Free Reserves: What They are, How They Work, Requirements

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. These funds are important to the amount of funds available in the economy.

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.