Two Assets

• Vault Cash: This is the paper bills and metal coins that is kept in the bank, that is, in the vault. This cash is used, quite literally, to "cash" checks and otherwise to satisfy currency withdrawal demands of depositors. Note that vault cash is not part of the official M1 money supply because it is held by banks (not the nonbank public) and thus it is not in circulation.


• Federal Reserve Deposits: This is deposits that banks keep with the Federal Reserve System to clear checks and assist in other banking activities. The Federal Reserve System provides banks with a range of banking services, including loans and deposits. Banks are not only required to keep deposits as a means of joining the Federal Reserve System, these deposits are used to process checks through the banking system.

Three Categories

• Legal Reserves: Legal reserves are the TOTAL of vault cash and Federal Reserve deposits. These two assets are the only two assets that satisfy the legal reserve requirements handed down by regulators. And the reason these assets are used to satisfy legal reserve requires is that these are the two assets banks use for daily operations--such as cashing or processing checks or generally satisfying deposit withdrawals. Legal reserves can also be thought of as total reserves.


• Required Reserves: Required reserves are the amount of reserves--vault cash and Federal Reserve deposits--that regulators require banks to keep for daily transactions. Required reserves are specified as a fraction of outstanding deposits--usually about 1 to 3 percent.


• Excess Reserves: Any legal (or total) reserves over and above those required by regulators are excess reserves. These excess reserves are used for loans, which makes them exceedingly important to the banking industry. Because reserves, unlike loans, do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they are required by law. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue.

Loans and More

• First, and most important for the study of money and banking, banks use excess reserves for loans. If someone needs a car loan, has good credit, and their local banks has excess reserves, then a little lending business is very likely.


• Second, banks might decide to direct excess reserves into investment securities, like U.S. Treasury securities or Federal Funds. A bank might do this for the liquidity not found with household or business loans, while earning interest that is not possible with reserves.