Excess reserves are funds that are held by a bank beyond what is required by regulatory guidelines. These funds are typically held in reserve in order to support any unexpected losses from loans and investments, or to be used as capital for future loan expansion and investment activities. Having excess reserves ensures that banks have enough liquidity to deal with potential problems which could arise from a variety of sources.

The Federal Reserve pays banks interest on these excess reserves. This interest rate is used to encourage bank behavior that follows the Federal Reserve's goals, such as keeping the fed funds rate low to promote economic growth. In addition, having a higher rate of interest on excess reserves can help encourage banks to maintain smaller amounts of excess reserves, thus putting them in a better position to make additional loans and investments.

The Fed's interest rate on excess reserves has been increased significantly since the financial crisis of 2008. Previously, banks paid nothing on excess reserves, but with the increase in rate banks now have a financial incentive to keep larger amounts of excess reserves. This can, in turn, lead to a decrease in lending, which helps to reduce the risk of a major banking failure.

Overall, excess reserves are essential for maintaining the stability of the banking system. They provide a cushion of protection against unforeseen losses from loans and investments, and they help promote the Federal Reserve's goals of low unemployment and strong economic growth. Additionally, excess reserves also provide banks with the liquidity to make additional investments and expand loan programs. By using the interest rate on excess reserves, the Federal Reserve is able to provide financial incentives that encourage banks to manage their reserves responsibly.