Central Bank Reserves are part of central bank money. They appear on the balance sheet as a liability.
When reserves are created, they are placed on the balance sheets of commercial banks as assets. In checking with double entry accounting, the liability is found with the central bank.
For an institution to engage with the reserves, it requires a master account. This means only member banks have access and can utilize them.
Central bank reserves should not be confused with bank reserves which applies to depository institutions and is a combination of vault cash along with other cash holdings.
The way this operates is the same regardless of whether the currency is USD, EUR, GBP, or JPY.
Difference In Liabilities
There are two forms of central bank money:
- banknotes
- reserves
The first is legal tender for a nation. For the United States, it is the dollar.
Banknotes are cash, currency in physical form. This was the basis for fractional reserve banking when most monetary transactions were done using this medium.
Since it is legal tender, it is available for the general economy. It is used to pay debts, taxes, and to make purchases. Settlement is instant with a transaction fully completed once the banknote is handed to the other person.
Banknotes are distributed through the commercial banking system. When these are printed, they are transferred to the banks and stored in their vaults. Over time, as customers make cash withdrawals, the currency enters the economy.
The creation of a banknote is a liability on the central bank's balance sheet as it has to counteract the expansion of the commercial bank's. Cash is an asset. Again, double entry accounting means a liability is the overall counterbalance. Hence we have a liability for central banks such as the Fed.
Deposits
It is important to follow the flow of capital throughout this process.
For banks, it all starts with deposits. This is legal tender (either in cash or digital form) that is submitted to the bank. At this point the bank has the option of lending the money out or buying government approved securities.
Since the money is owed to the depositor, plus interest, deposits are a liability to the bank. The currency received is the asset. This is switched to a security through purchase.
When QE is taking place, the security is replaced with reserves, completing the accounting.
Bank Instrument
Reserves are nothing more than a bank instrument. It is used for a specific purpose enabling the central bank to implement monetary policy.
In the United States, a reserve is redeemable for $1. The catch is it only applies to central bank money. This means a reserve can be converted into a banknote. Digital dollars are the realm of commercial banks.
Reserves were an after thought until the introduction of quantitative easing (QE), first implemented by the Bank of Japan. When the Federal Reserve started to follow suit, attention was paid to reserves.
Under QE, the monetary policy is to buy Treasuries or mortgage backed securities (MBS). This is done through the repurchase (Repo) market. A swap is arranged where the reserve is placed on the balance sheet of the commercial bank and the assets (or security) is placed on that of the Fed.
Swap arrangements of this nature are short-term. Most of the agreements are overnight, repeating the process each day. This allows the Fed to inject liquidity using assets other than cash.
A reserve has a peg to $1 in banknotes. It can be thought of as a stablecoin. Unlike cryptocurrency, the use cases of reserves are rather limited.
Banks with reserves cannot use them to do stock buybacks, pay bonuses, rent branches, or purchase stationary. They can only be transferred to other financial institutions with master accounts.
Two-Tiered Settlement
When it comes to the banking system, there are two tiers where settlement is required.
Individuals and business use commercial banks. These accounts operate with "digital" dollars, i.e. commercial bank money.
When a transfer is made from one bank to another, the participating accounts require the proper debits and credits. Once completed, the first layer is settled. The ledger of the receiving bank increases whereas the sender is decreased.
To fully settle, the central bank's balance sheet requires adjustment. Reserves are used to balance out the transaction at this level. Each day, the reserves are moved to the proper banks based upon the net.
This is the major use case for reserves. Another is member banks purchasing securities from other institutions (with master accounts). Essentially, we are looking at inter-bank currency.
Printing Press Goes Brrr
Quantitative Easing (QE) sends the Internet screaming with memes stating how the "Printing Press Goes Brrr". This image harkens back to the days when the central bank actually did print currency.
QE does not expand the amount of currency (legal tender) in circulation. Reserves are for banks only. Here is where people mistakenly believe the central bank is having an impact upon things such as inflation. Under this, we have the money supply expanding, which could result in price increases.
Unfortunately, reserves are not part of that supply.
Money Supply
Governments along with central banks tried for account for the amount of money in circulation. As it evolved, this became a tougher proposition. M0, M1, and M2 were all attempts at categorizing what was happening.
The money supply of an economy is the currency. It is legal tender that moves through as business and individuals engage in commerce.
Banking and the financial system can use different forms of money. The central bank and Eurodollar systems each have their own. The latter, as an example, is based upon collateral.
Reserves are a part of the monetary base (M0). This means that the Fed can expand the monetary base yet does not directly impact the money supply. The only way for that to expand is for banks to lend. US dollars, along with other fiat currency operating under fractional reserve banking, is dictated by loans made by banks. Banknotes (along with coins) have a minor impact. Reserves are not applicable.
Collateral
The international lending system is based upon collateral. This is often called the Eurodollar, shadow banking, or off-shore system. Whatever the term, it is built upon secured lending. That means all agreements are based upon one party putting collateral up against another.
Under these swap agreements, securities allow banks and other financial institutions to access the liquidity it needs. QE does the opposite. It removes securities from the commercial banks balance sheets and replaces this with reserves, The securities are collateral to the system whereas reserves are not. When this is done on a large scale, balance sheet constraint occurs.
At this level, we can see how QE actually tightens financial conditions, pushing the financial system into deflationary money. With this reduction in collateral, global lending starts to seize up.
Reserve has a major impact at the central bank layer but are nothing when looking at the commercial bank and Eurodollar systems.
When the central bank removes a security such as a bond from a commercial bank balance sheet, it is effectively removing it from circulation, at least according to the other two systems. This means the central bank can utilize the power of that asset on the balance sheet but nobody else can.
By doing this, the monetary policy is trying to create scarcity in the asset, driving up prices and reducing interest rates.
Quantitative Tightening (QT) has the goal. The central bank starts to reduce its balance sheet by putting securities onto the market. Often this is done by either letting the assets reach maturity where they are paid off or by reversing the swaps. By placing the securities back in the commercial banks possession, removing the reserves, it provides more to the market.
Why Pay Interest
Many have questioned why central banks would pay interest on the reserves. This is a relatively new occurrence, happening only in the past 15 years or so.
One of the main reasons to do this is to incentivize banks to hold reserves. Before this, banks kept their central bank reserves light since there was, effectively, a penalty for doing so.
The other factor in this is monetary policy. By setting an interest rate on reserves, the central bank is helping to establish a path to achieve its desired rate. Central banks can only affect interbank lending rates. It does this in a series of ways. Paying interest on reserves is one way to establish their desired targets.
Many question the effectiveness of this action, especially within the banking industry. It long has ignored what the central banks are doing, especially in regard to its reserves. Commercial and investment banks have a number of factors to consider regarding their balance sheets. Return on investment is only one criteria, and not always the most important.
New Debt Issued
When a country issues new debt, it is done through its Treasury. The actual sale of the assets are done through the central bank, who have agreements with the primary dealers. These are banks that act as security warehouses, purchasing the bonds and notes on behalf of their clients (or their own accounts). These institutions typical cater to hedge funds, insurance companies, and pension funds.
This is a situation where reserves are not much use. Sovereign debt is issued to raise money to fund government expenditures. This means the money sent out as payment has to be legal tender. This is what the nation's Treasury is interested in receiving.
That means sovereign debt is sold for existing currency. Reserves are not applicable since the Treasury cannot use them to pay the government's bills.