As the term suggests Excess Reserves are those reserves which are more than the required standard reserves in any financial institutions like banks etc. The standard reserve ratio is fixed by the Central bank which is mandatory for the banks to keep that ratio.
Beyond that ratio, anything that is in excess is called as Excess Reserve. However, banks do prefer excess reserve because they are not yielding anything to the institution. They are cash and are of not any use.
It is more advisable to make those reserves fruitful by investing them in either short term loans or may be secured loans.
The advantages of Excess Reserves are as follows:
- Banks will have more cash in their hand
- Liquidity rate is high
- Creditworthiness increases of the bank
- Investors get attracted
- It can also improve the Credit Rating of the bank
- Acts a safety measure in times of sudden requirement of cash
Thus the above advantages make banks create more and more excess reserve and increase their liquidity ratio.
The following are the disadvantages that Excess Reserves can create:
- The excess funds are idle funds
are supposeto be invested in
- More than the required amount means hard cash is not being used properly
- It is also considered as a costly affair as the cash has to be maintained
Thus if it has advantages then it also has disadvantages. The best way to is to have minimal and as per required Excess Reserves neither beyond that nor less than that.
Calculation of Excess Reserve
Suppose in a bank there are:
Assets Rs. 500,000
Creditors Rs. 300,000
Loans Rs. 150,000 then the Excess Reserves can be calculated by:
Excess Reserves (if any) = Assets – Liabilities (Creditors + Loans)
Excess Reserves = 500,000 – (300,000 + 150,000)
Excess Reserves = 50,000
Thus Excess Reserves is a double edged sword which has advantages as well disadvantages. However, it is recommended to keep it minimal if the cash is not invested properly in the business. Thus bank authorities should always keep a vigilant eye on the Excess Reserves that the institution has.