The Federal Reserve’s Influence Over Excess Reserves

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.

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.