Banks, Central Banks and Money

by Stubborn Mule on 18 December 2009 · 7 comments

One misconception about the mechanics of money that I mentioned in my last post is the idea that banks can hoard their reserves at the central bank* rather than lending them out.

Here I will explain why this idea simply does not make sense, but no more casinos and gaming chips. No more senior croupiers and casino cashiers. I will dispense with the metaphor and instead stick to a more prosaic explanation, looking at interactions between banks and central banks.

All banks have their own accounts with the central bank. Often these are called “reserve accounts”, although in Australia they are called “exchange settlement accounts” (ESAs). As the Australian terminology suggests, the primary function of these accounts is to facilitate settlement of transactions that take place between banks. To keep it simple here, I will stick to the terminology of “reserve accounts”.

Five DollarsTo see how this works, imagine I make a $100 purchase from a shop on my credit card. If the shop banks with the same bank as I do, all that happens is that our bank increases the balance of my credit card by $100 and also increases the balance in the shop’s bank account by $100. With a couple of simple accounting entries and no movement of any physical currency, the transaction is complete. In fact, as was discussed in the casino money post, this simultaneous $100 loan advance to me and $100 deposit raising for the shop has effectively “created” an additional $100 of money in the economy that was not there before.

Things are slightly more complicated if the shop banks with a different bank. In that case, my bank (let’s call it “Bank C”) will still debit $100 from by credit card, but it now has to make a $100 payment to the shop’s bank (“Bank W”). The way this is done is through the two banks’ reserve accounts: my bank will have its balance with the central bank reduced by $100 and the shop’s bank will have its balance increased by $100. In practice, this does not happen for every individual transaction. On any given day, there will be a large number of payments to and from every bank. So, banks will net all of these transaction each day and then transfer money between their reserve accounts to cover the net amount owed one way or another.

One problem that can then arise is that a bank may not have a sufficient balance in its reserve account to make the settlement payments. The typical solution is for the bank to borrow what it needs from another bank. Sticking with the simple example of the $100 purchase and ignoring the fact that the figures involved here are unrealistically small, my bank may only have $50 in its reserve account and may therefore choose to borrow $50 from another bank. This loan results in $50 being transferred into its reserve account, bringing the balance up to $100 which it can then transfer to Bank W’s reserve account. It may even be that Bank C could borrow from Bank W, in which case it is effectively making good on the payment of the $100 by a combination of a $50 reserve account transfer and a $50 loan. As a last resort, if Bank C is unable to borrow from another bank, it will have to borrow from the central bank. Acting as a lender of last resort in this way is part of the function of a central bank.

Looking at all of these scenarios, purely internal account entries at Bank C, reserve balance transfers between Bank C and Bank W and combinations of reserve transfers and inter-bank loans, there is one very important point to note. At no point did the aggregate balance across the reserve accounts of all banks change. All that happened was that balances were shuffled from one bank to another. In fact, contrary to the view of certain financial commentators, it is impossible for a bank to lend its reserves to the private sector. Banks can certainly make loans, but these loans never take money from a bank’s reserve account and give it to an individual or a business (who, after all, do not have accounts with the central bank). If anything, these loans may move some of their reserve balances to the reserve account of another bank and so the actions of one bank can affect that bank’s reserve balance, but not the total amount of bank reserves.

So, how can aggregate reserve balances change? The only way this can happen is through the transactions of entities, other than banks, which deal directly with the central bank. This means the central bank itself or the government treasury, which also banks with the central bank. In its management of monetary policy, the central bank will routinely conduct “market operations” which involve lending to banks (which increases aggregate reserve balances) or borrowing from banks (which decreases aggregate balances). Similarly, the execution of fiscal policy by the treasury will also involve government spending (which increases aggregate balances), debt issuance or taxation (both of which reduce aggregate balances). To give an example of the mechanics behind one of these processes, imagine you are due a tax refund and you receive a cheque from the tax office. Once you deposit this cheque at your bank, the bank will increase your account balance by the amount on the cheque and then put a claim in to the tax office for that amount. This claim will be met by means of a transfer into the bank’s reserve account. For accounting clarity, there will also be a debit of the account with the central bank associated with the tax office, but in a modern economy with fiat money the government is effectively the monopoly issuer of currency (just like the casino is the monopoly issuer of chips in the last post) and so there is no sense in which the amount credited to the bank’s reserve account actually has to come from anywhere. It is simply a matter of the central bank saying that the bank’s balance has increased.

