personal views of a former fed trader

Two Tiered Monetary System

We have a two tiered monetary system, where one type of money is used when transacting with the Fed and between commercial banks (reserves), and another type of money is use when transacting with everyone else (bank deposits). This note explains the two types of money, and how they interact with each other.

Fed Reserves

Reserves are an unsecured liability of the Fed that can only be held by entities with an account at the Fed. Think of it as a checking account at the Fed, except that deposits in the account can only be used to pay entities who also have a checking account at the Fed. Broadly speaking, only depository institutions like commercial banks or credit unions are eligible to have accounts at the Fed. But there are also other notable entities such as the U.S. Treasury, GSEs like Fannie Mae, and clearing houses like the CME. When these entities make payments to each other, they pay in reserves.

Since reserves can only be sent to entities who also have a Fed account, the total level of reserves in the financial system cannot be changed by account holders. Reserves can never leave the Fed’s balance sheet and are simply shifted from one Fed account to another on the Fed’s balance sheet. It is a closed system. The total level of reserves is determined by Fed actions, which create or destroy reserves. Reserves are created when the Fed expands its balance sheet by buying assets, and extinguished when those assets are repaid. One exception to this is that reserves can be converted to currency at the request of commercial banks. If a commercial bank needs $1 million in currency, it calls the Fed, who then sends an armored truck carrying $1 million in currency to the commercial bank. The Fed then deducts $1 million in reserves from the commercial bank’s Fed account.

Bank Deposits

Bank deposits are an unsecured liability of a commercial bank that can be held by anyone with an account at the commercial bank. Bank deposits are what constitute the vast majority of what people think of as “money.” When you logon to your online bank account, you are simply seeing how many bank deposits you have—how much your bank owes you.

Bank deposits are created when a commercial bank purchases assets or creates loans. When a bank makes a $1 million dollar to you, it is simply adding $1 million to your bank account. A commercial bank does not lend out bank deposits, it creates bank deposits. That being said, the commercial bank has to make sure its deposits are backed by sound loans and that it has enough liquidity to meet payments to other commercial banks.

Each commercial bank creates its own bank deposits, but depositors are able to transfer deposits from one bank to another. While the aggregate level of commercial bank deposits is determined by the collective actions of commercial banks, each individual commercial bank can lose or gain bank deposits as its customers make or receive payments. For example, if you take your $1 million on deposit and pay a contractor who banks at another bank then your bank will experience a deposit outflow of $1 million.

Although you are paying your contractor, behind the scenes your bank is paying your contractor’s bank. Payments between banks are settled in reserves, which are a risk free (Fed cannot default on reserves, but commercial banks can default on their deposits). Both commercial banks have accounts at the Fed, so your bank will wire $1 million in reserves to the contractor’s bank. If your bank doesn’t have enough reserves to settle the payment, it can go borrow the reserves.

Interaction Between the Two Tiers: Quantitative Easing

I will use quantitative easing as an example of how the two tiers of money interact. In quantitative easing the Fed purchases Treasury securities from an investor (via a primary dealer, which I will omit for simplification) and pays for the securities with reserves it creates.

Although the investor is not eligible to hold reserves, its commercial bank is eligible. When the investor sells the Treasury to the Fed, the Fed will create reserves to pay for it. The reserves will be deposited in the Fed account of the investor’s commercial bank. The commercial bank will in turn credit the investor’s account with bank deposits. At the end of the day, there are more reserves and bank deposits in the financial system.

16 Comments

  1. james

    Can the Commercial Banks use their Fed created Bank Reserves to buy non treasury things like bonds and stocks?

  2. Sam

    Hello,

    Could you please clarify this comment “At the end of the day, there are more reserves and bank deposits in the financial system.” I agree that there are more reserves, but at the same time, there are fewer Treasury Securities in the financial system as the Fed swaps Treasury securities with bank reserves. So shouldn’t the total assets in the banking system remain unchanged? Thank you

    • Fed Guy

      That would be true if all the Treasuries were held by banks. Then it would just be an exchange of Treasuries for reserves. But most Treasuries are not held by banks. For example, if an investor sells $100 in Treasuries to the Fed, then the investor’s bank receives $100 reserves as payment from the Fed and the investor receives $100 in bank deposits. The bank’s balance sheet expands – more reserve assets and deposit liabilities.

