What are bank Reserves? Simply put, bank Reserves are how banks settle transactions (bank transfers from one client to another) between each other.

When a customer deposits $100 in Bank A, Bank A’s total Reserves increases by $100, and its liabilities increase by $100. Deposits are liabilities from a bank’s perspective because deposits are funds that they owe to customers: 

Now, when the customer transfers $100 to a friend who holds an account in a different bank, Bank B, Bank A has to transfer its Reserves to Bank B:

This transfer is done via the Fed, where US banks have accounts holding Reserves for just this purpose – to settle transactions amongst themselves. Banks in other countries will have accounts with their own domestic Central Banks, with their own domestically denominated Reserves.

Different Central Banks have different policies, but in general, banks do not transfer reserves between each other every time a transaction is initiated.

Instead, they do it on  a net basis at the end of the day, simply because it is a lot more convenient. This practice means that individual banks in the financial system will have vastly differing needs for Reserves at the end of each business day.

These differing needs create demand and supply in the domestic interbank market for Reserves, where banks lend/borrow Reserves from each other in order to meet their daily business needs. Naturally, such a market will have its prevailing interest rate, a good example of which is the Fed Funds target rate that market folks always talk about. 

Since domestic banks must have Reserve accounts with their respective Central Bank in order to settle transactions with their counterparty banks, Central Banks can, and do use Reserves as a means to achieve their respective monetary policies.

For example, they can create them by purchasing assets from domestic banks, a la QE, or destroy them by selling assets to domestic banks.

This ability to create Reserves has led many to believe that Central Banks can create money at will, and is hence at the root of the hysterical chorus of “hyperinflation is coming” with each new iteration of QE (The hysteria is unfounded).

Some Central Banks also have a Reserve Requirement Ratio (RRR), which requires banks to hold a certain percentage, say 10%, of their deposit liabilities in their accounts at the Central Bank.

Different Central Banks implement such a rule for different reasons , some, such as the People’s Bank of China (PBoC), uses the RRR as an important tool to manage their domestic money supply. Other Central Banks have given up on the RRR altogether, setting them at zero, including the Bank of England (BoE) and more recently, the Fed.

So why the differing approaches?

This is where the role of Reserves in the financial system and wider economy becomes a little bit more complex, and a lot more misunderstood, which will be explained in further detail next.

To be continued…