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Tuesday, September 6, 2022

Bank Reserves Demystified

Bank reserves feature prominently in Economics 101 discussions of banking. As is entirely typical for Economics 101 macroeconomics, the topic is either taught incorrectly or in a misleading fashion. Bank reserves — better referred to as “settlement balances” — are just private sector bank deposits at the central bank. If you know what a bank deposit is, you know what a “bank reserve” is.

One initial tangential point is that what I am referring to are no loan loss reserves taken by banks. In a country like Canada where reserve requirements were abolished in the 1990s, loan loss reserves might be the only “reserves” that comes up in conversation outside of macroeconomic circles. A loan loss reserve is an estimate of future credit losses on a bank’s loan book — they are holding a “reserve” against the value of assets that are held at book value.

For simplicity, I am not going to attempt to get into the details of payments systems. For out purposes, we can simplify the situation to be that private banks hold deposits at the central bank, and when they need to transfer money to each other, this is done via a transfer of between deposit accounts. If the private bank needs to wire money to/from the central government, the deposit balance is reduced/increased. Note that although the banks will sometimes transact on their own account, they are mainly acting as agents on behalf of their customers. That is, if a customer needs to pay a $100 tax bill to the central government, the bank will reduce the customer’s deposit balance by $100 and then “transfer” the money to the government (which just reduces the private bank’s balance at the central bank).

(If we do want to worry about payment systems, there is a new entity introduced into transactions. Banks — both private and the central bank — send payments to each other via the payments system. However, net transactions are supposed to net out to zero, and so if we look at end-of-day balance sheets, the payments system is not supposed to be visible. If it is, something has probably gone horribly wrong.)

Dealing With Misunderstandings

Once we realise that “reserves” are just a type of asset held by private banks, a lot of points of confusion should be dissipated. The most typical problem is the idea that “banks lend reserves” to non-banks. Since non-banks are normally precluded from holding deposits at the central bank, there is no way for a bank to transfer a “reserve” to that customer. (Banks can “lend reserves” to each other in inter-bank markets.)

Another issue I see is the belief that banks need reserves in order to deal with depositors’ transfers elsewhere. In particular, this comes up in the context of extending loans — since loan amounts typically are used to buy things, banks allegedly need to hold bank reserves ahead of loan extensions.

I would argue that this is the result of a hidden assumption: money is a something resembling a commodity, and needs to be held before transfer. This misses credit relations. Payments systems typically allow the equivalent of overdrafts: banks can run deficits during the day. They only need to settle up to desired balance levels by the day’s close. If it looks like the bank is going to have a balance that is either “too high” or “too low,” it undertakes offsetting transactions in money markets (including inter-bank markets) to steer the balance back to the desired level.

If we look at the Canadian pre-2020 system, it is entirely possible that the “desired balance” at the end of the day is $0. This means that if look at end-of-day balance sheets (the only ones that are published), settlement balances would always be close to $0 (with misses that were relatively insignificant compared to the size of bank balance sheets).

Banks do not need to hold settlement balances (reserves) to meet cash inflows/outflows, they just need the ability to generate cash in money markets (typically by having liquid assets that can be sold or borrowed against).

Required Reserves Do Not Provide Liquidity

Let us imagine we are in a country that has reserve requirements. (With the abolition of reserve requirements in the United States, this might have to be a developing country.) Regulatory requirements vary from country to country. But my guess is that most follow a system similar to the old system in the United States: banks are required to hold a certain amount of deposits at the central bank, with the amount a fraction of the bank’s deposit liabilities. For example, if the reserve ratio is 10%, for every $100 in (certain classes of) customer deposits, the bank needs to hold $10 in deposits at the central bank.

However, getting a handle on a bank balance is sheet is not easy, give the rapidity of transactions. In the United States, this meant that the reserve requirements were based on deposits as of certain date in the recent past. Until the next reserve calculation date, the amount of required reserves are fixed.

Does this necessity to hold required reserves help their ability to meet customer outflows? Of course not! Imagine that you held $2000 in deposit at your bank, and then the government decided it was concerned about your liquidity, and decreed that your bank balance is not allowed to drop below $1000. Yay — you now only have $1000 available to spend.

