The High Levels of Excess Reserves 2008-2012: An Investigation into the Determinants of the U.S. Banks' Liquidity Hoarding during the Global Financial Crisis

Abstract

Excess reserves, the indication of a bank's opportunity to invest, have historically been quite predictable and low for many years. From early sixties to August of 2008, the percentage of excess reserves in relation to required reserves has been between 1% to 9%. In September 2008, shortly prior to the tipping point of the 2008 financial crisis, the level of excess reserves began to rise dramatically and has stayed quite high even four years later. The watershed moment of Lehman Brothers and AIG failing precipitated a banking panic that involved drastic policy changes by the Fed and financial firms scrambling to find liquidity in anticipation of a credit crunch and drawdowns of credit lines. In less than six months, excess reserves ballooned to over $900 billion, which accounts to 2,063% of required reserves. Surprisingly, the large amount of excess reserves did not return to the previous levels. Instead, it has increased even more to nearly $2 trillion. This paper thus investigates the determinants for banks to hoard liquidity. The data reveals that high losses in loans and investments have caused banks to prognosticate higher levels of precautionary reserves. Furthermore, the very low federal funds rate and high unemployment rate have given banks limited opportunities to use the reserves in other alternative investment vehicles. Finally, the Federal Reserve's decision to pay interest on excess reserves provided incentives for banks and made holding reserves above the required amount no longer a cost for the bank.