Question

Short Answer: Keep it concise. What are excess reserves and why might a bank want to keep them as part of their assets? Why wouldn't a bank want to keep excess reserves as part of their asset portfolio? What is a "bank run" and how does it cause bank failure? What does it mean that the Federal Reserve is the "Lender of Last Resort" and why is this role important in a bank panic?

Answer 1

Excess reserves are the reserves banks are required to hold over and above the reserve ratio mandated by regulators. This serves the purpose of a buffer as they are essentially excess liquid deposits held by the bank, rather than being lent out, which could be used in case of a sudden loan loss or heavy cash withdrawal by customers of the bank.

Barring the reserve ratio mandated by authorities, bank prefer to lend out any excess reserves as it would allow them to earn interest on them. The higher the amount of excess reserves they are required to maintain in the bank, the lesser they can earn in terms of interest by lending the same amount.

A 'bank run' refers to a situation in which a large number of clients choose to withdraw their money from the bank around the same time and such a thing usually happens because all the clients believe that the bank will probably fail in the near future. This belief acts as a feedback mechanism as the belief pushes them to withdraw money and such withdrawals on a large scale in turn causes the banks too fail. The failure occurs due to the reason mentioned in the previous answer; banks choose to lend out any excess reserves. If all clients were to try and withdraw money simultaneously, the bank doesn't have enough liquid assets to give all its clients their money and hence, the bank fails.

The Federal Reserves' function as "Lender of the Last Resort" implies that when all else fails for banks to be able to meet their liquidity requirements, they turn to the Federal Reserve for funds, i.e. the Federal Reserve becomes their last resort for help in a crisis situation and loans them funds. This is a crucial role in a panic situation, like that of a "bank run", in order to prevent the banks from failing, as well as to prevent all the clients from losing their money. In essence, this prevents a breakdown of the banking system and also a loss of faith in the credibility of the system.