While banks have a number of different assets that could, in principle, be used as reserves to back deposits, those that can be legally used to satisfy reserve requirements are vault cash and Federal Reserve deposits, both of which are commonly used to facilitate daily deposit transactions.

Any legal reserves held by banks over those needed to satisfy requirements are termed excess reserves or free reserves. Whereas required reserves are used to maintain the safety and liquidity of deposits, excess reserves are used for interest and profit generating loans.

Fractional-Reserve Banking

Fractional-reserve banking makes it possible for banks to pursue two activities simultaneously: (1) safely maintaining the liquidity of checkable deposits and a portion of the money supply and (2) acting as a financial intermediary to match up lenders (especially households depositing paychecks) and borrowers (especially businesses investing in capital goods).

The practice of fractional-reserve banking means that banks must balance the profitability of loans with the safekeeping of deposits. Tilting too far in the direction of loans jeopardizes the safety of deposits. Excessively emphasizing safekeeping limits profit. In either case, problems can emerge and banks can go out of business if a proper balance is not maintained.

The Federal Reserve System

This is where the Federal Reserve System (or the Fed) enters the picture. Established in 1913, the Federal Reserve System is the principal regulator of the U.S. bank system. As the word "Reserve" in the name suggests, the Fed places a great deal of emphasis on the reserves that banks have available to back up deposits. To this end, the Fed regulates the reserves through reserve requirements.

The Fed sets required reserves in large part to ensure that banks avoid the bankruptcy pitfalls that can emerge if they do not keep sufficient reserves. However, in principle, the Fed can also use required reserves to control monetary policy. By reducing required reserves, banks can make more loans and increase the money supply. By raising required reserves, banks can make fewer loans and decrease the money supply.

While such monetary policy actions are possible, in theory, they are seldom used. The Fed prefers other options, including open market operations or the discount rate, to control the money supply.

Running Through Some Numbers

Suppose for example, that AmosWEB National Bank has $50 million in checkable deposits. Based on these reserve requirements, no reserves are needed for the first $6.6 million. The next $38.8 million (the difference between $45.4 million and $6.6 million) requires $1.164 million in reserves (3 percent of $38.8 million). The next $4.6 million (the difference between $50 million and $45.4 million) requires $0.46 million in reserves (10 percent of $4.6 million). As such, AmosWEB National Bank is required to keep $1.606 million in reserves to back up its $50 million in checkable deposits.

Legal and Excess

• Legal Reserves: Legal reserves are simply the total amount vault cash and Federal Reserve deposits held by banks. While banks have a number of different assets that could, in principle, be used as reserves to back bank deposits, vault cash and Federal Reserve deposits are the only assets that are permitted by government regulations.


• Excess Reserves: Any legal (or total) reserves over and above those required by regulators are excess reserves. These excess reserves are used for loans, which makes them exceedingly important to the banking industry. Because reserves, unlike loans, do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they are required by law. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue.