Why Do Banks Hold Excess Reserves?: Precautionary Demands or Monetary Policy Factors?

Abstract

This paper empirically investigates why Japanese banks have held large excess reserves for almost two decades, not only in crisis periods but also in peacetime. Examining the panel data for commercial banks over the period FY 1991–2007, we identify two factors that explain their demand for reserves: a short-term inter-bank money market rate (opportunity costs), and the Tier 1 capital adequacy ratio (precautionary demands). The former is often pointed out as a factor by previous literature, while the latter is our contributed new finding to the literature on reserves accumulation. We found the positive relationship between banks’ capital and their excess reserve holding, or liquidity holdings. This finding has an implication for the current financial regulatory reforms, monetary and macro-prudential policies.