You say: "Can banks buy bonds or equities with reserves? Yes, they can". Shouldn't this answer be no, but instead their other assets are reallocated? In other words, if banks can buy selected stocks with reserves, how does the seller of the stock receive their funds if reserves are not legal tender? I'm not understanding how "reallocation" can convert "reserves" into stocks, unless the reserves get outside the system somehow.
When banks buy from other banks they use reserves to settle, easy.
When banks buy from a pension fund, the pension fund can't settle in reserves right?
But it can settle with bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
Think that piece of information is also lacking for my understanding: there are financial sector deposits that are not really spendable in the real economy. Didn’t know this. Thanks! Also: great explainers and nice to see you engage with the tons of readers and our comments.
Can reserves be removed from the system? If so how. And if not what happens to banks behaviours over time if reserves keep increasing in the system and their use is limited. Also what do reserves yield? More reserves?
so, the crucial bit here (which was not explicitly mentioned) is that bank reserves allow banks to expand their balance sheet, i.e. make loans (create money in real economy) and get bonds or whatever they need. As I understand, that is actually the definition of what is a "bank reserve" (probably that's way Alf assumed it as a known fact in the article).
Also, it kind of explains the importance of the repo spike: when banks cannot find an opportunity to make a loan based on their bank reserves, they swap the reserves for the bonds back at Fed. And, as I understand, the important part here is exactly that the swap is done with the central bank, not with commercial banks. A swap with a commercial bank would be fine, just some business in finance and real economy. But a swap with Fed means that there is no more business to be done in the real economy.
I’d have had the same question as Gabe above. Now that it was already asked, your response actually throws me off even further:
There are interbank only reserves and deposits. Now you respond that “yes, banks can buy bonds with reserves” but you speak of not real-econ spendable deposits.
If the bank has 0 deposits and the PF has 100 bonds, with what deposits can the bank purchase 50 bonds (as they have 0 and the PF cannot be paid in reserves)? Are you saying the bank creates 50 deposits out of nowhere to purchase the bonds? Isn’t money out of thin air for credit creation only?
Your contents & expertise are much appreciated! Thank you for all you do =)
Thank you for highlighting that. But so this seems to be the piece of the puzzle none of the money expert commentators have expressed clearly so far —> banks actually don’t need to have anything for purchasing from nonbanks? Deposits are not created solely via credit creation but also for purchases banks perform?
Bank A doesn’t have something the non-bank market holds —> bank a wants/needs it —> bank a creates the money and now has the asset —> the asset’s seller has the deposit money?
Yes, that’s how banks operate: expanding balance sheet on both sides (asset side getting the security from non-bank; liability side a deposit for the non-bank). Are there constraints to this? Yes, regulatory constraints such as capital requirements, but also market constraints (eg the interbank interest rate for reserves). Mehrling nicely summarizes all of this here https://sites.bu.edu/perry/files/2019/04/Retheorizing-Liquidity.docx (and his money and banking mooc goes into some detail on all of this).
Bank A buys the stock from a private investor, and pays the bank (Bank B) that the private investor has an account with in bank reserves. Bank B then credits the private investors account with money in their deposit account - Bank B is happy to do this because Bank A paid them in Bank Reserves already.
I think this is the case. I would like it if Alf could confirm.
Exactly. Who are the banks buying these bonds and equities from? And why is the seller willing to give them up in exchange for less useful bank reserves?
Fed QE transactions are not limited to bank counterparties, so there is also a path for QE to add commercial bank deposits:
"When the Fed purchases a financial asset, it pays for it by creating bank reserves. Nonbanks cannot hold reserves because they do not have an account at the Fed. When the Fed purchases a financial asset from a nonbank investor, the Fed sends the payment as reserves to the investor’s commercial bank. The commercial bank then credits the investor’s bank account. In this instance, the commercial bank is acting as an intermediary between the Fed and the investor since the investor is unable to hold reserves. The Fed’s action of purchasing assets increases the level of central bank reserves in the system as well as commercial bank deposits."
It seems to me that this has the same net effect as when the Fed buys a bond from a commercial bank and then that bank replaces the bond with an identical bond from a non-bank investor.
Ok, commercial banks swap their bonds for reserves, but, why do they do so? The article discusses what happens afterwards but not why banks agree to the QE in the first place.
