Question

If no decent lending opportunity arises in the economy, and the central bank pays an interest rate on reserves that is similar to other low-risk investments, do you think banks will be willing to hold large amounts of excess reserves?

Short answer

Banks will be willing to hold large amounts of excess reserves in the absence of decent lending opportunities.

Step-by-step solution

Concept Introduction

if no decent lending opportunity arises in the economy, and the central bank pays an interest rate on reserves that is similar to other low-risk investments.

Step 2:Bank tries to find borrowers 

Bank tries to find borrowers, who fulfill the purpose of handsome return and safety of principal amount lent. Thus, bank will look for the borrowers, who can pay high- interest rates and are prompt in repayments. Banks keep security and return as prime objective prior to lend.

On the other hand, bank manages liquidity of its assets in such a manner that it can meet the demand of deposit outflow without violating the reserve requirement.

Step 3:Bank will prefer to keep excess reserves in high proportion 

To meet the demand of deposit outflows, banks keep some portion of their portfolio in the liquid asset, although, in this process they earn lower interest rates.

The bank while diversifying their portfolio, assess the demand of liabilities to be paid and they keep their excess reserves. Banks also keep US government securities to minimize this loss of interest.

Banks also build up strategies to earn more interest on their investments to meet the costly payment on the liabilities.

Hence, bank manages between the risk associated with the investment and return on the investment.

Therefore, in absence of decent lending opportunities, the bank will prefer to keep excess reserves in high proportion.

Final answer

Banks will be willing to hold large amounts of excess reserves in the absence of decent lending opportunities.