In this excerpt from Andrew Bailey’s lecture at LSE in honour of Charles Goodhart, the Governor of the Bank of England argues that Central bank reserves are important for financial stability as well as for the Bank’s main role of keeping inflation low.  

It may not be a topic for dinner table conversations, but the central bank balance sheet plays a crucial role in everyday economic life. Its main liabilities – central bank reserves, the deposits that commercial banks hold at the central bank – serve as the ultimate means of settlement for transactions in the economy. Central bank reserves, in other words, are the most liquid and ultimate form of money. They underpin nearly all other forms of money such as the deposits individuals or businesses hold at commercial banks. The Bank issues physical bank notes directly to the public too, of course, but they are a smaller part of overall money stock.

Some transactions can happen simply by moving money from one account to another at the same commercial bank. In that case, the central bank need not be involved. But whenever money has to be transferred from an account at one commercial bank to an account at another commercial bank, that transaction has to be settled between them. That is where the central bank’s balance sheet comes in. Commercial banks hold reserves at the central bank. So transactions can be settled by moving these reserves – claims on the central bank – across the central bank balance sheet by debiting one commercial bank’s reserve account and crediting another’s. It is the confidence that payments can be settled in this way that ultimately gives commercial bank money its value. It ensures the singleness of money, that people can be confident that money is fungible at equal value – that the money they hold in their account is as good as any other.

The majority of money is created when banks make loans to their customers.

I want to talk about the key role that central bank reserves play in delivering our core mandates of maintaining financial stability and implementing monetary policy, and what those roles imply for the future of the Bank of England’s balance sheet. Starting with financial stability, central bank reserves are the safest and most liquid of financial assets, the ultimate means of settlement. This makes them an essential anchor for the stability of commercial banks and the wider financial system. Commercial banks can create money simply by extending loans to their customers. It is worth pausing at that sentence. It is the answer to one of the simplest but most teasing questions I get asked, particularly when I visit schools: “how is money created?” The majority of money is created when banks make loans to their customers. But banks need to hold sufficient reserves, or ‘liquidity’, to meet the potential outflows of money from their customers’ accounts. So by ensuring that all transactions can proceed smoothly, central bank reserves play an important role in maintaining financial stability.

This does not imply that banks need to hold reserves for all eventualities. They can borrow liquidity from each other in the so-called money market, for example, to smooth out demands. And central banks stand ready to provide additional liquidity, in the form of central bank reserves, as needed for the system to operate smoothly. Effectively, banks can borrow the reserves they need from the central bank, by pledging other assets as collateral for the loan. As Charles put it in a paper he published in 2011: “the essence of central banking lies in its power to create liquidity, by manipulating its balance sheet” in this way.

But first to the second important role that central bank reserves play in today’s monetary system: central bank reserves are remunerated at the official policy rate and as such they provide an essential anchor for the implementation of monetary policy. The Bank’s Monetary Policy Committee sets the level of Bank Rate to meet its 2% inflation target. The Bank puts these monetary policy decisions into effect through the remuneration of reserves at that rate. By pinning down the near-end of the interest rate curve, this is the first step in the transmission of monetary policy through financial markets to the real economy and thus influencing inflation.

While in principle we could implement monetary policy with a much smaller level of reserves than we have today, I argue that financial stability considerations point towards an increased reserve demand since the financial crisis, one that the central bank has very good reason to meet.

There are other ways of affecting short-term interest rates for monetary policy purposes, but all involve the use of central bank reserves in some way or another. Before the global financial crisis, most central banks operated with a much lower level of reserves than today and an interest-rate ‘corridor’ between official rates on a borrowing and a deposit facility. The approach involved managing the ‘scarcity’ of reserves such that the money market rate was in the middle of the corridor. The Bank of England operated a variant of this approach that required firms to specify the quantity of reserves they wanted to hold on average each month and then incentivised them to manage their holdings to this target by paying Bank Rate only on this target.

While in principle we could implement monetary policy with a much smaller level of reserves than we have today, I argue that financial stability considerations point towards an increased reserve demand since the financial crisis, one that the central bank has very good reason to meet. But how many reserves do we need in the system to secure financial stability as well as to implement monetary policy effectively – what is the optimal level? And given that level, we are faced with another question: which assets should the Bank hold to back it?

Decisions on how we supply reserves will affect where it intersects demand. We need to account for potential market distortions from our choices, and what they imply for the balance between liquidity provision directly through the Bank’s facilities and indirectly via the money market, both in normal times and in stress. And we need to consider where interest rate risk sits within the system and what the implications are of that. These are important questions. How we answer them will shape the Bank of England’s balance sheet for years to come.

You can read Andrew Bailey’s lecture in its entirety here.

All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.

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