Meet the Author

Ben R. Craig |

Senior Economic Advisor

Ben R. Craig

Ben Craig is a senior economic advisor in the Research Department. His principal fields of activity are the economics of banking and international finance.

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Meet the Author

Matthew Koepke |

Research Analyst

Matthew Koepke

Matthew Koepke is a former research analyst in the Research Department of the Federal Reserve Bank of Cleveland.

04.29.11

Economic Trends

The Federal Reserve’s Influence over Excess Reserves

Ben Craig and Matthew Koepke

As the economy continues to emerge from the recession, it is not yet clear how sustainable the recovery is. One concern is the strength of bank lending and banks’ apparent preference to hold reserves instead of lending to consumers and businesses. Banks are required to hold a percentage of their customers’ transaction accounts as reserves at the Federal Reserve, but reserve balances greater than those required are considered to be excess reserves. The level of excess reserves has expanded more than twentyfold since September 2008, leaving many to question why have banks have decided to hold such high levels of excess reserves instead of lending them out. In actuality, banks have little control over the aggregate level of excess reserves—changes in excess reserves are driven by changes in the Federal Reserve’s balance sheet.

The Federal Reserve’s credit-easing policy tools have had a significant impact on the level of excess reserves. The two largest credit-easing tools are the Fed’s purchases of long-term treasuries and its purchases of federal agency debt and mortgage-backed securities. As a result of these purchases, the levels of securities on banks’ balance sheets have declined and their levels of excess reserves have risen. (When the Fed buys securities, it buys them from banks by crediting their accounts at the Fed, which increases the banks’ reserve balances.) Since September 2008, the levels of security purchases on Federal Reserve’s balance sheet have increased from $3.7 billion to the current level of $1.97 trillion.

The Fed’s purchases of securities have also increased level of liabilities on its balance sheet. Currently, the largest component of the Federal Reserve’s liabilities is excess reserves. Since the Fed began buying long-term securities in September 2008, the level of excess reserves has grown from $68.7 billion to its current level of $1.47 trillion. The increase in asset purchases and the subsequent increase in excess reserves illustrates the lack of control that banks have over the aggregate level of excess reserves in the banking system and shows that changes in excess reserves are driven by changes in the Federal Reserve’s balance sheet.

While banks cannot control the overall level of excess reserves, there are a several ways they can reduce the level of excess reserves on their own individual balance sheets. They can lend excess reserves to other banks in the federal funds market, they can lend them to consumers or businesses, or they can purchase securities. Each of these outlets has been constrained for various reasons since the recession.

Lending in the federal funds market has been constrained two factors. In October of 2008, the Federal Reserve began paying interest of 25 basis points on excess reserves. Before that time, banks sought to minimize their holdings of excess reserves by making interbank loans in the federal funds market. This new policy, coupled with the effective federal funds rate declining to under 25 basis points in November 2008, created a disincentive for banks to lend in the overnight market.

Since the decline in the effective federal funds rate and introduction of interest on excess reserves, activity in the federal funds market has declined significantly. One measure of how active banks are in the federal funds market is reserve velocity. Reserve velocity measures how quickly a unit of reserves is traded in a single day; thus a reserve velocity of 100 implies that a unit of reserves is traded 100 times in a day. Because the current rate paid on excess reserves exceeds the rate a bank would receive in the federal funds market, the reserve velocity has fallen from its peak in December 2007 of 353 to 2.4 as of December 2010. The lack of incentive to lend excess reserves to other banks explains why banks with high levels of excess reserves are choosing to hold reserves instead of lending them to other banks.

Banks’ incentives to purchase securities or to lend excess reserves to consumers or businesses has also been diminished by the low interest rate environment. Banks are likely to hold excess reserves until there is more certainty as to when the Federal Reserve will begin to unwind its asset purchases and increase interest rates. Banks are unlikely to purchase new longer-term securities because they are likely to incur losses on those securities if interest rates rise. Moreover, banks would prefer to lend to borrowers when they can earn a high net-interest margin. As of December 2010, 63.5 percent of loans secured by 1-4 residential properties had a maturity greater than three years. Consequently, banks will be apprehensive to lend until there is more certainty about when the Federal Reserve will begin to sell its security holdings, how long it will take to sell them, and what the impact on interest rates will be.

On the surface, the large increase in excess reserves makes it appear that banks have significantly tightened their lending standards and are hoarding reserves, but in reality the increase in excess reserves has been a result of the Federal Reserve’s asset purchases. Moreover, the incentives to reduce those reserves through the usual channels—the federal funds market, consumer and business loans, and security purchases—have been greatly reduced by current conditions.