Question

Why do banks want to maintain as little excess reserves as possible? Under what circumstances might banks desire to hold excess reserves? (Hint: see Figure 14.3.) Follow up question: In recent years, the Fed has purchased toxic assets and bonds from banks and given them cash in exchange. The idea has been to boost lending and therefore economic activities and employment. This is called QE for quantitative Easing. However, banks have not been keen in issuing loans to individuals and firms and have been sitting on cash in the form of deposits held at the Fed while they earn interest on it. Why banks have not been aggressive to lend?

Answer 1

From a bank's point of view , the decision to hold excess reserves above the legally required level or not involves evaluating a tradeoff between

• the opportunity cost of holding reserves
• a need for liquidity

Banks usually choose not to keep reserve because the money deposited is loaned out. Banks are in the business of making profits. When the bank loans out its customers' money it makes an overall net gain or profit. Banks don't make money from the reserves, in fact it a cost for them to maintain those reserve. Excess reserves represent unused lending power. The opportunity cost of excess reserves can be high.

In some cases, banks may be hesitant to make loans and therefore might want to hold excess reserves if they expect arelatively high withdrawal rate from the bank and hence they increase the overall liquidity.

Lending comes down to "risk"; that is to say what is the risk in that money not being repaid, or at best more slowly than intended. Also , Lending activities become constricted when federal fund rate and discount rates are high.Reduced lending activities result in reduced profits; interest from loans is the primary way banks make money. a high discount rate and a high federal funds rate encourage lending; banks can increase their reserves
Because of QE, the banks have a total increase in reserves. The banks take funds injected by the Federal Reserve and keep them as excess reserves, which earn an essentially risk-free interest rate.