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
I read through the comments and I feel like I am in the twilight zone. Everyone asks the same question I have, no one seems to answer it, but everyone is thanking everyone for clearing things up!!!! The question I can't find the answer to in this thread is: If reserves aren't money how can they be used to buy stocks and bonds? If a commercial bank tries to buy a bond from me I will say hell no, I can't spend your stinking reserves. If on the other hand, they buy from another commercial bank, it's just a bunch of incestuous shuffling of bonds among banks having no effect on the economy. PLEASE CLARIFY. I am begging here.
Reserves are money for banks: when a bank wants to buy from another bank, they pay with reserves.
When a bank wants to buy from another financial institution or from Douglas, they can't pay in reserves: they need to pay with bank deposits (that you can spend, while a pension fund can't...but still, bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
So when a bank gets more reserves it can create more deposits, but when it gets more bonds it can't? Or it can't create as many? I thought deposit creation was constrained by regulatory balance sheet requirements, and bonds and reserves were about equal in terms of value to regulators. Is that wrong?
Not a 100% sure but I think that the reserves the central bank issues for the bonds are a legal way for banks to satisfy their reserve requirements (which are a mix of various bonds, cash, equities etc). While you cant spend the issued reserves, having more of them frees up your other assets that you can use in the market. I could be wrong but this is what I understood.
That sounds correct, although I will have to tease out the details a bit. It seemed Alf focussed a lot of attention on the part of the process that I already understood and started arm waving at the crux. Still, he is a wonderful asset and I am not bellyaching.
Banks can buy bonds or equities with reserves only from another bank. Reserves are an instrument to pay for anything (including bonds or equities) within banks only. Thus, this is a closed network which cannot boost prices of bonds or equities.
When banks buy from other banks they use reserves to settle, easy.
When banks buy from a pension fund, the pension fund can't settle in reserves right?
But it can settle with bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
How come there are now all of a sudden deposits that are not real-economy spendable? Next to interbank reserves and real-econ spendable deposits, these “new” non-spendable deposits are like a third type of money that popped out if nowhere 😩
Central banks give notice to dealers that they wish to buy certain securities such as Treasuries or MBS. The dealers find these securities on their own balance sheets or broker them from another investor. Once the security is delivered to the central bank the central bank credits the reserve balance of the dealer.
I have two questions (some overlap with questions in the chat).
1. Why do banks sell their bonds to the central banks in the first place, if its better for them to hold bonds instead of reserves? How can they be forced?
2. How exactly do HQLA help with interest rate risk hedging? Because they bring more yield or are there other reasons?
1. Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
2. The bonds (eligible for HQLA) purchased carry interest rate risk - that can be used to hedge the interest rate risk on the liabilities' side of the balance sheet for banks.
Great article Alf. The only part I don’t understand is also how the commercial banks get “forced” into the swap? Is it a matter of the bonds being on the market and the central bank just buying them all up at any price?
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
Why don't (or do) reserves get exchanged at some kind of discount since they are not fully fungible with "regular" dollars? Also, what is the mechanism for forcing commercial banks to participate in QE? Regulatory mandate?
In our "old" low interest rate world there were fund managers that have tried to get access to reserves by depositing. The rates paid by the Fed on reserves has been higher than deposit rates. However the Fed would not give these funds access. Keeping a closed loop with banks.
Reserves only exist within the Central Bank; commercial deposits only exist with in a single commercial bank. There is no exchange between the two. From the commercial bank perspective, one is an asset, one is a liability; and the counterparties for each do not interact except through the commercial banking system.
Thanks for replying. I understand that a customer deposit is a liability for a commercial bank. But doesn't a commercial bank have both Reserves and regular dollars on the asset side of their balance sheet? (ie If I make an interest payment to my bank don't they now have a regular dollar asset from the interest income I paid them?)
If you make the interest payment with physical currency ("cash"), then yes, they will hold that as an asset. However, cash represents a small portion of transactions and assets. If we consider Bank of America, its balance sheet shows less than 1% of assets as cash. (https://finance.yahoo.com/quote/BAC/balance-sheet/) The main reason is the overhead. You need vaults, security guards, armored cars, inventory checks, etc. A bank can exchange reserves for cash, and vice versa. It will maintain some cash inventory to supply ATM's, but if it has excess, it will return it to the central bank. If you've ever tried to go to a bank branch and withdraw more than few K as cash, you will likely have gotten to meet the manager for a cordial discussion about getting a heads-up next time -- since they just don't keep that much around, and they are of course very attentive to anything that looks like a bank run where everyone wants to withdraw cash at once.
