Free Reserves
Free reserves are the monetary reserves that a bank holds in excess of required reserves, minus reserves borrowed from the central bank. More free reserves can mean more available bank credit, which in theory lowers the cost of borrowing and leads to inflationary pressures. Free reserves rose to unprecedented levels following the financial crisis, when the Federal Reserve offered to pay interest on banks' excess reserves. As of March 26, 2020, reserve requirements for banks of all sizes went down to 0%. Under fractional reserve banking, commercial banks can only hold a limited amount of their total funds in a liquid form at any given time. Free reserves are the monetary reserves that a bank holds in excess of required reserves, minus reserves borrowed from the central bank. Free reserves are the reserves a bank holds in excess of required reserves, minus reserves borrowed from the central bank. For example, banks with less than $16 million had no reserve requirements, banks with between $16.9 million and $127.5 million were required to hold only 3% in reserve, and banks that had over $127.5 million were required to hold 10% in reserve.
What Are Free Reserves?
Free reserves are the monetary reserves that a bank holds in excess of required reserves, minus reserves borrowed from the central bank.
How Free Reserves Work
Under fractional reserve banking, commercial banks can only hold a limited amount of their total funds in a liquid form at any given time. In other words, not all deposits are kept on hand in cash; most are lent out or otherwise invested. U.S. federal law requires banks to hold a certain portion of their funds in cash vaults or in Federal Reserve Bank accounts. These reserve requirements vary based on the size of the bank. Typically, banks were required to hold anywhere between 3% and 10% of their money in reserve. For example, banks with less than $16 million had no reserve requirements, banks with between $16.9 million and $127.5 million were required to hold only 3% in reserve, and banks that had over $127.5 million were required to hold 10% in reserve.
Subtracting borrowed reserves from excess reserves yields a bank's free reserves, which are available to be lent out. This is typically how a bank makes money--by investing its account holders' dollars--yet also what got it in a lot of trouble in 2008, as lending was over the top and inflated. As a result, when individuals stormed banks to withdraw their cash on hand, the banks had already lost billions of dollars in investments. The reserve requirement was instated as a result to protect assets.
Excess reserves, on which the Fed pays interest, are reserves that exceed these requirements. Borrowed reserves are those that banks borrow from the Federal Reserve at the discount rate.
More free reserves a mean more available bank credit, which in theory lowers the cost of borrowing and leads to inflationary pressures. Free reserves rose to unprecedented levels following the financial crisis, when the Fed offered to pay interest on banks' excess reserves. This development coincided with an unprecedented cut in the federal funds rate to near-zero, but these policies have not spurred inflation because of a prevailing deflationary environment. The increase in Fed liabilities caused by rising free reserves has been more than balanced out by the assets the Fed created through quantitative easing.
Updates to Free Reserve Requirements
Effective on March 26, 2020 the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to zero percent. Amidst a period of economic downturn, this change was made in order to encourage banks to lend out all of their money during the pandemic. This change was also enacted during the 2008 financial crisis to encourage lending.
Related terms:
Bank Credit
Bank credit is the total amount of credit available to a business or individual to borrow from a banking institution. read more
Bank Reserves
Bank reserves are the cash minimums financial institutions must retain to meet central bank requirements. Read how bank reserves impact the economy. read more
Checking Account
A checking account is a deposit account held at a financial institution that allows deposits and withdrawals. Checking accounts are very liquid and can be accessed using checks, automated teller machines, and electronic debits, among other methods. read more
Deflation
Deflation is the decline in prices for goods and services that happens when the inflation rate dips below 0%. read more
Deposit
A deposit is both a transfer of funds to another party for safekeeping and the portion of funds used as collateral for the delivery of a good. read more
Discount Rate
"Discount rate" has two distinct definitions. I can refer to the interest rate that the Federal Reserve charges banks for short-term loans, but it's also used in future cash flow analysis. read more
Excess Reserves
Excess reserves are capital reserves held by a bank or financial institution beyond what is required by law or regulations. read more
Federal Funds
Federal funds are excess reserves that commercial banks deposit at regional Federal Reserve banks which can then be lent to other commercial banks. read more
Federal Funds Rate
The federal funds rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight. read more
Federal Reserve System (FRS)
The Federal Reserve System is the central bank of the United States and provides the nation with a safe, flexible, and stable financial system. read more