Tuesday, October 11, 2016

What are the bank reserves? why are they so important?

This article is part of the Money Series.

Last time, we saw how a single commercial bank can create money by creating loans, so expanding its  balance sheet, and how it destroys money when the loan is repaid, so contracting its balance sheet. In a fiat money system, the trend of credit is always increasing, otherwise the system collapses, since to repay the interests and to have growth, new money must be created. Before reading this post, I strongly encourage you to have a look at that post.

Today, we want to focus on bank reserves: what they are, what is their purpose.
It is essential to understand the bank reserves if we want to understand:

1. how money is transferred from one bank to another.
Example: you pay the car dealer by means of a bank transfer from the account that you have at your bank, and the account that the dealer has at his bank.
2. where the cash comes from
Example: you go to an ATM and withdraw some money. Is this money following a different bank circuit than the money that you pay through a bank transfer?
3. How the famous Quantitative Easing works
Example: the ECB is said to be injecting 80 billion euros in the economy each month
4. What is an Open Market operation
5. What happens if there is a bank run
6. How money is "multiplied" when money is moved from one bank account to another (or "fractional reserve"mechanism, which is non correct, as we will see in the future).
7. Why banks want to become bigger and bigger.
8. Why the recent war on cash.

I remind you that currently there are three types of money:

1. Cash, issues by the Treasury
2. Bank deposits, that is Money created by the commercial banks
3. Bank Reserves, created by the central banks

Cash accounts only for less than 3% of the money in circulation, which is measured by the indicator M2. The rest, that is 97%, is created by commercial banks, and this is the money we use for settling payments on a daily basis.
Bank reserves are "digital cash"that banks use to settle money transfers between them, so they are not considered in M2 Money supply, because they can be used only by banks and not by ordinary people. You cannot go to the grocery shop and pay with bank reserves.

I also remind you that nowadays there exist the following identities:

Money = Credit = Debt

Money is credit since it is always created by banks and it comes with an interest: you pay back in the future more money than what you got from the bank. Since credit is somebody else's debt, the second equality is straightforward.

We can argue that real money is such when it does not bring an interest: therefore gold is real money, bitcoin is real money and cash is real money since they do not bring an interest, or a yield. This is going to become an academic discussion, that I leave to others since, at least to me, the added value of this kind of discussion tends to zero after the first 5 minutes. I already discussed this point here.
In its essence, since money today is digital, money is information, it is a collection of ones and zeroes in the bank ledgers. And as any ordinary information, it undergoes through a complex process that modifies it, spreads it, compress or expand it, and destroys it eventually. How this process is standardized is at the very basis of our civilization.

Now, you can view bank reserves as cash that banks keep at the central bank. These deposits at the central bank are typically a percentage of the loans that commercial banks have in their balance sheets. Why? let's make an example.

Bill has an account at bank B. Charlie has an account at bank C. Charlie is a car dealer.
Both bank B and bank C have an account at the central bank, and each of them has a certain amout of reserves on its own account.
Bill goes to Charlie, buys a car and sets the payment by a bank transfer.
Bill's account at bank B decreases by 10K, the reserves of bank B at the central Bank decreases by 10K, while the reserves of Bank C at the central Bank increases by 10K, and these 10K are also an increase of Charlie's account.

So, the net transfer of money from Bill's account to Charlie's account is actually a transfer from Bank B to Bank C, and this is done via a exchange of bank reserves. There is no van with cash going from Bank B to Bank C. Only a net transfer of "cash-like"reserves, completely digital...and cyphered.

Indeed, reserves are like cash for banks. Extremely liquid, they can be moved by typing figures on a keyboard.

In a day, there are millions of bank transactions, and most of them will clear up with the others: in other terms, many bank transfers may go from bank B to bank C, but many others, in the same day, may go the way aroung, from bank C to bank B. So, in reality, the NET settlement is just a tiny fraction of the overall payments. That's the main reason why the bank reserves are only a fraction of the assets of a bank.

When you withdraw money from an ATM, the cash reserves of the bank decrease by the same amount. So, theoretically, if many people go to the ATMs or to the bank counters to withdraw their money or send their money to other banks, the bank reserves of the "victim"bank may go rapidly to zero. In that case, either the bank can get extra reserves (by paying an interest, of course) from other banks or from the central bank, or the bank becomes illiquid, ie it cannot pay its debts on the short term: if you want to repay a debt, and you are without cash, you can sell your car, but it requires time. In the meantime, you are formally bankrupt.

Of course, the bigger the bank, the less money in reserves it needs to have in percentage with its assets. In fact, the net settlements on a day by day basis will be minuscule with respect to the size of the bank. Ideally, if there was only one super bank, its  bank reserves held at the central bank would go to zero since all the payments and bank transfers would be internal. So, bigger is better for banks since they can keep less reserves with respect to their size.

You can imagine that, if a bank is supposed to have 10% of his assets in bank reserves (in reality it is much less), this is money that cannot be reinvested in assets with a higher yield. Especially now that Central Banks are giving zero or negative interest rates. So, the less it is, the better it is for the bank.

In this context, a war on cash, that is the banning of cash, for a bank is extremely helpful: it decreases the risk of going illiquid if too many people withdraw their money at the same time. Simply, they cannot.
So, a "no cash policy"is definitely good for banks, which also get total control over your deposits: just remember, when you put money in your bank account, that money belongs to the bank, which has a liability towards you. That's why you have to communicate your bank in advance if you want to close your account with them.

We have answered some of the questions listed above. In a future post, we will have a thorough view on the fractional reserve, or money multiplier, model.

This graph is taken from here. It shows the vertical increase of credit in UK up to 2010, when the crisis hit violently UK. You can see by yourself that the increase of credit was much sharper than the increase of the central bank reserves up to the burst of the financial bubble. The UK reacted by lowering the interest rates, devaluing violently the Pound Sterling against the euro and the dollar and pumping reserves through Quantitative Easing.

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