If you instead make your interest payment with a transfer from another bank account, it depends. If it is from an account at the same bank, they just credit and debit your two accounts. If it is from an account at a different bank, the two banks will settle it as part of nightly reconciliation of net flows across the banking system, where any net imbalances are settled by transferring reserves between them at the central bank.
A last point to consider is what we mean by "regular dollars". One reason that a lot of discussion about money gets confusing is that dollars are a unit of measure, not a specific thing. Cash currency, central bank reserves, commercial bank deposits, and Treasury bills are all distinct forms of money. We measure all of them in dollar units, but they are not the same thing of course.
Hi Matt! Reserves and spendable bank deposits are two parallel forms of money: reserves are money for banks and bank deposits held by the private sector (ex financial institutions) are real-economy money. They are just two parallel forms of money.
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
Alf great stuff. Question - "They start buying the very same bonds QE is buying". Can banks use their new reserves asset at the Central Bank to buy Treasuries? Or must they use normal cash?
Thanks, James! Yes: if they buy bonds directly from another bank they will simply settle with reserves. If they buy bonds from another financial institution, the transaction can settle with bank deposits - which are a liability for the commercial bank against which the bank will have reserves. So indirectly it's always possible for banks to ''use'' reserves to buy bonds.
Thanks Alf makes sense. I was saying this point to someone who replied with this, which has confused me. Would you be able to "proof" their reply?
Reserves still have an effect on lending – reserves are like a “hot potato” – because they attract such low interest rates (relative to gilts) it means that banks (individually, not in aggregate because as you say total reserves are forced to rise with QE) don’t really want to hold on to them. So in in aggregate banks do have to hold the higher level of reserves. But they can individually try to offload them more quickly – after all, if Bank X has more reserves than it wishes/is required it can independently deplete its own reserves by lending more money out. But that money gets deposited immediately in Bank Y which means there’s an offsetting rise in its reserves. So Bank Y does the same think – offloads reserves by lending – and they end up at Bank Z. And the process continues. So, as far as I understand it, high levels of reserves in aggregate can mean a greater amount of bank lending for that given level of reserves, as banks individually attempt to maximise their returns. The “hot potato” remains in circulation – but banks are keen to pass it round quicker the “hotter” (i.e. the greater the discrepancy between Bank Rate and sovereign or other yields) and the “bigger” (the amount of reserves in aggregate) gets.
Thanks Alf. This is a difficult topic for me but you explained it so well and concisely. P.s., I am also a goalkeeper 🧤⚽️ (I recall you mentioning that in the talk with Hugh) 😊
"When a Central Bank performs QE and directly buys bonds from a commercial bank, they merely change the composition of the commercial bank asset side" ⬅ But as a private citizen, my bond portfolio has just increased in value, which I can then sell and receive more bank "deposits" for those bonds than I could before QE. So surely QE does indirectly result in more bank deposits being created, as long as people who just got richer from their bond portfolio decide to cash out some of their gains?
Capital gains generated by QE directly and by the portfolio rebalancing effect indirectly effectively lead to higher prices which can be somehow considered ''real-economy money printing'' too.
Yes they are richer if the bond's price rises. However, who holds bonds and in what sort of accounts. Most bonds are held in fixed income portfolios eg. Banks, Insurance Companies and asset managers. If you also hold bonds then you are either holding them through an insurance or fund product or you are buying them in a retirement account. You are getting wealthier. This is the great wealth inequality of QE.
More importantly why would you sell? What are you going to buy if not other financial assets like equities. If you are retired and withdrawing funds your income gain is being impacted by the rising value of other financial assets and their falling yields. The terrible risk of this policy is that the duration of assets is increasing. (Duration ~time need to recover your initial investment purchase.) As duration of assets increases then the sensitivity that asset has to rate changes is increasing.
So as the central banks reverse policy then the asset bubbles they have created start to pop.
Thanks for your thoughts. Yes, I agree, these gains are concentrated at first in the hands of the top 10%. Re: "More importantly why would you sell?", people are far more likely to spend more lavishly on vacations, celebrations, new cars and house renovations when their portfolios are rising. Maybe a 60-year-old doubles the amount they intend to splash on their daughter's wedding, and this trickles into the hands of service workers. Job creations have often been heavily been in the low-paid service worker sector. Some macro thinkers say that "QE is all psychology and is only an asset swap. The reserves are trapped in accounts at the fed and so QE doesn't really actually do anything". My comment was intended to check the extent to which Alf is making a similar claim.
