Excess reserves represent a capital reserve which financial institutions such as banks hold. They keep more than what their overseeing regulators, internal control mechanisms, or creditors require. This is especially important for commercial banks. The reason is because the central banking authority within their jurisdiction sets their additional reserves by establishing a standard in reserve requirements. Such reserve ratios as these determine the least amounts of liquid deposits which the banks must hold in reserve. This could be cash or similar to cash instruments like Treasuries. When the banks hold more than the reserve ratio reserves require of them, it becomes excess reserves.
Financial companies may choose to hold excess reserves because it provides them with an additional safety measure. This comes in handy if there is plethora of cash withdrawals from the banks’ customers or an unanticipated loan loss which the bank must book in the form of write downs. This additional cushion boosts the security in the banking system. It is particularly crucial when economic uncertainty hits. It is also possible to improve the credit rating of a financial company when it voluntarily increases the amounts of its extra reserves. The credit ratings agencies such as Standard & Poor’s’, Moody’s, and Fitch Ratings all like to see higher reserves from financial institutions.
The United States’ Federal Reserve is the central bank for the U.S. They possess a number of tools in their toolkit for monetary normalization. The first of these is the ability to establish the fed funds rate. Besides this, they can alter the interest rate which banks receive for their required reserves and excess reserves. Interest on reserves is known by its acronym IOR, while interest on excess reserves is called by the acronym IOER.
Before October 1st of 2008, the U.S. banks did not receive any interest on their reserves. It was actually the Financial Services Regulatory Relief Act of 2006 which permitted the Federal Reserve to give an interest rate and interest to banks in this the first American instance of it. The rule originally had been set to take effect for October 1st of 2011. Because of the outbreak of the Great Recession, the government made the decision to move up the implementation timetable with the Emergency Economic Stabilization Act of 2008. This meant that for the first time ever, without warning, banks were required to keep excess reserves with the Federal Reserve.
By August of 2014, excess reserves had reached a record amount of $2.7 trillion because of the funds released by the quantitative easing program. The receipts from this program increased the reserves from $2.3 trillion as of the middle of June 2016. These QE funds came to the commercial banks from the Federal Reserve. They gave them out as reserves instead of cash. Yet the interest which the Fed doled out for the reserves became payable in cash. It also registered as an interest income to the banks that received it. This interest which the banks received in cash from the Federal Reserve would otherwise have accrued to the United States Treasury coffers.
From a historical perspective, this fed funds rate was the one for which banks would loan out money to each other. It is typically utilized as the benchmark rate for all loans based on variable rates as well. The two interest rates mentioned above, IOER and IOR, are each decided by the Federal Reserve. It is the FOMC Federal Open Market Committee which sets them. Because of these rules and laws, banks have both an incentive and an obligation to inventory excess reserves now. This is particularly the case when the market rates are under the fed funds rate. It also means that the interest rates payable on extra reserves now work as proxy for the future fed funds rate. It is only the Federal Reserve with the authority to alter this interest rate level.