(2) Bank Reserves — Facilitator of Settlement Between Banks

Image credit

In discussing widely held misconceptions about bank reserves, Garreth Rule sketches in the below excerpt the process by which banks effect settlement among themselves by transferring bank reserve balances from one bank's (bank reserve) account at the central bank to that of another bank. 

Bank reserves are like a special kind of money held and exchanged only between banks and the central bank. Any net liability held by one bank vis-à-vis another bank, the central bank or other agencies of the state can only be discharged by offering bank reserves in payment. 

Garreth Rule shows that banks are unable to dictate the overall level of reserves in the system; instead they are restricted to distributing the given level among themselves.

Banks must at all times have enough funds to acquire the bank reserves they need to conduct their operations. Under this condition, they are able to alter the proportion of bank reserves and other assets they hold within their overall portfolio of assets. Thy can do this by 

• selling bonds to obtain bank reserves, 

• buying assets from the central bank to reduce bank reserves,

• borrowing bank reserves from the central bank or other banks

•  lending them out to other banks. 

However, while these operations alter the composition of the portfolio of assets held by the individual banks, in aggregate they cannot bring about a reduction or an increase of the total amount of reserves available to all banks.

I have singled out the below passage as it gives a broad outline of how rearranging bank reserve balances among banks ensures settlement in the payment system.

Misconceptions regarding reserves Misconception 1 — reserves and other assets One of the biggest misconceptions is the idea that commercial banks in aggregate can choose between reserves and other assets. This supposes that the total amount of reserves being held at the central bank at any point is directly controlled by commercial bank decisions. While it is true that an individual commercial bank is free to choose between reserves and other assets, at the system-wide level the quantity of reserves is determined by accounting identities on the central bank’s balance sheet. 

(1) To understand this idea, consider what happens when an individual commercial bank attempts to reduce its reserve balance (Table C). 

(2) If the commercial bank buys an asset, then while the purchasing bank’s reserve balance has been reduced, the selling bank’s account has been credited by the same amount. If the institution selling the asset does not hold a reserve account at the central bank then its correspondent account at its clearing bank is credited with the balance and that clearing bank’s reserve account is credited with the reserves. Even if the commercial bank attempts to reduce its reserve balance by purchasing an asset in a foreign currency then the reserves will remain in the system. To purchase the foreign asset the commercial bank must obtain the foreign currency: to do this it must exchange its domestic currency (the reserves) for this foreign currency with another bank. The bank providing the foreign currency then receives the reserves. 

Even when commercial banks increase their lending they cannot reduce the total amount of reserves in the system (Table D). 

The initial process of lending involves only the extension of an individual commercial bank’s balance sheet, an increase in assets from the freshly created loan and a matching increase in liabilities from the accompanying deposit created for the recipient of the loan.  

At this point there is no impact on the quantity or distribution of reserves across commercial banks; it is only when the recipient of the loans spends their new deposit then reserves may move between commercial banks in the manner discussed above for settling transactions. If there is a distinction between required and free reserves, the process of lending can lead to a reclassification of reserves, but not a change in the total quantity. From the initial starting point, Bank A makes a new loan, the impact of which is to lengthen its balance sheet by increasing loans as assets and deposits as liabilities. There is no impact on reserves. 

If the borrower subsequently spends the loan at a business that holds its account at Bank B, the deposit transfers from Bank A to Bank B and in return reserves move from Bank A to Bank B. There is no impact on the total quantity of reserves. The only feasible means by which commercial banks can independently reduce the total quantity of reserves in the system is by exchanging reserves for banknotes. However, similar opportunity costs exist for commercial banks in holding banknotes as for individuals. In particular bank vaults are expensive to maintain. Moreover this does not reduce the monetary base, merely alters its composition.

The source.