Interest on excess reserves

In banking, excess reserves are bank reserves in excess of a reserve requirement set by a central bank.

In the United States, bank reserves for a commercial bank are held in part as a credit balance in an account for the commercial bank at the applicable Federal Reserve bank (FRB). This credit balance is not separated into separate "minimum reserves" and "excess reserves" accounts. The total amount of FRB credits held in all FRB accounts for all commercial banks, together with all currency and vault cash, form the M0 monetary base. Holding excess reserves has an opportunity cost if higher risk-adjusted interest can be earned by putting the funds elsewhere. For banks in the U.S. Federal Reserve System, this earning process is accomplished by a given bank by making short-term (usually overnight) loans on the federal funds market to another bank that may be short of its reserve requirements. Other banks may instead choose, however, to hold their excess reserves to facilitate upcoming transactions or to meet contractual clearing balance requirements.

On October 3, 2008, Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the Federal Reserve banks to begin paying interest on excess reserve balances ("IOER") as well as required reserves. The Federal Reserve banks began doing so three days later. Banks had already begun increasing the amount of their money on deposit with the Fed at the beginning of September, up from about $10 billion total at the end of August, 2008, to $880 billion by the end of the second week of January, 2009. In comparison, the increase in reserve balances reached only $65 billion after September 11, 2001 before falling back to normal levels within a month. Former U.S. Treasury Secretary Henry Paulson's original bailout proposal under which the government would acquire up to $700 billion worth of mortgage-backed securities contained no provision to begin paying interest on reserve balances.

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