Banks’ holdings of excess reserves; Behavior of consumption: Cleveland Fed researchers

The lower cost of holding excess reserves has made them much more attractive to banks, say Cleveland Fed researchers

Excess reserves -- cash funds held by banks over and above the Federal Reserve’s requirements -- have grown dramatically, from $1.9 billion in August 2008 to $2.6 trillion in January 2015. Holding excess reserves is now much more attractive to banks because the cost of doing so—in the form of foregone interest—is significantly lower than it was before the financial crisis, according to Federal Reserve Bank of Cleveland researchers Ben Craig and Matthew Koepke.

Banks actively manage their reserves, comparing what they might earn by parking the funds in an alternative asset (“forgone interest”) with the cost of last-minute borrowing to cover an unforeseen shortfall in required reserves. Craig and Koepke say the risk-adjusted return on alternative assets has been low compared to the return on safer excess reserves, which now earn interest (25 basis points since December 2008) paid by the Federal Reserve. So banks are holding these assets as cash instead of buying securities or cycling the liquidity through the financial system in the form of loans.

The fact that banks are holding excess reserves in response to the risks and interest rates that they face suggests that the reserves are not likely to cause large, unexpected increases in bank loan portfolios, say Craig and Koepke, assuming current conditions remain unchanged. However, the researchers also say it is not clear what banks are likely to do in the future when the perceived conditions change.

Read Excess Reserves: Oceans of Cash

Services play a large role in determining the level of overall consumption, say Cleveland Fed researchers

Consumption -- which represents approximately 70 percent of GDP -- is typically less volatile than GDP, falling by less in downturns and rising by less in recoveries. While consumption has three components -- durables, nondurables, and services – it is services that largely determine the path for the level of aggregate consumption, according to Federal Reserve Bank of Cleveland researchers Daniel Carroll and Amy Higgins.

Durables consumption is the most volatile, declining sharply during recessions and rebounding strongly during recoveries. But the researchers note that durables make up the smallest share of aggregate consumption and therefore have the smallest impact on the level of consumption. Nondurable goods represent a larger share of consumption than durables, but their share has been falling, from roughly 33 percent in 1982 to 22 percent today.

Meanwhile, the share of services has grown -- to roughly two-thirds of aggregate consumption. Services tend to be less volatile, say Carroll and Higgins, and their large share means they play a much larger role in determining the level of overall consumption.

Read The Behavior of Consumption in Recoveries

Implementing Dodd–Frank, reforming Fannie Mae and Freddie Mac, and studying what banks are doing to keep financial data safe are among the policy issues that are likely to continue to be priorities for Congress in 2015, says Federal Reserve Bank of Cleveland policy analyst Ericka Thoms in Forefront, the Bank’s policy publication.

Read Policy Watch: Preventing Crises and Protecting Pocketbooks

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892