  3. franco

    Reserves can never leave the Fed’s balance sheet and are simply shifted from one Fed account to another on the Fed’s balance sheet.It is a closed system.

    But if a bank buys shares from another bank, they exchange reserves between their fed accounts. Then that same bank sells those shares to an investor, in this way, it does not take the money from the closed system to the “open” system??

    • Paul Lebow

      Well Joe didn’t respond but here’s my two cents –

      It seems to me that the reserves are just transferred to the investor’s bank to balance the investor’s new deposit. The investor is not a bank, but his money is recorded in his bank’s balance sheet as a liability to balance the corresponding reserves it receives. So reserves are still safe an secure in the reserve circuit.

    • EW421

      i dont think banks buy shares of another bank by using bank reserves, this reserve’s used for interbank loans

  4. Lee Xing

    bank A buys shares from Bank B
    bank A Assets: reserves -$100
    bank A Assets: shares +$100
    bank B Assets: shares -$100
    bank B Assets: reserves +$100

    bank A sell shares to investor
    bank A Assets: shares -$100
    bank A Assets: reserves +$100
    investor’s bank Assets: reserves -$100
    investor’s bank Liabilities: bank deposit -$100

    overall the level of reserves still remain unchanged after all the transactions. One thing to notice here, I assumed cash/currency is not involved here(assume investor bought share using the deposit saved in another bank, not cash)

  5. Ben

    Can you walk me through the T Account/journal entries of when the borrower fails to pay back the $1m loan from the commercial bank’s point of view? Understood after paying the contractor the borrower’s commercial bank still has the $1m of loan amongst its asset. With a default, the $1m loan is credited (written down) and what is it balanced with? Additional expense that then hits retained earnings?

    • Paul Lebow

      I hope Joe answers but it seems to me that the borrower’s bank will have to make up the reserves after foreclosure sale of the collateral. I assume banks fold in a certain failure rate and must have adequate capital to handle them… until they don’t.

  6. Val

    Is it possible to know the amount of QE that purchased investors’ Treasury securities vs the amount that swapped Treasury securities for reserves?

  7. Josh

    Thank you! This was great

  8. James Mathew Harris

    This was good. I followed your links and while bank reserves can be spent on anything *between banks* I wish that you noted its highly unlikely its going to be used to purchase consumer goods. So while QE can expand the money supply, its not going to effect the CPI since banks aren’t hoarding cans of soup in their vaults.

    You mention a 2 tiered system here, and this is true. Professor Perry Merhling goes the next step and talks about a hierarchy of money. His most recent work deals with international swap lines. Are you familiar with his work?

  9. Mark

    Hello,
    My question is in relation to “Payment to contractor” illustrative example on creation of bank deposits section.
    Commercial Bank has an asset/loan of $1mil. and its previous liability, as it relates to your example, is reduced to $0 because payment has been made on behalf of the customer. In other words, although reserves and deposits have decreased by $1mil. after payment to contractors Bank, the loan remains an asset on the originating Bank’s books.
    Given that total assets and liabilities didn’t change, what balances the existing loan asset on the liabilities side of the Bank that originated the loan? Is it some type of a charge/entry related to Bank’s capital/equity?
    Thank you!

  10. Gerd Weyer

    Answers to the following questions are greatly appreciated.

    On the H.6 Fed statistical release why is “Currency, Not seasonally adjusted” different than “Monetary base; currency in circulation; not seasonally adjusted”?

    How are “reserves” distributed amongst banks. I know banks can borrow reserves using the Federal Funds Rate. My question is when the Federal Reserve increases reserves by purchasing assets through open market operations using primary dealers do the reserves of individual commercial banks increase or only Federal Reserve banks and the Federal Reserve banks lend reserves to the commercial banks.

    If capital is not sufficient to absorb bank losses during a major financial crisis can reserves be converted into currency and used to prevent bankruptcy?

  11. David

    Joesph,

    The insight & guidence you give is appreciated. Would you be interested in assisting (consulting or otherwise) in monetary policy, instrument design for a digital economy that will structure devaling fiat into IP production of a deliverable physical, scaling a global industry with socio-economic and environmental outcomes ? Its a synergistic trade credit turns the fiat into a hedge backed by the forward production. If you wouldn’t mind joining on an intro zoom to hear more I’d appreciate it. This worthy project needs the brightest minds. Cheers

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