What are Excess Reserves? How do Excess Reserves Work?

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What are Excess Reserves? Anyone who is not into banking might not understand the meaning of excess reserves. That does not mean that if you are not into banking, you should not know what excess reserves mean.

What are Excess Reserves?

You need to understand the meaning of excess reserve so that the next time someone says it, you will know what they are talking about. That is why we are going to be talking about excess reserves in this article today.

What are Excess Reserves?

For you to be a financial institution or organization, you have to have a financial reserve that you can use to run your financial organization. Banks and other financial institutions usually have cash reserves that are used for day-to-day purposes. An excess reserve is when the cash that is held by a financial institution, such as a bank or any other institution, exceeds the requirement that is set by the authorities.

What this means is that when a bank or any other financial institution has more cash than they need or require, the extra cash is what we call excess reserve. It is basically anytime a bank keeps more money on hand much more than what they are required to hold the extra is the excess. One of the major reasons why banks hold extra reserves is when there is a financial or commercial certainty.

How do Excess Reserves Work?

As a bank, they are mandated by law to have a limit to the amount of cash that they hold in their possession in the bank at a certain time. Banks typically receive deposits from customers and then lend that deposit to other borrowers at a higher rate to make income. A bank will not lend out all the money that it has because they need liquid cash to keep up with the expenses of running the bank.

This is why the federal government sets a minimum amount for a bank to keep in their possession at a certain time. This minimum amount of cash that they must keep is known as the reserve requirement. But when a bank exceeds this limit, the extra money is called the excess reserve. The excess reserve is not meant for lending; it is meant to be available in case of an emergency.

Why do Banks keep Excess Reserves?

From what we have explained, you should know that the Federal Reserve does not encourage or approve of banks’ keeping excess reserves. That being said, what is the reason or why do banks at times hold excess reserves in their possession in contravention of the Federal reserve minimum requirements? One of the major answers to this question is the fact that it acts as a safety net in a time when there is financial uncertainty.

When a bank discovers that the economy is uncertain or there is insurance that the bank will not be able to lay hold of enough cash for customers, it will keep excess reserves. It is the cash from the excess reserve that a bank will now fall back on in case of an emergency where cash is needed. This means that a bank simply keeps excess reserves in preparation for a rainy day.

Excess reserve typically means making sure that there is always cash out every time so that customers can make whatever transactions they like without looking for cash.

What is the Interest in Excess Reserves?

Before 2008, banks were not paid for ER in the US, but today banks are being paid for excess reserves as a result of the global financial crisis. They simply instruct the Federal Reserve to pay a rate of interest to a bank or any bank holding excess reserves. The interest being paid to banks for excess reserves is known as interest on excess reserves (IOER).

What is the Difference between Required Reserves and Excess Reserves?

As we have seen in this article, a bank’s required reserve is the minimum amount of cash a bank must keep on hand which is determined by the Federal Reserve. On the other hand, the excess reserve is the extra amount of cash that a bank keeps above the minimum dictated by the federal reserve.

Another difference is that the required reserve ensures that a bank has enough cash to carry out its normal day-to-day financial obligations. The excess reserve is kept in a bank in case of a financial or certainty emergency to protect the bank from unexpected financial loss.

What is the Difference Between Free Reserves and Excess Reserves?

A free reserve is part of the excess reserve that does not include the reserves borrowed from the Central Bank. It does not mean that if a bank has a higher level of excess reserves, it will also have high levels of free reserves. “Free cash” is also described as the amount of cash that a bank can actually lend out. This means that if there is a shortage of fuel reserves, the bank cannot lend out much.

Frequently Asked Questions 

What are examples of ER?

A typical example of an excess reserve is if a man keeps 20 million in deposits and his reserve ratio is 10% of the entire money the bank keeps. The required reserve of that bank is 2 million dollars. Anything above the 2 million dollars the bank keeps is considered an excess reserve. This means that if a bank is required to keep two million as an excess reserve if they keep 3 million then 1 million is the excess reserve.

What is ER on balance sheets?

If you are using a balance sheet to calculate an excess reserve, all you need to do is to subtract the required reserve from the legal reserves held by the bank. After subtracting the required reserve from the excess reserve, the figure you get is your excess reserve. If the answer is zero, then there is no excess reserve kept by that bank.

How does a bank get ER?

Banks can easily get excess reserves in the United States of America by simply making a short-term loan on the federal funds market to another bank that is short of reserve funds. This means that a bank can get excess reserves from another bank when they are short on its reserve requirements.

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