QE is not only psychology indeed, but the portfolio rebalancing effect is real.
We are talking third and fourth round effects though, and many uncontrollable variables in the middle (are the capital gains going to be saved? spent? used to pay back debt?).
I just want to push back hard against the incorrect ''Central Banks go brrrr''.
What is also a puzzle is that QE under Bernake and Draghi did not create inflation. This was the stated purpose of this policy initially. It created a wealth effect but it is doubtful that it created greater income for those without assets. However, the great fiscal-covid-spending along with QE created massive inflation.
I have a theory that part of the problem is that keeping zombie companies alive and refusing to allow the field to be cleared and resources released has badly hurt the economy. Generations of the smartest talent have abandoned their science and engineering degrees to work on spreadsheets in the finance sector. And who can blame them when starting a business is a far worse life than working on Wall Street, spending all of your money on buying the most expensive house you can, and getting paid as much from owning their house (via capital appreciation) as going to work every day. The extra money that trickled down from asset holders into the low-paid service economy has been offset by the stagnation of the higher-productivity parts of the non-finance-sector economy.
Great piece. Curious doesn’t an increase in bank reserve naturally enable the bank to issue larger credits per Basel III? Assume bank had 10x reserve ratio with 1 dollar in reserve and 10 dollars in credit, enlarging its reserve to 2 dollars certainly can double its credits?
Not really: the level of bank reserves is almost irrelevant for the decision-making process when it comes to bank lending.
Banks lend if the borrowers' creditworthiness is good, and if the RoE on the loan (loan yield vs capital requirements) is attractive enough against the borrower's risk profile.
My question is similar: Isn't the reason of doing QE to encourage banks in more lending activity (instead of buying HQLA)? So when a commercial bank has more reserves after having sold bonds to the central bank, the commercial bank should be able to lend more money - correct? Thanks, Alf.
So I assume QT means banks will need to reverse this process and increase holdings of reserves, since their bond holdings will be skewed to the upside as reserves are pulled from the system by the Fed? Also how would the recent rout in the bond/equity markets affect banks allocation to HQLA's? I guess increasing volatility means they would reduce exposure to corporate debt and move to treasury's?
Thank you, this is educational. How did they expect QE to increase inflation if most of the buyers of risk assets are a small proportion of the population, and their extra capital usually goes to equities and other real assets? Until recently, QE really only succeeded in raising prices of stocks and houses.
You say: "Can banks buy bonds or equities with reserves? Yes, they can". Shouldn't this answer be no, but instead their other assets are reallocated? In other words, if banks can buy selected stocks with reserves, how does the seller of the stock receive their funds if reserves are not legal tender? I'm not understanding how "reallocation" can convert "reserves" into stocks, unless the reserves get outside the system somehow.
Hi Gabe.
When banks buy from other banks they use reserves to settle, easy.
When banks buy from a pension fund, the pension fund can't settle in reserves right?
But it can settle with bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
Drawing some T-accounts by yourself will help :)
Think that piece of information is also lacking for my understanding: there are financial sector deposits that are not really spendable in the real economy. Didn’t know this. Thanks! Also: great explainers and nice to see you engage with the tons of readers and our comments.
Education is my goal #1, Marat. If somebody takes enough time to read and even ask a question, I got to answer! :)
Can reserves be removed from the system? If so how. And if not what happens to banks behaviours over time if reserves keep increasing in the system and their use is limited. Also what do reserves yield? More reserves?
so, the crucial bit here (which was not explicitly mentioned) is that bank reserves allow banks to expand their balance sheet, i.e. make loans (create money in real economy) and get bonds or whatever they need. As I understand, that is actually the definition of what is a "bank reserve" (probably that's way Alf assumed it as a known fact in the article).
Also, it kind of explains the importance of the repo spike: when banks cannot find an opportunity to make a loan based on their bank reserves, they swap the reserves for the bonds back at Fed. And, as I understand, the important part here is exactly that the swap is done with the central bank, not with commercial banks. A swap with a commercial bank would be fine, just some business in finance and real economy. But a swap with Fed means that there is no more business to be done in the real economy.