So, treating the central bank and the treasury as part of a broad “government sector”, the only way aggregate reserve balances can change is through the actions of the government sector, not through the dealings of banks with the private sector. Reflecting on what governments have done through the financial crisis can then solve the supposed riddle of the large reserves, particularly in the US and the UK. Governments around the world have made extensive use of fiscal stimulus packages, putting their budgets into deficit. Where has all of this stimulus spending ended up? In the reserve accounts of banks. Furthermore, some central banks have conducted extensive “quantitative easing” programs, which is just a fancy name for buying large volumes of bonds of various types (including corporate bonds and mortgage-backed securities). Without going into the reasons or the efficacy of quantitative easing, the relevant point here is that the process of central banks buying bonds directly results in increases in bank reserve balances. Are banks then hoarding these balances? Of course not. There is nothing they can do to reduce reserve balances by lending. The balances will not go down again until governments run surpluses or central banks start selling down their bond holdings again (or both). Does it matter that these reserve balances are so high? Not in the least.

There is one last point to clarify in dispelling the myth of reserve hoarding and that is the notion of “excess reserves”. In some countries, including the US, banks are required to have a minimum balance in their reserve accounts as a percentage of their total deposits. In the US, this minimum percentage is 10%. So, a bank with $1 billion in deposits must maintain at least $100 million in reserves with the US Federal Reserve (the US central bank). Any balances in excess of this amount constitute “excess reserves”. So, a bank with $1 billion in deposits and $150 million in reserves has $50 million in excess reserves. Unlike aggregate reserve balances, the actions of individual banks can affect aggregate excess reserves. Recall that bank lending effectively creates new money in the form of deposits. Now imagine that this bank with $1 billion in deposits writes a whole lot of new loans totalling $200 million. For simplicity imagine that all of the money is spent at businesses which bank with the same bank (much like the first $100 shopping scenario above), so this bank now has $1.2 billion in deposits and a minimum reserve requirement of $120 million. It still has $150 million in reserves, but its excess reserves have now dropped from $50 million to $30 million. Of course, it is not the case that the bank has spent the $20 million difference, it’s just that this $20 million is no longer considered “excess”.

Before we start getting too generous and conclude that commentators bemoaning reserve hoarding were actually talking about excess reserves, there are a couple of points to note. First, many countries, including the Australia and the UK, do not have minimum reserve requirements (and the article I linked to at the top refers to banks in the UK). Second, the relationship between excess reserves and bank lending is not straightforward. Many banks have reacted to the crisis by making greater use of the bond market. The reason for this is that, deposits can be withdrawn at call and so poses risks for the bank (so-called “liquidity risk”), just like the risk the casino runs that too many people will cash in their chips at the same time. Bonds on the other hand do not have to be repaid for a specified period of time, typically three to five years and so help to reduce the bank’s liquidity risk. For the same reason, banks have been tempting depositors with attractive interest rates to switch to term deposits. These term deposits are not subject to reserve requirements in the US and other countries that have minimum reserve requirements. So this shift in liquidity can increase the banks excess reserves whether or not they continue to lend.

So while finance commentators can reasonably ask whether bank lending has been swung too far from the easy money days of lending too freely to excessively tight lending practices, worrying about banks “hoarding reserves” is to completely misunderstand the workings of the banking system.

