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Can Banks Spend Their Reserves?

Bank reserves can never leave the balance sheet of the Fed, but that does not limit how they can be spent. Reserves are a form of money and can be spent on anything. However, banks transact with other banks in a different way than how banks transacts with non-banks. This is due to our two-tiered monetary system, where not everyone is eligible to hold reserves. For the cryptocurrency fans: this is the equivalent of a bitcoin holder able to pay another bitcoin address, but unable to send bitcoin to someone with only a Ethereum address. In this note I sketch out a few illustrations that should be helpful in understanding how this works in a bank-to-bank and bank-to-non-bank scenario.

Note: Although banks can spend reserves on anything, bank are heavily regulated in what they can buy. They cannot go out and load up on equities and high yield or other risky assets without violating risk and regulatory limits. Regulation and profitability, not reserves, is what constrains a bank’s balance sheet.

Bank to Bank Transactions

In this example a bank will purchase an asset – be it a Treasury, office building, car etc. from another bank. The transaction is essentially an asset swap, where Bank A swaps $100 in reserves for an $100 asset that Bank B holds. The aggregate balance sheet of the banking system does not change.

Bank to Non-Bank Transaction

In this example Bank A will purchase an asset from a non-bank, who banks with Bank B. Note that this results in the creation of bank deposits. The Non-Bank essentially converts his asset into bank deposits through the sale. Bank deposits are created when a bank creates a loan asset or buys something from a non-bank.  Whereas the aggregate level of reserves in the banking system is unchanged, the aggregate balance sheet size of the banking sector is $100 larger. The spending of reserves by any individual bank does not change the aggregate level of reserves in the banking sector, but it does shift the distribution.

In practice, banks must hold a certain level of reserves to meet regulatory liquidity thresholds. For large banks, this is usually to meet the Liquidity Coverage Ratio. The LCR mandates banks to hold a level of high quality liquid assets like reserves, Treasuries, or reverse repo backed by Treasuries in proportion to their expected 30 day outflows. Banks that spend their reserve levels will thus only buy other HQLA assets like Treasuries or Treasury reverse repo. For example, in late 2018 JPM decided to invest a large chunk of its reserves into reverse repo. This was a time when repo rates (proxied by the Secured Overnight Funding Rate) rose comfortably above the Interest on Reserves paid by the Fed on reserves. 

2 Comments

  1. Murray

    Do you know if these types of commercial bank to commercial banks swaps play out much in reality? because If I have a liquid treasury why would I want to swap it for reserves

    Or if I have a risky corporate bonds why would the other party want to swap me their safe reserves?

    In what scenario would each party both be happy with the swap

    • Fed Guy

      When commercials banks swap reserves for Treasuries (reverse repo transaction), they are doing that maximize profit subject to their regulatory constraints. They can earn slightly more on the reverse repo loan than the interest the Fed offers on reserves. Treasuries and reserves are considered equal under liquidity regulations, so it is neutral from a regulatory standpoint.

      Commercial banks could swap Treasuries for reserves if they needed liquidity via repo loans. For example, suppose Bank A’s big depositor withdrew a ton of deposits to deposit at Bank B. Bank A will need reserves to meet those withdraws (the reserves will be wired to Bank B). Bank A may repo out their Treasuries to temporarily raise liquidity to meet those outflows. The key here is that inter-bank payments can only be settled in central bank reserves, not Treasuries. In practice commercial bank’s rarely do this today because the level of reserves is so high they don’t need liquidity.

      In practice Commercial banks do not lend in reverse repo against risky collateral. This is because their regulatory metrics a lot, and because in the post 2008 crisis world the repo market for risky collateral is much smaller and less liquid. A hedge fund or other investment fund could do this trade to earn a relative high return (the risky collateral will be haircut so risk is not high)

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