I’d have had the same question as Gabe above. Now that it was already asked, your response actually throws me off even further:
There are interbank only reserves and deposits. Now you respond that “yes, banks can buy bonds with reserves” but you speak of not real-econ spendable deposits.
If the bank has 0 deposits and the PF has 100 bonds, with what deposits can the bank purchase 50 bonds (as they have 0 and the PF cannot be paid in reserves)? Are you saying the bank creates 50 deposits out of nowhere to purchase the bonds? Isn’t money out of thin air for credit creation only?
Your contents & expertise are much appreciated! Thank you for all you do =)
"When banks make loans to nonbanks or buy assets, such as marketable securities, from nonbanks they create new bank deposits by transferring the loan or payment amount to the borrower or security seller. " https://www.federalreserve.gov/econres/notes/feds-notes/understanding-bank-deposit-growth-during-the-covid-19-pandemic-20220603.htm
Thank you for highlighting that. But so this seems to be the piece of the puzzle none of the money expert commentators have expressed clearly so far —> banks actually don’t need to have anything for purchasing from nonbanks? Deposits are not created solely via credit creation but also for purchases banks perform?
Bank A doesn’t have something the non-bank market holds —> bank a wants/needs it —> bank a creates the money and now has the asset —> the asset’s seller has the deposit money?
Yes, that’s how banks operate: expanding balance sheet on both sides (asset side getting the security from non-bank; liability side a deposit for the non-bank). Are there constraints to this? Yes, regulatory constraints such as capital requirements, but also market constraints (eg the interbank interest rate for reserves). Mehrling nicely summarizes all of this here https://sites.bu.edu/perry/files/2019/04/Retheorizing-Liquidity.docx (and his money and banking mooc goes into some detail on all of this).
I had the exact same question, would love to understand this part a bit better Alf.
Replied above, Wayne :)
Makes sense, thanks!
Bank A buys the stock from a private investor, and pays the bank (Bank B) that the private investor has an account with in bank reserves. Bank B then credits the private investors account with money in their deposit account - Bank B is happy to do this because Bank A paid them in Bank Reserves already.
I think this is the case. I would like it if Alf could confirm.
Yes Rishi, that is pretty much it.
Exactly. Who are the banks buying these bonds and equities from? And why is the seller willing to give them up in exchange for less useful bank reserves?
Fed QE transactions are not limited to bank counterparties, so there is also a path for QE to add commercial bank deposits:
"When the Fed purchases a financial asset, it pays for it by creating bank reserves. Nonbanks cannot hold reserves because they do not have an account at the Fed. When the Fed purchases a financial asset from a nonbank investor, the Fed sends the payment as reserves to the investor’s commercial bank. The commercial bank then credits the investor’s bank account. In this instance, the commercial bank is acting as an intermediary between the Fed and the investor since the investor is unable to hold reserves. The Fed’s action of purchasing assets increases the level of central bank reserves in the system as well as commercial bank deposits."
- Wang, Joseph J. Central Banking 101 (p. 39)
This is true. Joseph is very good at this too :)
It seems to me that this has the same net effect as when the Fed buys a bond from a commercial bank and then that bank replaces the bond with an identical bond from a non-bank investor.
Ok, commercial banks swap their bonds for reserves, but, why do they do so? The article discusses what happens afterwards but not why banks agree to the QE in the first place.
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
I read through the comments and I feel like I am in the twilight zone. Everyone asks the same question I have, no one seems to answer it, but everyone is thanking everyone for clearing things up!!!! The question I can't find the answer to in this thread is: If reserves aren't money how can they be used to buy stocks and bonds? If a commercial bank tries to buy a bond from me I will say hell no, I can't spend your stinking reserves. If on the other hand, they buy from another commercial bank, it's just a bunch of incestuous shuffling of bonds among banks having no effect on the economy. PLEASE CLARIFY. I am begging here.
Ciao Douglas!
Reserves are money for banks: when a bank wants to buy from another bank, they pay with reserves.
When a bank wants to buy from another financial institution or from Douglas, they can't pay in reserves: they need to pay with bank deposits (that you can spend, while a pension fund can't...but still, bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
Drawing some T-accounts by yourself will help :)
So when a bank gets more reserves it can create more deposits, but when it gets more bonds it can't? Or it can't create as many? I thought deposit creation was constrained by regulatory balance sheet requirements, and bonds and reserves were about equal in terms of value to regulators. Is that wrong?