* I originally linked to this article but, as has been pointed out to me, not only does that article misunderstand the mechanics of central bank reserve accounts, but the writing was rather impenetrable. I have therefore replaced the link with another that is equally misguided, but easier to read.

Possibly Related Posts (automatically generated):

{ 7 comments… read them below or add one }

1 Marco December 18, 2009 at 8:10 pm

Hi Stubborn,

Thanks for another great post Stubborn!

Let me see if I understand this point: every time the Executive Branch component of the Government Sector makes a transfer, it creates reserves (as in the tax refund example).

Clearly, as governments all over the world have made transfers due to the GFC and associated recession, then reserves worldwide must be large, regardless of how liberally or conservatively banks lend.

But, do these reserves have any economic implication? Because in general I suppose banks don’t pay interests on them (except when coming from interbanks or Central Bank loans).

Is the money supply according to the MMT equivalent to the sum of cheque deposits and cash?

As a side note, some time ago I found an Austrian website where it was argued that Central Banks INDUCED banking insolvency crisis.

They were arguing from the American experience (which in itself is quite curious, as the Fed was created AFTER the bank run of 1907, if I remember well) and assuming a fractional reserve system.

They presented a simplified example, very much like yours. Their point was that, when processing transactions involving two banks (like your second example), one bank could run short of money. And, of course, they, in the usual manner, invoked responsibility and accountability and all that BS that Central Banks supposedly encourages banks to violate.

As you explain here, it is the presence of the Central Bank that, in the last instance, guarantees that the transaction is done (if there is no possible interbank lending). Not like they claim. In other words: they confuse the remedy with the disease.

Besides, in many places there is a Depositors Guarantee: which I believe acts like a kind of insurance.

2 Gary J December 19, 2009 at 12:42 pm

Sean – I think you have quite a few factual errors in this article.

Firstly, in the case of excess reserves in the US this is largely due to the Fed now paying interest on reserves. Absent the Fed paying interest on reserves they would not be able to meet their monetary policy target of 0-0.25%. Banks would bid the rate down in the overnight market thus their rate targeting would be ineffective. Notice how excess reserves exploded once the Fed started paying interest on reserves.

Secondly, excess reserves will not go down until govt runs budget surpluses. The US has run a deficit for the most part of the last 25yrs??? Budget surpluses affect the monetary base but are not a driver of excess reserves.

The three main drivers of excess reserves are: Bank capitalization (ability) and desire to lend, consumer and business desire to lend/save or in the current environment hoard cash and finally Central banks rate targeting method.

3 stubbornmule December 19, 2009 at 1:45 pm

Marco: all things being equal, government spending increases reserves and issuing/selling government debt reduces reserves. In most circumstances, increases in reserves are neutralised (or “sterilised” as it’s sometimes known) by issuance of government debt. However, over the last couple of years, many central banks have been buying securities in large quantities, so government spending is not being neutralised. I would argue that this build up of reserves does not matter. Others would disagree (Austrians among them) on the basis that it represents an expansion of money supply which is always inflationary. My counter to that would be that in the UK and US where the economies remain extremely sluggish, there is very little risk of an inflation breakout. That problem could emerge when their economies bounce back, at which point it governments would be in a position to wind back both their stimulus spending and their bond purchases.

4 stubbornmule December 19, 2009 at 2:03 pm

gary: while it is true that the Fed has begun paying interest on reserve balances, this is not in itself enough to explain the growth in reserves. After all, the Reserve Bank of Australia has always paid interest on reserve balances (at a rate of 0.25% below the target cash rate). Furthermore, as you note yourself, the impact of not paying interest on reserves tends to be to push short rates down. So, the role of interest on reserves can be expected to be more significant when the target rate is high not a the current very low 0-0.25% level in the US.

