For some observers, the rapid growth of excess reserves in the U.S. banking system during the financial crisis has been a troubling development—a sign that banks are “hoarding” funds rather than lending them out and hence that the Federal Reserve’s efforts to restore the flow of credit to firms and households have faltered. In “Why Are Banks Holding So Many Excess Reserves?” (Current Issues in Economics and Finance, vol. 15, no. 8), authors Todd Keister and James McAndrews dispute this view. Using a series of examples to illustrate how reserves are created, they demonstrate that the buildup of excess reserves is simply a by-product of the lending facilities and asset purchase programs established by the Federal Reserve during the financial crisis. The very high level of reserves, the authors contend, reflects the large scale of the Fed’s initiatives, but conveys no information about the lending behavior of banks.

As the authors explain, reserves are funds held by a bank, either as balances on deposit at the Federal Reserve or as cash in the bank’s vault or ATMs, that can be used to meet the bank’s legal reserve requirement. Between September 2008 and the end of 2009, reserves surged from about $45 billion to more than $900 billion. Excess reserves—the portion of reserves remaining after a bank has met its legal requirement—accounted for the bulk of the increase.

To explain this surge, Keister and McAndrews present simple examples that show how the types of actions taken by central banks to ease liquidity strains during the financial crisis—loans to banks and other firms as well as direct purchases of assets—create large quantities of reserves. The level of reserves in a country’s banking system, the authors observe, is determined almost entirely by the central bank’s actions. By contrast, the actions of individual banks will have no effect on aggregate reserves: As the authors’ examples show, an individual bank can lower its reserves by lending them out or using them to purchase other assets, but its actions simply transfer the funds to other banks’ reserve accounts and do not alter the total level of reserves in the banking system. Thus, the current high level of reserves in the U.S. banking system reflects the scale of the Federal Reserve’s recent policy initiatives and cannot be interpreted as evidence that banks are stockpiling funds rather than lending them out.

In the final section of the article, Keister and McAndrews discuss the importance of paying interest on reserves—as the Fed began to do in October 2008—when the level of excess reserves is unusually high: “Paying interest on reserves allows a central bank to maintain its influence over market interest rates irrespective of the quantity of reserves in the banking system. The central bank can then scale its policy initiatives according to conditions in the financial sector, while setting its target for the short-term interest rate in response to macroeconomic conditions.”