To what extent there are reasons for a government to impose reserve requirements, they certainly do not help banks’ liquidity positions. The lack of good justifications for reserve requirements explains why the developed countries have quietly abolished them without anything interesting happening. (The reason why people expect things to happen is because of laughable Economics 101 money multiplier models.)

Concluding Remarks

With the United States finally abolishing reserve requirements, one can only hope that Economics 101 textbooks will catch up to this. Within a few decades, people might finally stop nattering on about them.


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(c) Brian Romanchuk 2022

7 comments:

  1. This is very clear, thanks. As you wryly note, it will take some time for what has already been happening to be acknowledged. If the time it has taken for the implications of the abandonment of Bretton Woods and the onset of soft currency economics to be acknowledged, I'd say a good 60 years ought to do it.

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  2. "Another issue I see is the belief that banks need reserves in order to deal with depositors’ transfers elsewhere. In particular, this comes up in the context of extending loans — since loan amounts typically are used to buy things, banks allegedly need to hold bank reserves ahead of loan extensions."

    I could not understand your point. Banks do need reserves in order to deal with depositor's transfers elsewhere. Banks won't need reserves if a customer is transferring resources to another account at the same bank, but if the customer is transferring "elsewhere" (to another bank), the original bank will necessarily need to have the reserves to do that.

    Depending on the jurisdiction and on the bank and its balance sheet, they may not have access to overdrafts, which necessarily means that they do need to hold reserves before transferring.

    For those that do have access to intraday overdrafts, they indeed will not need to hold reserves before transferring, but they will need to hold the reserves by the end of the business day, which is not long before the transfer. This is a small technical detail that doesn't change the fact that reserves are needed in order to accommodate "transfers elsewhere", be it before the transfer is made or up to the end of the same day that the transfer is made.

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    Replies
    1. If you actually read what I wrote, you would note that banks can operate without ever having settlement balances on their end of day balance sheet. Since those are literally the only balance sheets produced, you cannot point to me a situation where those banks hold reserves on their balance sheet.

      Delete
    2. There is the possibility that some banks operate without ever having settlement balances on their end of day balance sheet, but you are ignoring the settlement balances inflows and outflows that happen during the day. They do exist and are essential.

      In order to honor a customer's transfer request, the bank necessarily had a outflow of settlement balances. In order to reach a zeroed balance at the end of the day, the bank will need do to something to generate a cash inflow. Maybe it will sell government bonds or something.

      In conclusion, banks do need reserves in order to deal with depositors’ transfers elsewhere.

      To make a comparison, imagine a person that always has $0 at his bank account at the end of every month. If you are not attentive, you may assume that this person doesn't need money to pay for his living (buying food and rent etc). After all, the end of month balance is always at $0 and doesn't seem to be changing. However, if you look in more details, the person actually do need money to pay for his living. It's just that he receives just enough income to pay for his living and always reach a $0 balance at every end of month. Money is still necessary, otherwise he will starve.

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    3. You are attempting to move the goalposts, and writing walls of text to act as a smokescreen. A "bank reserve" is a *positive settlement balance* *held at the central bank* *at the end of the day*. In order for a bank to hold reserves, by definition, it has to hold them at the end of the day.

      And your example is utterly ridiculous. If a bank has a negative settlement balance intraday, it cannot be "holding" a settlement balance to meet future needs.

      You have just "proven" that banks want to receive inflows via the payments system. That is entirely obvious and tangential to the point I am discussing.

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    4. "You are attempting to move the goalposts, and writing walls of text to act as a smokescreen"

      You claimed that banks do NOT need reserves in order to deal with depositors’ transfers elsewhere, and I'm claiming that they do, as far as real world evidence goes. I don't think this is tangencial issue, this is a big deal and core to the concepts with are trying to convey in this post.

      I'm also trying my best to write clearly and objectively.

      But I have realized that you are acting disrespectfully so I will not engage in discussions with you anymore. Your readers are not punchbags. If you are frustrated with something in your life,
      don't take it out on me.

      Delete
    5. You refused to read what I wrote, and just repeated things that were covered by the article text. What am supposed to do, completely re-type my article in the comment section for the benefit of one person?

      Delete

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