Not a 100% sure but I think that the reserves the central bank issues for the bonds are a legal way for banks to satisfy their reserve requirements (which are a mix of various bonds, cash, equities etc). While you cant spend the issued reserves, having more of them frees up your other assets that you can use in the market. I could be wrong but this is what I understood.
That sounds correct, although I will have to tease out the details a bit. It seemed Alf focussed a lot of attention on the part of the process that I already understood and started arm waving at the crux. Still, he is a wonderful asset and I am not bellyaching.
I answered above, Douglas.
But I should really write a comprehensive book on global macro and monetary mechanics, it seems
Banks can buy bonds or equities with reserves only from another bank. Reserves are an instrument to pay for anything (including bonds or equities) within banks only. Thus, this is a closed network which cannot boost prices of bonds or equities.
Very interesting, Mr. Alf. Can you please explain how a bank uses reserves to purchase treasuries, corporate bonds, and certain stocks?
Hi TD.
When banks buy from other banks they use reserves to settle, easy.
When banks buy from a pension fund, the pension fund can't settle in reserves right?
But it can settle with bank deposits.
Now, if a pension fund had 100 in bonds and 0 in bank deposits and the bank buys 50 in bonds from the pension fund, the latter will now have 50 in bonds and 50 in (financial sector, not real-economy spendable) bank deposits.
The amount of (financial) bank deposits in the system has increased.
If the pension fund would deposit the money at the same bank, the matching accounting item would be...reserves. Indirectly, reserves has been used to ''back'' the bond purchase.
If the pension fund would deposit the money at another bank instead, that bank would now have additional deposits to match with an accounting item which is...reserves.
Our initial bank could settle the transaction with the other bank using reserves.
It's easier to explain with T-accounts, but the main point is that either banks use reserves to directly buy bonds (from other banks) or they use reserves to ''indirectly back'' the transaction when buying from other financial institutions.
Drawing some T-accounts by yourself will help :)
How come there are now all of a sudden deposits that are not real-economy spendable? Next to interbank reserves and real-econ spendable deposits, these “new” non-spendable deposits are like a third type of money that popped out if nowhere 😩
Central banks give notice to dealers that they wish to buy certain securities such as Treasuries or MBS. The dealers find these securities on their own balance sheets or broker them from another investor. Once the security is delivered to the central bank the central bank credits the reserve balance of the dealer.
Great article, thanks Alf!
I have two questions (some overlap with questions in the chat).
1. Why do banks sell their bonds to the central banks in the first place, if its better for them to hold bonds instead of reserves? How can they be forced?
2. How exactly do HQLA help with interest rate risk hedging? Because they bring more yield or are there other reasons?
Thanks!
1. Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
2. The bonds (eligible for HQLA) purchased carry interest rate risk - that can be used to hedge the interest rate risk on the liabilities' side of the balance sheet for banks.
Great article Alf. The only part I don’t understand is also how the commercial banks get “forced” into the swap? Is it a matter of the bonds being on the market and the central bank just buying them all up at any price?
Thank you, very kind!
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
Why don't (or do) reserves get exchanged at some kind of discount since they are not fully fungible with "regular" dollars? Also, what is the mechanism for forcing commercial banks to participate in QE? Regulatory mandate?
i have a similar question - why are banks even participating in the swap, when reserves are suboptimal for them? so is it enforced?
Hi Vladimir, see the answer to Matt above.
In our "old" low interest rate world there were fund managers that have tried to get access to reserves by depositing. The rates paid by the Fed on reserves has been higher than deposit rates. However the Fed would not give these funds access. Keeping a closed loop with banks.
Reserves only exist within the Central Bank; commercial deposits only exist with in a single commercial bank. There is no exchange between the two. From the commercial bank perspective, one is an asset, one is a liability; and the counterparties for each do not interact except through the commercial banking system.
I had replied in a very similar way to Matt. Well done! :)
Thanks for replying. I understand that a customer deposit is a liability for a commercial bank. But doesn't a commercial bank have both Reserves and regular dollars on the asset side of their balance sheet? (ie If I make an interest payment to my bank don't they now have a regular dollar asset from the interest income I paid them?)
