Why Are Banks Holding So Many Excess Reserves?

by: Donald Marron

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 lend. 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.