Non-Borrowed Reserves: What They are, How They Work

What Are Non-Borrowed Reserves?

Non-borrowed reserves are bank reserves—that is, the funds a financial institution holds in cash—that are its own, and not money on loan from a central bank.

Understanding Non-Borrowed Reserves

Under the fractional reserve banking system, depository financial institutions (what most of us think of as banks) only hold a limited amount of their total funds in a liquid form at any given time. Instead, they invest or lend out most of the deposits they receive from customers.

However, in order to increase financial stability—discouraging bank runs, for example—central banks impose reserve requirements, forcing these institutions to keep a certain portion of their funds either as vault cash or on deposit in accounts at the central bank.

To satisfy these reserve requirements, banks can borrow from the central bank if they need a cash infusion. In the U.S., that central bank is the Federal Reserve. The Fed, or more precisely, one of the 12 Federal Reserve banks, makes overnight loans to commercial banks at a discount rate. The central bank lending facility meant to help commercial banks manage short-term liquidity needs is called the discount window.

Reserves that are the bank's own, and not on loan in this way, are non-borrowed reserves. Non-borrowed reserve funds are calculated each week.

In practice, the vast majority of reserves in the U.S. are non-borrowed since discount window borrowing is relatively expensive and carries a stigma. It implies the bank isn't managed well, letting itself get into a cash crunch.

Non-Borrowed Reserves vs. Excess Reserves vs. Free Reserves

A bank's non-borrowed reserves overlap with, but are not exactly the same as, its excess reserves or free reserves.

Excess reserves refer to any reserves a bank has that exceed the Fed's reserves requirements, whether they are borrowed or not. Subtracting borrowed reserves from excess reserves yields a bank's free reserves, which are available to be lent out (the reason they're called "free"). In other words, free reserves consist of the cash a bank holds in excess of required reserves, minus any money borrowed from the central bank.

Since the financial crisis of 2008–2009, the Fed has paid interest on excess reserves. Combined with a near-zero federal funds rate, that policy drove the level of excess reserves to unprecedented levels in the ensuing decade, meaning that few institutions had a need to borrow to make up a shortfall.

More free reserves mean more available bank credit, which in theory lowers the cost of borrowing and eventually leads to inflationary pressures. However, that has not happened this time, because of a prevailing deflationary environment.

Reserve Requirements and Monetary Policy

Reserve requirements are set by the Federal Reserve's board of governors. The board determined the reserve requirements that make up one part of the three main tools of monetary policy. The other two are open market operations (OMO) and the Fed's discount rate.

In March of 2020, the Fed announced that reserve requirement ratios would be set at 0%. This is different from the requirement ratios that existed before, which had reserve requirements based on the amount of net transactions accounts at the institution. Before the change, banks with more than $127.5 million on deposit were required to maintain a reserve of 10% of deposits.

The Federal Reserve's purpose is to maintain a stable and growing economy by encouraging price stability and as full employment as possible. Other than engaging in open market operations and adjusting the discount rate, the Fed will adjust reserve requirements—as they did in March of 2020—to influence the amount of money an institution can lend. In effect, when the Fed adjusted the requirements from 10% to 0%, that meant the bank increased its ability to lend out its deposits by 10%.

There is a direct relationship between the reserve requirements the Fed sets and interest rates. If the reserve requirement rises, that means a bank has less money to lend out. Because the supply of money they are able to lend out is lower, interest rates will rise as a result.

Example of Non-Borrowed Reserves

Although banking policy has a reputation for being difficult to understand, non-borrowed reserves are easily calculated. To find a bank's amount of non-borrowed reserves, you would add all the deposits the has at the Federal Reserve to the bank's available cash. Then, you would subtract any funds that were borrowed.

Breaking it down, let's say a bank experienced deposits of $20 million. The bank, in order to meet its reserves, has borrowed $10 million. In this scenario, the bank has $2 million cash on hand. The sum of total deposits plus cash on hand equals $22 million. Once you subtract the borrowed amount of $10 million, you arrive at the bank's non-borrowed reserves amount of $12 million.

The Bottom Line

Non-borrowed reserves are held by banks as additional protection against unexpected withdrawals. They are reserves that are typically the result of excess deposits and are not loans taken from a central bank, and they are calculated each week.