The level of commercial bank reserves is determined by the size of the Fed’s balance sheet, and the proportion of reserves that end up in the Fed accounts of banks. When the Fed purchases securities or makes loans, it creates reserves out of thin air to fund them. A $100 purchase of Treasury securities results in the creation of $100 in reserves. A $100 FX Swap loan also creates $100 in reserves. Reserves can only be created or destroyed by the Fed, but banks are not the only entities eligible to hold reserves.
Reserves can never leave the Fed’s balance sheet, but they can be shifted around the Fed’s balance sheet. Think of it as Bitcoin ledger, where Bitcoins are paid to other wallets but always remain on the ledger. Only entities with an account at the Fed can hold reserves, so the created reserves are shuffled amongst the different Fed account holders as payments are made. For example, when commercial bank A makes a payment to commercial bank B, then reserves are wired from bank A’s Fed account to bank B’s Fed account. The total level of reserves stays the same. Most reserves are held by depository institutions such as commercial banks or credit unions, but there are other notable entities that have Fed accounts. These other entities, such as the Treasury, can at times have large holdings of reserves. The level of reserves held by the banking sector decreases when reserves move into these other Fed accounts.
Fed Balance Sheet Size
In recent months, the Fed has rapidly expanded its balance by purchasing securities and lending to market participants. The Fed has so far purchased around 2.7 trillion of Treasuries and Agency MBS, which were paid for through the creation of reserves. [For more details on the mechanics of QE purchases, see this post]. In addition, the Fed lent to a wide range of market participants through its alphabet soup of credit facilities, and through FX swaps. These actions expanded the Fed’s balance sheet by around $3 trillion, but only increased bank reserves by around $1.2 trillion. This is because some of the reserves moved into the Fed accounts of non-banks.
Other Reserve Account Holders
While most reserves are held by banks, other notable reserve holders include the Treasury, Government Sponsored Enterprises, Designated Financial Market Utilities, and the Foreign Repo Pool. The reserve holdings by these accounts can be large, effectively “draining” reserves from the banking system. The section below will briefly discuss some of the dynamics that drive changes in these other balances. Also note that banks have the option of converting their reserves into currency (ie bills and coins), so reserves can also decline when the demand for currency increases.
Treasury General Account
The Treasury General Account (“TGA”) is the U.S. government’s checking account, and a significant driver of changes in bank reserve balances. [Note in the past, when the Fed operated in a reserve scarcity framework, the Treasury would also keep liquidity in accounts at commercial banks. See TT&L program and this FEDS Note.] The level of the TGA is dictated by the inflows and outflows of government expenditures, as well as a precautionary guideline to hold enough liquidity to cover 5 days of outflows. For example, during April tax season the TGA will usually briefly swell by a few hundred billion as tax payments flow out of the banking sector and into the TGA. Over the past few months, the TGA has been unusually elevated at over $1 trillion. This may reflect the Treasury’s view of upcoming cash needs (such as PPP loan forgiveness), and the need to hold higher precautionary balances given the higher level of Treasury debt. Note that Treasury has issued over 2 trillion of Treasury bills in recent months, and those will need to be constantly rolled over.
Foreign Repo Pool
The Foreign repo pool is basically a checking account service provided by the Fed to foreign central banks. It is common practice for central banks to provide these services to each other. However, the transaction is structured as a repo transaction where the foreign central bank is lending to the Fed in exchange for Treasury security collateral. When a foreign central bank moves deposits from a bank to the Foreign Repo Pool, reserves are leaving the banking sector and being “lent” to the Fed. This is similar to the Fed’s Reverse Repo Facility, where counterparties like money market funds can lend to the Fed. The foreign central bank does not hold reserves, but a reverse repo asset (with Treasury collateral). The balances for the foreign repo pool are relatively stable, as many central banks value a risk-free counterparty.
The Fed allows a few other entities to hold Fed accounts, including the GSEs (Fannie, Freddie etc.) and the DFMUs (clearing houses). The collective balances for these entities are usually stable, but there are seasonal and market dynamics that influence them. For example, heightened market volatility can lead clearing houses to increase their own liquidity and demand higher margin balances from their clients. There are also slight monthly fluctuations largely due to the GSE float period. Float period is when Fannie and Freddie receive mortgage payments from homeowners, which result in a payment from the Fed accounts of banks to Fannie and Freddie’s Fed account. Fannie and Freddie collect these payments as they come in, and then remit them to the Agency MBS investors on the date Agency MBS interest payments are due. This payment from Fannie and Freddie to the investors sends reserves from their Fed account back to the banking sector. The chart above shows that the monthly spikes have been particularly high; potentially due to higher float period balances as Agency MBS prepayments surged because homeowners are prepaying their mortgages via refinancing.
Fed reserves are convertible to currency by commercial banks. When a commercial bank needs more currency, it calls the Fed. The Fed will deduct the amount from the bank’s reserve balances and then send over an armored truck full of currency. Currency growth is stable so in the absence of any Fed actions the level of reserves in the financial system would gradually decline through demand for currency.