Excess Reserve Ratio: A Key Factor in Monetary Policy

The excess reserve ratio is a crucial component of monetary policy, and it's essential to understand its role in regulating the money supply. A higher excess reserve ratio means that banks hold more reserves, which can limit lending and economic growth.

In simple terms, the excess reserve ratio is the amount of excess reserves held by commercial banks as a percentage of their deposits. This ratio is set by central banks, such as the Federal Reserve in the United States, to control the money supply and manage inflation.

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The excess reserve ratio is a crucial concept in banking, and it's actually quite simple once you understand it. Excess reserves are capital reserves held by a bank or financial institution above amounts required by regulators, creditors, or internal controls.

Commercial banks have to meet standard reserve requirement ratios set by central banking authorities. These ratios determine the minimum liquid deposits, such as cash, that must be in reserve at a bank.

Excess reserves are measured against these required reserve ratios, and more is considered excess.

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Reserves have been a part of banking in the U.S. since the 1800s, with state laws requiring reserves after a real estate bubble and bad banking practices caused a crash in 1837.

The Financial Services Regulatory Relief Act of 2006 marked a significant shift, authorizing the Federal Reserve to pay banks a rate of interest for the first time. This created an incentive for banks to hold reserves with a central bank.

Excess reserves hit a record $2.7 trillion in August 2014 due to quantitative easing payouts after the Great Financial Crisis.

The Federal Reserve eliminated requirements for U.S. banks to hold reserves in 2020 by dropping the required reserve ratio to zero, implementing a program of interest on reserve balances (IORB) to create a floor for overnight rates.

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Before the crisis, the banking system had a stable level of reserves, growing at an annual average of 3.0 percent from 1959 to just before the financial crisis.

The total amount of reserves was set by the Federal Reserve through open-market operations. This helped to stabilize the federal funds rate.

Excess reserves as a percent of total reserves in the banking system were nearly constant, rarely exceeding 5.0 percent. This stability was a key characteristic of the pre-crisis banking system.

Before the crisis, banks could obtain additional funds through overnight loans in the federal funds market. This market allowed banks with extra reserves to lend to other banks.

There were no interest payments on excess reserves, whether they were held as vault cash or in a Fed account. This meant that banks didn't earn interest on their excess reserves.

Only in times of extreme uncertainty and economic distress did excess reserves rise significantly as a percent of total reserves.

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The Federal Reserve's expansion of excess reserves has been a significant factor in the banking system's response to financial crises. This expansion has led to a substantial increase in the amount of excess reserves held by banks.

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In 2008, total reserves in the banking system expanded by 326.9 percent, and another 389.6 percent in 2009. This rapid growth was largely due to the Fed's credit-easing policies, including lending to financial institutions and purchasing long-term securities.

The Fed's purchase of federal agency debt and mortgage-backed securities was a key factor in the expansion of excess reserves. By January 2015, the Fed held just over $1.8 trillion dollars of agency debt and mortgage-backed securities and an additional $2.5 trillion of Treasury securities.

As a result of the Fed's actions, the amount of excess reserves in the banking system expanded greatly. The increased demand for reserve assets was matched by the Fed's willingness to supply them, resulting in a significant increase in the banking system's liquidity.

The expansion of excess reserves has had a notable impact on the banking system's lending practices. Despite massive infusions of liquidity, banks' lending has increased only slowly, and after a long period of decline. This suggests that banks are holding these assets as cash instead of cycling the liquidity through the system in the form of loans.

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The Current Environment is vastly different from what it was before the 2008 financial crisis. Since December 2008, the Federal Reserve has paid interest on all reserves, a rate of 25 basis points.

Banks used to park their cash in the federal funds market for short periods, but now that rate has lagged behind the interest rate paid by the Federal Reserve for excess reserves, hovering between 7 and 20 basis points.

The opportunity cost of holding excess reserves has also decreased, as other short-term parking places like three-month Treasury bills have yielded less than the Fed pays. This makes holding reserves a more attractive option for banks.

The Federal Reserve's new policy has resulted in a significant decrease in the marginal cost of excess reserves. The perceived risk of counterparty default has lessened since the height of the crisis, but it still exceeds its pre-crisis level.