If you make the interest payment with physical currency ("cash"), then yes, they will hold that as an asset. However, cash represents a small portion of transactions and assets. If we consider Bank of America, its balance sheet shows less than 1% of assets as cash. (https://finance.yahoo.com/quote/BAC/balance-sheet/) The main reason is the overhead. You need vaults, security guards, armored cars, inventory checks, etc. A bank can exchange reserves for cash, and vice versa. It will maintain some cash inventory to supply ATM's, but if it has excess, it will return it to the central bank. If you've ever tried to go to a bank branch and withdraw more than few K as cash, you will likely have gotten to meet the manager for a cordial discussion about getting a heads-up next time -- since they just don't keep that much around, and they are of course very attentive to anything that looks like a bank run where everyone wants to withdraw cash at once.
If you instead make your interest payment with a transfer from another bank account, it depends. If it is from an account at the same bank, they just credit and debit your two accounts. If it is from an account at a different bank, the two banks will settle it as part of nightly reconciliation of net flows across the banking system, where any net imbalances are settled by transferring reserves between them at the central bank.
A last point to consider is what we mean by "regular dollars". One reason that a lot of discussion about money gets confusing is that dollars are a unit of measure, not a specific thing. Cash currency, central bank reserves, commercial bank deposits, and Treasury bills are all distinct forms of money. We measure all of them in dollar units, but they are not the same thing of course.
This was incredibly helpful. Much appreciated. I see that to think about this properly it is important to abstract it into accounting terms.
Incredibly good answer here! Bravo!
Hi Matt! Reserves and spendable bank deposits are two parallel forms of money: reserves are money for banks and bank deposits held by the private sector (ex financial institutions) are real-economy money. They are just two parallel forms of money.
Commercial banks participate in QE because there is always a clearing price at which it's convenient for them to sell bonds for reserves - they will record some juicy capital gains in the process.
Thanks Alf!
Alf great stuff. Question - "They start buying the very same bonds QE is buying". Can banks use their new reserves asset at the Central Bank to buy Treasuries? Or must they use normal cash?
Thanks, James! Yes: if they buy bonds directly from another bank they will simply settle with reserves. If they buy bonds from another financial institution, the transaction can settle with bank deposits - which are a liability for the commercial bank against which the bank will have reserves. So indirectly it's always possible for banks to ''use'' reserves to buy bonds.
Thanks Alf makes sense. I was saying this point to someone who replied with this, which has confused me. Would you be able to "proof" their reply?
Reserves still have an effect on lending – reserves are like a “hot potato” – because they attract such low interest rates (relative to gilts) it means that banks (individually, not in aggregate because as you say total reserves are forced to rise with QE) don’t really want to hold on to them. So in in aggregate banks do have to hold the higher level of reserves. But they can individually try to offload them more quickly – after all, if Bank X has more reserves than it wishes/is required it can independently deplete its own reserves by lending more money out. But that money gets deposited immediately in Bank Y which means there’s an offsetting rise in its reserves. So Bank Y does the same think – offloads reserves by lending – and they end up at Bank Z. And the process continues. So, as far as I understand it, high levels of reserves in aggregate can mean a greater amount of bank lending for that given level of reserves, as banks individually attempt to maximise their returns. The “hot potato” remains in circulation – but banks are keen to pass it round quicker the “hotter” (i.e. the greater the discrepancy between Bank Rate and sovereign or other yields) and the “bigger” (the amount of reserves in aggregate) gets.
Hi James!
Yes, banks lend reserves to each other all the time.
I thought you were referring to real economy lending.
Thanks Alf. I truly appreciate you breaking these things down the way you do. Much appreciated.
My pleasure!
Thanks Alf. This is a difficult topic for me but you explained it so well and concisely. P.s., I am also a goalkeeper 🧤⚽️ (I recall you mentioning that in the talk with Hugh) 😊
Bravo Nicholas!
"When a Central Bank performs QE and directly buys bonds from a commercial bank, they merely change the composition of the commercial bank asset side" ⬅ But as a private citizen, my bond portfolio has just increased in value, which I can then sell and receive more bank "deposits" for those bonds than I could before QE. So surely QE does indirectly result in more bank deposits being created, as long as people who just got richer from their bond portfolio decide to cash out some of their gains?
Hi Drew, this is a smart point.
Capital gains generated by QE directly and by the portfolio rebalancing effect indirectly effectively lead to higher prices which can be somehow considered ''real-economy money printing'' too.
