What are bank reserves?

Bank reserves are deposits that commercial banks and other depository institutions hold in their accounts at Federal Reserve Banks. They serve three primary functions: satisfying regulatory reserve requirements (though these were reduced to zero in 2020), settling interbank payments through the Fedwire system, and serving as the Fed's operational lever for monetary policy through adjustments to the total supply of reserves.

Before 2008, the US banking system operated with relatively scarce reserves, approximately $40-50 billion in total. In this "scarce reserves" regime, small changes in the supply of reserves had significant effects on the federal funds rate, giving the Fed precise control over short-term rates through open market operations. The financial crisis and subsequent QE programs transformed the system by flooding it with trillions of dollars in excess reserves.

The current "ample reserves" framework, in place since 2008, operates fundamentally differently. With over $3 trillion in reserves, changes in the quantity have minimal effect on rates. Instead, the Fed controls the funds rate by setting the interest rate it pays on reserve balances (IORB), currently one of the most important rates in the financial system. Banks will not lend reserves in the federal funds market at a rate below what the Fed pays on reserves, effectively creating an interest rate floor.

The critical policy question during QT is how far reserves can be drained before the "ample reserves" regime transitions back toward scarcity, potentially causing money market dislocations. The September 2019 repo market spike occurred when reserves fell below an uncertain threshold. The Fed monitors several indicators to gauge reserve adequacy: the level of reserve balances on the H.4.1 release, the behavior of money market rates relative to IORB, and the usage of the Standing Repo Facility. Understanding reserves is essential for tracking the pace and limits of QT.