Bank reserves can be a confusing topic for anyone who doesn’t have banking and finance experience. In this piece I will explain what reserves are, why they exist and what their role is in the financial system.
Central Bank reserves are deposits on reserve at the Central Bank. In the case of the USA reserves are issued by the Federal Reserve. This is often confusing for the average person who will likely never process a payment with reserves. This is because the reserve system is really just a payment system for the banks. So you can think of the banking system as being two tiered. There is the deposit system we all use. And the reserve system is a banking system that the banks all use with accounts at the Federal Reserve.
Before the creation of the Federal Reserve the US financial system was largely dependent on the health of private banks and private clearing systems. When a financial panic would break out the economy would often slide into a deep recession or depression in part because the financial system would freeze. Banks would refuse to settle payments with one another which would ripple through the rest of the economy and exacerbate downturns.
In 1907 there was an especially bad panic that required a private bailout by JP Morgan. This led to a series of regulatory reforms that eventually resulted in the formation of the Federal Reserve in 1913. This system created a decentralized Central Bank that would regulate and better maintain the banking system by establishing an interbank payment system. So, instead of having private banks settle all of the payments you would now have a Central Bank helping to oversee and settle payments between banks.¹
For instance, if Bank of America loans you $100 and the Central Bank requires a 10% reserve to be held then this will result in the Central Bank creating a $10 deposit for Bank of America. This deposit is a $10 asset for Bank of America as well as a $10 liability since it owes the reserve deposit back to the Federal Reserve. For the Federal Reserve these reserves are a $10 deposit liability and a $10 asset for the loan.
Since the reserve system is essentially imposed on the banking system you can think of all reserves as being “required”. That is, some quantity of reserves is necessary for payments to settle everyday. Central Banks typically set a quantity of “required reserves” and any excess quantity above that is called “excess reserves”. In today’s system there are quite a bit of excess reserves because Central Banks have expanded their balance sheets to buy bonds in policies like Quantitative Easing. But it’s best to think of all reserves as being required since they are issued by Central Banks and the quantity of reserves is essentially imposed on the banking sector.
It’s important to note that the existence of the reserve system is primarily for the purpose of settling interbank payments and smoothing the settlement of transactions. This is particularly important during times of panic when the private interbank markets would sometimes seize up. By having this system under public control the system is unlikely to fail when it is most needed because the Federal Reserve does not need to operate at a profit to remain solvent. This significantly reduces the instability in the banking system by ensuring that banks can always be confident when processing payments among one another.
Reserves also play an important role in helping the Central Bank transact monetary policy. Since the Federal Reserve has a mandate of ensuring full employment and price stability they will attempt to influence the financial system to optimize these conditions. In the process of doing this they will alter interest rates and the quantity of reserves in efforts to stimulate or slow the economy. At present these operations include Quantitative Easing and the payment of interest on excess reserves. QE is a process by which the Central Bank expands its balance sheet thereby increasing the quantity of reserves in the financial system in order to influence interest rates and private portfolios.²
In normal times the Federal Reserve would influence interest rates by altering the quantity of reserves in the interbank market. Banks try to lend their reserves to banks with a shortfall thereby maximizing profits, but since this is a closed system the banks can never get rid of their reserves in the aggregate. This puts downward pressure on interest rates so the Federal Reserve would try to control this quantity to reduce the desire to lend. In today’s world with QE there is an excess amount of reserves in the interbank system. This puts a huge amount of downward pressure on rates so the Fed must do something to put a floor under this. They do this by paying interest on reserves. This eliminates the desire to lend the reserves at a rate lower than what the Fed will pay.
When we look at the reserve system it’s important to remember that the Federal Reserve is basically just a big clearing house to help settle interbank payments. But it’s also important to note that the only reason we need a reserve system is because we have a private competitive banking system that can become unstable at times. This system is stabilized in part by the existence of a Central Bank which provides liquidity and stability when banks most need it.
¹ – See, the History of the Federal Reserve
² – See, Understanding Quantitative Easing
NB – In a separate, but related note it’s helpful to point out that banks do not “lend out” their reserves except to one another. That is, the money multiplier theory that most of us learn in Econ textbooks is misleading. Banks make loans and find reserves after the fact If they need to borrow them from the Central Bank or from another bank they do so within the banking sector. To learn more about the basics of banking please see here.
NB 2 – Banks can also hold cash as a form of reserves, but for practical purposes it’s best to think of reserves as electronic loans/deposits since they account for the vast majority of reserves.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.