Yes they are richer if the bond's price rises. However, who holds bonds and in what sort of accounts. Most bonds are held in fixed income portfolios eg. Banks, Insurance Companies and asset managers. If you also hold bonds then you are either holding them through an insurance or fund product or you are buying them in a retirement account. You are getting wealthier. This is the great wealth inequality of QE.
More importantly why would you sell? What are you going to buy if not other financial assets like equities. If you are retired and withdrawing funds your income gain is being impacted by the rising value of other financial assets and their falling yields. The terrible risk of this policy is that the duration of assets is increasing. (Duration ~time need to recover your initial investment purchase.) As duration of assets increases then the sensitivity that asset has to rate changes is increasing.
So as the central banks reverse policy then the asset bubbles they have created start to pop.
Thanks for your thoughts. Yes, I agree, these gains are concentrated at first in the hands of the top 10%. Re: "More importantly why would you sell?", people are far more likely to spend more lavishly on vacations, celebrations, new cars and house renovations when their portfolios are rising. Maybe a 60-year-old doubles the amount they intend to splash on their daughter's wedding, and this trickles into the hands of service workers. Job creations have often been heavily been in the low-paid service worker sector. Some macro thinkers say that "QE is all psychology and is only an asset swap. The reserves are trapped in accounts at the fed and so QE doesn't really actually do anything". My comment was intended to check the extent to which Alf is making a similar claim.
QE is not only psychology indeed, but the portfolio rebalancing effect is real.
We are talking third and fourth round effects though, and many uncontrollable variables in the middle (are the capital gains going to be saved? spent? used to pay back debt?).
I just want to push back hard against the incorrect ''Central Banks go brrrr''.
What is also a puzzle is that QE under Bernake and Draghi did not create inflation. This was the stated purpose of this policy initially. It created a wealth effect but it is doubtful that it created greater income for those without assets. However, the great fiscal-covid-spending along with QE created massive inflation.
I have a theory that part of the problem is that keeping zombie companies alive and refusing to allow the field to be cleared and resources released has badly hurt the economy. Generations of the smartest talent have abandoned their science and engineering degrees to work on spreadsheets in the finance sector. And who can blame them when starting a business is a far worse life than working on Wall Street, spending all of your money on buying the most expensive house you can, and getting paid as much from owning their house (via capital appreciation) as going to work every day. The extra money that trickled down from asset holders into the low-paid service economy has been offset by the stagnation of the higher-productivity parts of the non-finance-sector economy.
Great piece. Curious doesn’t an increase in bank reserve naturally enable the bank to issue larger credits per Basel III? Assume bank had 10x reserve ratio with 1 dollar in reserve and 10 dollars in credit, enlarging its reserve to 2 dollars certainly can double its credits?
Ever since March 2020 the US bank reserve requirement is 0%
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
wow
Hi, thanks for the kind words.
Not really: the level of bank reserves is almost irrelevant for the decision-making process when it comes to bank lending.
Banks lend if the borrowers' creditworthiness is good, and if the RoE on the loan (loan yield vs capital requirements) is attractive enough against the borrower's risk profile.
My question is similar: Isn't the reason of doing QE to encourage banks in more lending activity (instead of buying HQLA)? So when a commercial bank has more reserves after having sold bonds to the central bank, the commercial bank should be able to lend more money - correct? Thanks, Alf.
My pleasure! As explained in the reply above, the level of bank reserves is irrelevant for bank lending decisions.
My article on this (and more): https://themacrocompass.substack.com/p/tmc-6-all-they-told-you-about-printing?s=w
So I assume QT means banks will need to reverse this process and increase holdings of reserves, since their bond holdings will be skewed to the upside as reserves are pulled from the system by the Fed? Also how would the recent rout in the bond/equity markets affect banks allocation to HQLA's? I guess increasing volatility means they would reduce exposure to corporate debt and move to treasury's?
Hey mate! Yes, if QT is not sterilized somehow with the money sitting at the RRP, bank reserves will need to drop.
As they drop, the portfolio rebalancing effect works the other way around.
Increasing volatility can affect HQLA allocation but accounting rules help smoothen that process.
Thank you, this is educational. How did they expect QE to increase inflation if most of the buyers of risk assets are a small proportion of the population, and their extra capital usually goes to equities and other real assets? Until recently, QE really only succeeded in raising prices of stocks and houses.
They thought banks lend reserves......which is wrong.
I am a better version of myself than yesterday. Thanks.
That's what I'm going for!