The importance of central bank reserves by Andrew Bailey

Lecture in honour of Charles Goodhart, London School of Economics
Published on 21 May 2024

Central bank reserves play a key role in delivering the Bank of England’s core mandates of financial stability and monetary policy. In this lecture, the Governor discusses implications for the future of the Bank’s balance sheet.

Lecture

It is a great pleasure to be here at this event, hosted by the LSE’s Financial Markets Group in honour of Charles Goodhart.

This evening, I am going to talk about central bank balance sheets and in particular the Bank of England’s balance sheet. An esoteric topic perhaps, but an important one, now more than ever. And it is a topic on which Charles has written extensively.

Charles worked at the Bank for nearly two decades, of course, before his distinguished career as a professor here at the London School of Economics. His article “The importance of money”, published in the Bank’s Quarterly Bulletin in 1970 and available on the Bank of England’s website, was a milestone in the study of the predictability of money demand.footnote [1] At the time this was an important issue in debates over monetary control mechanisms and the relative merits of monetary ‘rules’ and policy ‘discretion’, a debate he masterfully summarised in his 1975 book on “Money, Information and Uncertainty”.

In this and later work, Charles brought his deep understanding of the nature of financial markets, of banking and of monetary assets to bear, the historical perspective always present. In his 1988 book “On the Evolution of Central Banks” he discussed “how the role and functions of Central Banks have evolved naturally over time, and play a necessary part within the banking system”. Fast forward two more decades – across a long list of significant contributions covering the full spectrum of monetary economics – it was with more foresight than most that he turned to “A Central Bank’s Optimal Balance Sheet Size?” in 2017, discussing principles for ‘monetary policy renormalisation’ after a decade of central bank balance sheet expansion.footnote [2]

I should not fail to mention that Charles was a policymaker too. He served as an inaugural external member of the Monetary Policy Committee, from June 1997 to May 2000. When he left Bank Rate was at 6.0%. It is tempting to bring up r* at this point. But I will resist and conclude instead that the Bank of England’s balance sheet seems a fitting topic for a lecture in Charles’s honour this evening.

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.footnote [3] 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.

In practice, transactions are processed through our Real-Time Gross Settlement (RTGS) service. This delivers final and risk-free settlement of transactions across the financial system with central bank reserves at its centre. Incidentally, this means that central bank reserves exist predominantly in digital form. So the road to a ‘digital pound’ is not as long as you might suspect. One way to think about wholesale Central Bank Digital Currency is as just another form of digital central bank reserves. Meanwhile, a new and improved RTGS is nearing completion. This will deliver an enhanced settlement service, supporting innovation in payment services. This is an exciting and important work programme, but not the subject for today.

Instead, 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.footnote [4] 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 of course comes with a package of macro-prudential policy and micro-prudential regulation. Macro-prudential policy works to ensure that the whole financial system is robust and that people can have confidence that their money is safe. And micro-prudential regulation, among other things, incentivises banks to take relatively more stable term deposits and to ensure that they hold an adequate amount of high-quality liquid assets, so-called HQLA which includes central bank reserves, to meet their payment obligations at all times. This regulation underpins the important singleness of money.

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.footnote [5] I will have more to say about this later.

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.

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.

In the system we have today, the much larger supply of reserves drives money market rates close to the ‘floor’ determined by Bank Rate. If money market rates were to fall much below Bank Rate, banks would have an opportunity to profit by borrowing reserves from other banks, for example, and earning Bank Rate on their reserve accounts. This ‘floor’ system has been successful in keeping money market rates very close to Bank Rate.

While in principle we could implement monetary policy with a much smaller level of reserves than we have today, I will argue this evening 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? These two questions are the topic of today.

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.

It is useful to start with some history.

By the time the Bank of England was founded in 1694, goldsmiths in London were carrying out banking business and issuing notes. Members of the public could go to their local goldsmith and deposit their gold and silver coins in exchange for a bank note that was easier and safer to carry around. Goldsmith bankers also created money by issuing further notes against their specie deposits to borrowers. The goldsmith bankers accepted each other’s notes, cashing them in only every few days and settling only the difference in gold and silver coin.footnote [6]

This was formalised in the London Banker’s Clearing House. By 1774, London bankers had switched from settling transactions in specie to settling in Bank of England notes. As a ‘Great Engine of State’, the Bank of England’s notes had special status, though that is a story for another day. Suffice to say that when the Bank entered the clearing system in 1864, banks had already started to settle with each other using their accounts at the Bank of England directly. These accounts were known as ‘bankers’ balances’ – and later as ‘central bank reserve accounts’. Bankers’ balances quickly grew in importance and became the fulcrum of the Bank’s operations with the money market by the late 19th century. Settling large transactions with a few entries in the Bank’s ledgers was certainly much more convenient – and much safer – than carrying heavy bags of gold and silver coin across town.

