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Why do banks hold excess reserves?

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Quick Answer

Banks and financial firms hold excess reserves to provide a measure of safety for certain circumstances, such as sudden loan losses or cash withdrawals by customers. The reserves that are held exceed the requirements for creditors, regulators or internal controls, according to Investopedia.

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Full Answer

Investopedia describes excess reserves as an amount of money measured by central banking authorities against standard reserve requirement amounts. The result is known as a required reserve ratio. Minimum required reserve ratios indicate how much money a bank should have in reserves, and anything above this ratio is considered an excess in reserves. Holding excess reserves can increase the desirability of that entity to potential investors despite an uncertain economy. The measurement of credit ratings by agencies like Standards & Poor's can rise by increasing the amount of excess reserves.

Investopedia states that reserves need to be in liquid forms of capital, such as cash in a vault, which do not create income. Since the cash in reserves is not generating income for the financial firm, in essence the firm may see no benefit in holding a very large amount of excess reserves. In an effort to minimize excess reserves, banks may lend out more money to borrowers to stabilize income flow.

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