account”).

The requirement exists to ensure banks maintain a buffer of liquid assets. If a customer walks in and demands their deposits, the bank must be able to satisfy the withdrawal. A minimum reserve buffer also gives a central bank direct leverage: if it wants to tighten credit, it can raise the required ratio, forcing banks to set aside more deposits and reducing the pool available for lending.

Required reserves do not earn interest (historically), so holding them is a cost to banks. This cost is baked into the economics of banking: a bank passes the cost to borrowers via higher loan rates or to depositors via lower savings rates.

In March 2020, the Federal Reserve eliminated reserve requirements for most banking institutions, effectively setting the required ratio to zero. This was a major operational shift, removing the mechanical constraint on lending, though as discussed elsewhere (Reserve Requirements Abolished), the real-world impact on credit was more muted than the policy change alone might suggest.

Excess Reserves: Voluntary Holdings

Excess reserves are any balance a bank holds above the regulatory minimum. Even when reserve requirements existed, banks held excess reserves for operational reasons: to settle interbank payments, buffer against daily deposit flows, and hedge against being unable to raise funds in a crisis.

After 2008, excess reserves became the dominant feature of the US banking system. As the Federal Reserve ran massive quantitative easing programs, buying trillions in securities, the payments flowed to bank reserve accounts. Banks were not required to hold most of those reserves — they could have lent them out or deployed them into other assets — but they chose to hold them in large quantities.

This choice reflects both incentives (what the central bank pays for excess reserves) and constraints (credit demand, perceived risk, regulatory capital rules). The interplay between these factors explains modern banking behavior.

Why Banks Hold Excess Reserves Voluntarily

Even absent a regulatory minimum, banks hold excess reserves for several reasons:

Operational liquidity: Banks need ready cash to settle payments with customers and other banks. A bank cannot lend out every dollar it receives and still operate smoothly. The amount of operational liquidity varies by bank size, business model, and market volatility. During crises, this buffer rises as banks become uncertain about their ability to raise funds.

Interest payments: Since 2008, the Federal Reserve and other central banks have paid interest on excess reserves. If the rate is competitive — close to or above what banks can earn by lending or buying other short-term assets — banks are incentivized to hold reserves. In 2020–2021, the Fed paid 0.15% on excess reserves; this was higher than what banks could earn on risk-free short-term assets, so holding reserves was attractive. When the Fed raised rates in 2022, the interest on reserves rose to 4.65%, making voluntary reserve holding very profitable.

Regulatory capital rules: Beyond reserve requirements, banks face capital adequacy rules, which set minimum ratios of equity to risk-weighted assets. Central bank reserves are typically zero-risk-weighted, meaning holding reserves does not consume a bank’s capital buffer. This creates an incentive to hold reserves instead of other assets that carry risk weight. When credit risk is high or capital is tight, banks accumulate excess reserves to preserve their capital position.

Credit risk and liquidity hoarding: During financial stress, banks become uncertain about their ability to borrow in money markets or raise deposits. They accumulate excess reserves as insurance. The 2008 crisis and the 2020 pandemic both triggered sharp increases in excess reserve holdings, as banks feared a liquidity freeze.

The Spread Between Required and Excess

In a stable environment with low interest rates and abundant credit, the distinction matters less. Banks hold only slightly more than the required minimum.

In a stressed environment or when the central bank pays high rates on excess reserves, the gap widens dramatically. US excess reserves averaged under $10 billion in 2006. By 2014, they exceeded $1.6 trillion. They fell to about $150 billion by 2018 as the Fed tightened policy, then exploded to over $2 trillion again during the 2020 crisis as the Fed cut rates and expanded its balance sheet.

The fluctuation is partly mechanical (the central bank’s actions determine the size of bank reserve accounts) but partly behavioral (banks decide how much excess they want to hold given the incentives facing them).

Central Bank Policy and Excess Reserves

By paying interest on excess reserves, a central bank can discourage or encourage lending without relying on reserve-ratio rules. If the rate is high, banks are indifferent between holding reserves and lending; if the rate is low or zero, lending becomes more attractive.

This tool is more flexible than reserve requirements. A central bank can adjust the interest rate daily, whereas changing a reserve ratio requires rule changes and takes time to propagate. After reserve requirements were abolished, the interest rate on excess reserves became the primary lever for central banks to influence bank behavior via the reserve position.

When the Federal Reserve wants to tighten monetary policy, it can raise the interest on excess reserves, making it more attractive for banks to hold reserves and less attractive to lend aggressively. When it wants to ease, it lowers the rate, encouraging banks to deploy reserves into loans and other assets.

The Distinction in Practice

For a typical retail or commercial bank, the distinction is operational. Required reserves are a liability — a cost of doing business. Excess reserves are an asset — earning interest and providing liquidity insurance. A bank’s treasurer monitors the two separately: the required amount is fixed (and now, in the US, often zero), while the excess is managed as part of the overall liquidity and portfolio strategy.

For a central bank, the distinction matters because it reveals banking system stress. A sharp rise in excess reserves (even when not required) signals that banks are hoarding liquidity, suggesting credit risk is perceived as high and lending is constrained. A fall in excess reserves suggests banks are confident and deploying capital aggressively.

The balance between required and excess has shifted over time and across countries. In Europe, where central banks have not eliminated reserve requirements, required reserves remain significant. In the United States, where requirements have been zeroed, the focus is entirely on excess reserves and the interest the Fed pays on them.

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