As to the point about past surpluses not creating the same run up in reserve balances you are right. This is because, as I noted in the post and the comment above to Marco, there are two key drivers of reserve balances: government spending and government sector buying/selling of bonds. In the past when deficits were run in the US, the impact on reserve balances was neutralised by the issuance of government bonds. With the extensive quantitative easing program in place over the crisis, the government sector (considered broadly to include the Fed) has been a net buyer of securities, which pushes in the same direction on reserve balances as government spending. In fact, there is a good case to be made that the role of government debt is not to “fund” government spending, but simply to drain reserves. In any event, my argument is that reserve balances will not fall while governments are running deficits and buying bonds. On or other (or both) has to reverse for balances to decline once more.

While you have been careful in your comments to use the phrase “excess reserves”, in all but my third last paragraph I was talking about aggregate reserves not excess reserves. The notion of excess reserves is only relevant in the US where there is a minimum reserve requirement (i.e. not in the UK, the country discussed in the article linked to at the top). As I note in that paragraph, the dynamics of excess reserves are more complicated as they depend on the mix of funding sources of each bank. Nevertheless, it remains the case even for excess reserves that government interactions with banks (fiscal and monetary) are significant drivers of balances. It still doesn’t make much sense to talk about banks “hoarding” their excess reserves as it is the Fed’s quantitative easing that’s pushing the balances up not the lack of lending.

5 stubbornmule December 19, 2009 at 2:10 pm

Gary: By the way, if you don’t agree with my line of thinking, you may like to chime in here: http://bilbo.economicoutlook.net/blog (a blog which runs a very similar line of thinking).

6 Marco December 19, 2009 at 4:03 pm

Hey, Stubborn

“My counter to that would be that in the UK and US where the economies remain extremely sluggish, there is very little risk of an inflation breakout”.

I agree to that, wholeheartedly. The last craze in the US now is that some people are actually calling for a decrease in the minimum wage, on the grounds that this is THE way to cut down unemployment, without triggering inflation. Believe it or not.

What’s more, I also believe this probably holds true to Australia. The latest figures in the “Australian National Accounts: National Income, Expenditure and Product”, released by the ABS don’t seem too bullish, to me.

If you are interested, have a look at Analysis and Comments (cat. 5206.0), 16 Sep 2009. Curiously, in spite of the news that employment had increased in November, in the September Quarter hours worked were still decreasing.

Have a look also at the charts for imports and exports.

7 Gary J December 29, 2009 at 9:44 am

Hey Sean – hope you had a great Christmas. Thanks for the response.

I agree with you and the Chartalists on the reserve impact due to QE – as you point out, as this is simple double entry book keeping, i.e. loan creates reserve.

However, I disagree with your statement “Does it matter that these reserve balances are so high? Not in the least”. The reason I disagree is that whilst bank reserve balances are high, this is largely because their clients have banked the proceeds of QE as deposits with them. So in reality it is the banks clients that feel “cash heavy”. Now whilst the total level of reserves remains unchanged this hides the fact that within this closed circuit we call money, markets are being bid up periodically by people/market participants feeling cash heavy, profit taken,new buyer, etc. You wrote a blog demystifying this yourself – people/markets are feeling cash heavy – hence the plethora of “crap” written in the mainstream media. Nonetheless, the Journalists are however expressing what I believe to be a wide spread “feeling”.

So – yes it does matter what level of reserves balances are in an economy.

I also think the Chartalists do not adopt a very practical resolution method. Essentially spend fiat money until full employment (as defined) is reached. Look at unemployment and fiscal deficits last year – conclusion very little money helped employment particularly the US, why? Govt spending was aimed at maintaining the status quo, supporting TBTF, propping up auto. The system needs to purge the mal-investment and excess leverage to grow – maintaining the status quo will only prolong the pain – ala Japan.

So yes in theory to huge fiscal spending too effectively fill the output gap (Keynesian thinking) – but the reality is govts particularly in the US spend on the highest paid donor = the existing elite = maintaining the status quo.

Also, I signed up to your blog the day before Melbourne Cup and the first email I got recommended Shocking – I put $10 on the nose at 10-1.

Best regards,

Gary

Leave a Comment

Previous post:

Next post: