Reserves, what are they good for?

It's 2022 and we're *still* saying banks lend reserves?

Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.

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The preview pic for today’s post is the Cleveland Fed’s (my future workplace!) vault door, which is not just the largest bank vault door in the world (at 200,000 pounds!), but is also said to contain the largest hinge ever built, at 94,000 pounds and 19 feet tall. Here’s some interesting footage from 1950 on the Cleveland Fed that touches on how some bits of what I’ll talk about in this post used to work back in the day.

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In a recent New York Times piece discussing whether money creation, particularly by the Fed, was financing the deficit (don’t worry, it’s not!), Paul Krugman slipped in an erroneous little sentence:

Since the 2008 financial crisis, however, banks have been voluntarily holding vast excess reserves, apparently because they don’t see enough good lending opportunities

This is an incorrect understanding of the role of reserves in the economy. I won’t be able to cover everything about reserves in this post, but I want to go through why this view is wrong. Banks do not, and in fact cannot, lend reserves to anyone except other banks. In previous instances when Krugman touched on this issue, he was a little closer to being correct, but even stronger models miss the mark.

What is a reserve?

Reserves, needless to say, put the “reserve” in “Federal Reserve”.

The Fed is a bank for banks. Just as you have deposits with your bank, banks have deposits with the Fed—these are reserves. Just like how you can go to the bank or an ATM to convert your deposit into physical cash currency (and reduce your deposits as a result), bank deposits at the Fed decline when banks want or need more physical cash currency. And, just as you often find it much easier to pay someone hundreds or thousands of miles away via electronic payment instead of by delivering a box of cash, banks settle payments with each other through reserves.

Reserves, like deposits, cannot leave the banking system except by transforming to cash. Bank account deposits are little more than sequences of numbers stored in an electronic system. Deposits represent, but are not, cash currency. You cannot pick up a deposit and look at it, or take your deposit to the store to buy stuff. You can use your deposit for purchases, but it’s not a physical “real” thing in and of itself. Reserves are no different: a bank cannot just take reserves out from the Fed and put them on the street. For deposits and reserves to leave the banking system, they must be transformed into cash.

One common issue is the very out-of-date impression of reserves given by many popular textbooks, and that people simply learned how the system worked before the financial crisis. Back in the day, reserves were scarce and kept scarce, and the game was different back then. The quantity of reserves had more sway since banks could plausibly be unable to settle payments if their behavior had led to too much financial activity, which would mean they would have to borrow at the fed funds rate. And, with no interest on reserves, there was no real point in holding reserves if you didn’t have to. Reserves were still unable to be lent out to the public, but you were much more inclined to lend them to other banks (or to borrow from other banks), which made them more of a “hot potato”. The total quantity was set by the Fed, as it still is now.

Since 2008, reserves are in abundance—it would take a real lot to be in a situation where you needed to borrow, especially with reserve requirements now at zero. Reserves exist now more or less just because…they do. Let’s dive into that.

Why so many reserves?

Just as banks issue deposits for consumers, the Fed issues deposits for banks. Just as your bank won’t spontaneously issue a million dollar deposit in your account without receiving a matching asset, the Fed does not spontaneously provide banks with trillions of reserves without acquiring a corresponding asset.

The massive stock of reserves at the Fed exist because the Fed acquired a massive stock of assets. This process is professionally known as Large Scale Asset Purchases, but doesn’t mind quantitative easing as a nickname. The Fed did not steal these assets—it paid for them, much like how your bank “pays” you with a deposit in return for giving them your cash. It is for this reason that LSAPs/QE should really not be referred to as money printing. Reserves are money, but they’re not money that is available to you and I; they are “printed” (how about “created”?) out of thin air, but the recipient isn’t any wealthier after receiving them. Are you wealthier after you swap your cash for a bank deposit? If so, please let me know which bank you use.

The reason the quantity of reserves is so high is, simply enough, because it is. The Fed alone determines the quantity of reserves in the system. In fact, nobody else can really do anything about it, except maybe in the pretty short run (perhaps between FOMC meetings). Why? If a bank decided it was holding more reserves than it wanted to, what could it even do about that? The best option is to either lend those reserves to another bank (if another bank even wanted them—there are already so many), or buy some sort of an asset with them (which, with regulation, isn’t always so straightforward, but is possible since banks can buy stuff with reserves).

Technically, a bank could go ham and rev up its lending activity to increase the amount of deposits, and assuming some desire for proportionality, cash too. This might bring down reserve balances, but a) bank lending is still far from unrestrained even if banks do not need reserves to lend, and b) the Fed can meet and decide to increase reserve balances anyway. Funny enough, if banks increased their lending, that might lead to the Fed needing to supply more reserves so that banks could clear their payments. Moreover, who says people really want cash anyway? So much of it is overseas to begin with.

The better, but still wrong, argument

In another piece from about a decade ago, Krugman elaborates a bit on what he means by “lending out reserves”:

Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.

Okay, well, a little better, but what does “lending” have to do with that process? Sure, when the Fed buys an asset the seller is given reserves in return, and they may very well like to “use” those reserves, perhaps by buying more assets. Maybe we can call purchasing something like a corporate bond lending, but that is not really the same thing as when a bank lends. And again: bank lending is not very reserve constrained anyway.

I wouldn’t really call this lending, either! It’s a chain of asset swaps. The Fed buys an asset from a bank; that bank gets reserves in return. Let’s say that bank personally really does not want to hold those new reserves and would rather use them to buy an asset; when they buy that asset, let’s say a corporate bond, the seller of that asset now has a more liquid deposit instead of a slightly less liquid asset. Sure, there might be more deposits downstream if this is how it goes, but it’s not really lending any more than how I don’t lend to the grocery store when my payment to them clears. Maybe if the asset is secured in the primary market we can be a bit more forgiving, but even then it’s still not the same as bank lending and deposit creation.

There’s a more broad issue here, too. Perhaps one bank, or even all banks, are reserve-phobic. Unfortunately, somebody has to hold them. One of three things can happen to reserves: you can keep holding them, you can send them to someone else, or they can be converted to cash currency. And even if you do magically find a way to throw your reserves into the void, the Fed can always make more!

At least Paul concedes that we may find his shorthand misleading, but even the longform of his model is iffy. Now, for fun, try to reconcile Krugman’s view—that banks hold so many reserves because they either can’t find good lending opportunities or enough assets to buy—with the FinTwit view that Fed fueled all of the last decade’s stock market boom through its money printing. Paul says banks have hardly been inclined to invest under any meaning of the term, FinTwit says banks have been investing too much all thanks to the Fed. Alas: neither are correct.

Does the quantity matter?

Not really. I’ll close by discussing a quote from Bill Dudley, former NY Fed president:

Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet.  This pushes down risk premia, and prompts private sector investors to move into riskier assets.  As a result, financial market conditions ease, supporting wealth and aggregate demand.  The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct—not the goal—of these actions.

If monetary policy seeks to be accommodative, it should seek to at least lower risk premia, which encourages more risk taking and investment, which leads to job and income growth and ultimately to stronger aggregate demand, mainly by adjusting financial conditions. The quantity of reserves is not the point—the point is the consequences of the action that created them, the buying of assets. The creation of reserves is not typically going to be what enables those risk premia to fall, nor what encourages lending or investment.