Holding liquid assets is subject to decreased short-run inflation risks, which are currently at an all-time low. This has led to a shift in banks' preferences toward holding large balances of excess reserves.

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The excess reserve ratio is a monetary policy tool used by central banks to control inflation and stabilize the economy. Central banks require commercial banks to hold a certain percentage of their deposits in reserve rather than lending them out.

This reserve requirement is set by the central bank and is typically a percentage of the bank's total deposits. For example, if the reserve requirement is 10%, a bank with $100 million in deposits would need to hold $10 million in reserve.

The excess reserve ratio is the amount of excess reserves held by commercial banks above the required reserve level. It's calculated by dividing the excess reserves by the required reserves.

Commercial banks can use excess reserves to make new loans or investments, which can help stimulate economic growth. In times of economic downturn, central banks can lower the reserve requirement to encourage banks to lend more and boost economic activity.

The excess reserve ratio can have a significant impact on the money supply and interest rates. As banks hold more excess reserves, they may not need to borrow as much from the central bank, which can reduce the money supply and lower interest rates.

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The simplicity of the excess reserve ratio hides the difficulty of predicting how banks will behave in its presence. Unfortunately, understanding this behavior is crucial for making informed policy decisions.

Banks are holding excess reserves in response to risks and interest rates, suggesting that these reserves won't lead to large, unexpected increases in loan portfolios. However, it's unclear what banks will do when conditions change or which conditions will trigger a massive change in their use of excess reserves.

Recent history is of little help in determining this question, as no balances this big have been seen in recent times. The Federal Reserve has no easy policy choices, particularly in the absence of a large body of accepted theory on how banks will handle their excess reserves under changing conditions.

The Great Depression provides a cautionary lesson. In 1936, US banks' reserves accumulated to record levels, and while there wasn't a dramatic increase in loans, the Federal Reserve increased the reserve requirement, which led to a dramatic reduction in loan portfolios.

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Excess reserves are still a viable tool in some economies, as demonstrated by the International Monetary Fund's guidance for central banks on using reserves and excess reserves in their operations.

The use of excess reserves to ensure bank liquidity is not unique to the US, and other countries continue to employ this strategy.

In fact, the International Monetary Fund publishes guidance for central banks on using reserves and excess reserves in their operations.

Central banks in other countries may still use excess reserves to ensure bank liquidity.

Here are some key facts about the use of excess reserves in other economies:

The use of excess reserves is an important tool for central banks to maintain liquidity in the economy, and it's not limited to the US.

Paying interest on excess reserve balances has been claimed to help guard against inflationary pressures by central bank researchers. This is because it allows the central bank to raise market interest rates without changing the quantity of reserves, thus reducing lending growth and curbing economic activity.

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Nobel-prize winning economist Eugene Fama argues that paying interest on reserves has increased the supply of short-term debt, which would increase bond yields through demand/supply effects.

Research suggests that the post-GFC low interest-rate environment has persisted, not because of the Federal Reserve's actions, but due to the demand for risk-free assets caused by the post-crisis 'flight to quality'.

Paying interest on reserves has been argued to protect against hyperinflation of the US dollar by Nobel-prize winning economist Eugene Fama.

Predicting how banks will behave with excess reserves is a complex task. The Federal Reserve's balance sheet and excess reserves have a one-to-one correspondence, but understanding bank behavior is crucial for policy decisions.

Banks are holding excess reserves due to risks and interest rates, which suggests they won't cause large loan portfolio increases. However, it's unclear what they'll do when conditions change or which conditions will lead to a massive change in their reserve use.

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Recent history isn't much help in determining this question, as no balances this big have been seen in recent times. The Federal Reserve might consider a policy change to remove excess reserves as a safety measure.

Raising the reserve requirement, charging interest on excess reserves, or removing liquidity from the system could be options. However, history shows that such actions can have unintended consequences.

In 1936, US banks accumulated record levels of reserves, and although loan levels didn't increase dramatically, the Federal Reserve increased the reserve requirement. This led to a dramatic reduction in loan portfolios, which some argue contributed to the 1937 recession.

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