Excess Reserves: Definition & Formula

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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Bank reserves are an important part of the banking system in the United States. In this lesson, you'll learn about excess reserves in the banking system and related concepts. You'll also have an opportunity to take a short quiz.

Definition & Conceptual Framework

Excess reserves are bank-held funds that exceed the Federal Reserve's minimum reserve requirement. You can determine excess reserves by subtracting required reserves from legal reserves.

Keep in mind, the United States uses a fractional-reserve system. A fractional-reserve banking system is a banking system where banks only hold in reserves a fraction of the money that is deposited with them. The deposits not held in reserves are used to make loans or are invested.

Required reserves are the level of reserves that the Federal Reserve requires that member banks hold to honor withdrawals. Legal reserves include the cash held by the bank for daily banking transactions (vault cash) and its deposits at one of the Federal Reserve regional banks. Primary reserves refer to the bank's cash and deposits, while secondary reserves are high-quality securities that are easily convertible to cash, such as treasury bonds.

Excess Reserve Formula

You can calculate a bank's excess reserves, if any, by using the following formula:

excess reserves = legal reserves - required reserves

If the resulting number is zero, then there are no excess reserves. If the resulting number is negative, the bank has a problem because it does not hold the minimum level of reserves required by law.

Let's look at an example. Federal regulations require that a bank hold ten percent of its demand deposits in reserves. The bank has $10,000,000 in demand deposits and legal reserves of $1,200,000. Let's calculate the bank's excess reserves, if any.

In this problem, you will first have to calculate the required reserves by determining what 10% of $10,000,000 is, which is $1,000,000, which we calculate by taking $10,000,000 * .10 = $1,000,000. Now, all you have to do is plug the numbers into the formula. Remember, excess reserves = legal reserves - required reserves.

So, excess reserves = $1,200,000 - $1,000,000, which means excess reserves = $200,000.

Let's look at another example. A bank has $1,000,000 in legal reserves. It has $12,000,000 in demand deposits, and federal regulations require the bank to hold 9% of deposits in reserve. Calculate the excess reserves.

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