Why Are Banks Holding So Many Excess Reserves?

That’s the question posed by a recent staff report from Todd Keister and James McAndrews at the New York Federal Reserve.

Their answer? Because the Federal Reserve has been really, really busy.

Keister and McAndrews begin their analysis by documenting the remarkable increase in excess reserves since the fall of Lehman:

Since September 2008, the quantity of reserves in the U.S. banking system has grown dramatically, as shown in Figure 1. Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented rise in excess reserves.

Excess ReservesSome observers have expressed two concerns about the spike in excess reserves:

  • First, some have wondered whether the spike in excess reserves means that banks are refusing to land. Keister and McAndrews, however, are skeptical of that concern, arguing that “the quantity of excess reserves … reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or the economy more broadly.” In short, the excess reserves reflect Fed actions, not bank lending decisions.
  • Second, some have expressed concern that the excess reserves are fuel for future inflation (a topic I’ve been meaning to address for some time, but I keep getting distracted by health care). The authors argue, quite rightly in my view, that this concern is also misplaced. The key reason is that the Federal Reserve gained a new power last fall — the ability to pay interest on reserves. That ability breaks the traditional link (in U.S. monetary policy) between reserves, bank lending, and inflationary pressures.

The whole paper is well worth a read for its simple walk-through of how various Fed actions may affect bank balance sheets, reserves, and inflationary pressures.

9 thoughts on “Why Are Banks Holding So Many Excess Reserves?”

  1. Can you explain how the paying of interest on reserves will break the link with bank lending and inflationary pressures? The education would be helpful. thanks

    1. Sure. I will probably write about this at greater length sometime in the future, but here’s the gist: Back in the old days, if the Fed did an open-market operation to buy some Treasuries, banks would find themselves with some new cash. They couldn’t earn any interest at the Fed, which then paid no interest, so the banks would try to lend that money out. Interest rates would fall, economy would get a boost, and, if done to excess, inflation would rise.

      In the new system, the Fed could do the same open-market operation, but the money wouldn’t necessarily get lent by the banks. If the Fed offered a high enough interest rate on reserves, the banks would just turn around and park the money there.

      In the old system, high reserves would thus signal money that the banks wanted to lend, but hadn’t injected into the economy yet. Under the new system, high reserves might just mean that the Fed is paying a high-enough interest rate .

      1. So I’ll, bite. Why doesn’t the Fed lower the interest rate on reserves? Wouldn’t this go to lending?

  2. Thank you for linking to this report.

    Unfortunately, this report ignores the effect of the interest being paid to banks for their reserves. That money will enter the system and, in all likelyhood, be held by banks as excess reserves. While the Fed may have the ability to prevent those excess reserves from being paid out in the form of new loans, the Fed currently doesn’t have the ability to prevent those profits from being paid out to bank shareholders as dividends. As that money enters the system there could be a boom of private lending that would enjoy a competitive advantage over banks with arbitrarily high interest rates. Inflation would likely follow as reserves bleed into M1. There’s no such thing as a free lunch.

  3. The Fed paying interest on reserves does change the game somewhat, but the essential dynamics viz-a-viz potential inflationary are unaffected. If there are excess reserves that banks want to employ to boost lending, then the inflationary impulse remains. The effect of paying interest is to diminish or eliminate the desire to boost lending.

    In effect, paying interest on reserves gives the Fed a more nuanced approach to shrinking the mountain of excess reserves, but it does not eliminate the problem of the potential inflationary impulse unless the Fed is willing to leave the mountain alone for a long time. That seems unlikely.

    That, at least, is how it appears at the moment.

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