In his 1972 book on “The Business of Banking” of this time, Charles showed that banks held more in the form of bankers’ balances than they needed purely for settlement purposes. Banker’s balances were unremunerated and would remain so until 2006. That does suggest some precautionary liquidity motive. But Charles also found evidence that banks held a certain level of balances to keep good relations with the Bank should they need additional liquidity, and that some banks pre-positioned collateral for that purpose. I will come back to both these points later in a modern context.

As Chart 1 shows, at the turn of the 20th century, on top of bankers’ balances (in orange), banks also held safe investment assets in the form of government securities (in blue) and a frontline reserve of cash in their tills to meet immediate customer demands (in green).footnote [7] This provided an adequate safety buffer given the nature of banking at the time. Banks largely provided working capital finance to firms. Their private assets were bills, short-term loans and overdrafts. They would not enter the mortgage market until the 1980s. So the banking system was relatively safe with little risk from maturity transformation.

Chart 1: At the turn of the 20th century, banks held adequate safety buffers

Government debt and central bank reserves held by banks as a ratio of deposits

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Footnotes

  • Sources: Bank of England, Thomas and Dimsdale (2017), Sheppard (1971), Capie and Webber (1985) and Bank calculations.

Both World Wars would see a major increase in the amount of government securities held by the banks, reflecting the banking system’s role in funding the Government’s deficit. As Chart 2 shows, at the end of World War 2 around three quarters of the banking system’s sterling assets were in the form of direct or indirect holdings of government debt instruments (in blue). The 1950s and 1960s saw the composition of bank assets move firmly back towards private sector lending (in green). But in this period, frequent balance of payments crises under the Bretton Woods system led to attempts to control bank lending. Pressure was applied to banks’ liquid asset ratios to reduce their illiquid
private-sector loan assets, and the Government applied direct controls on credit provision. In other words, credit provision to the economy was actively discouraged.

Chart 2: The composition of bank assets changed in the 1950s and 1960s

Sterling bank lending to the public and private sector credit as ratio of GDP

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Footnotes

  • Sources: Bank of England, Thomas and Dimsdale (2017), Sheppard (1971), Capie and Webber (1985) and Bank calculations.

Then during the 1970s and 1980s, financial liberalisation and the removal of controls on the banks and building societies led to a significant decline in the public sector liquid assets ratio.

Chart 3 illustrates how the clearing banks had entered the mortgage market and maturity transformation increased. Banks increasingly became liability managers and competed for funds in wholesale markets. Restrictions on building societies were also removed in the early 1980s and they were allowed both to access wholesale funding and offer many of the services of banks. By the early 2000s only the bare minimum of reserves required for day-to-day settlement were held – and very few public sector liquid assets, which could be used as collateral to obtain more reserves from the Bank when required. That left banks dependent on the availability of wholesale funding markets. As it turned out, this was not a good situation.

As the global financial crisis unfolded later in the decade, wholesale funding markets dried up and it became increasingly difficult for banks to sell securities backed by mortgages or other assets, or to use them as collateral to borrow cash. Banks were now left with an ‘overhang’ of illiquid assets on their balance sheets. The Bank had to widen the collateral it was prepared to accept in its money market operations, and it introduced schemes to allow banks to swap what had become illiquid private securities for UK Treasury bills. 

Chart 3: Maturity transformation increased with financial liberalisation

Private sector assets held by banks and building societies as ratio to GDP

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Footnotes

  • Sources: Bank of England, Thomas and Dimsdale (2017), Sheppard (1971), Capie and Webber (1985) and Bank calculations.

The other leg of the policy response, of course, was the introduction of Quantitative Easing, or QE. As Chart 4 illustrates, QE has been the dominant driver of reserves creation and the significant increase in the level of reserves over the past two decades, including in response to the Covid-pandemic. But further reserves were added to the stock with term funding schemes, including the launch, in March 2020, of the Term Funding Scheme with additional incentives for Small and Medium-sized Enterprises, or TFSME for short. Until it closed for new loans in April 2021, the scheme offered multi-year funding at close to Bank Rate for banks that increased lending, especially to SMEs, in order to avoid that their lending rates would edge up. 

As Chart 4 also shows, the process of reserve expansion has now gone into reverse. Asset purchases are being unwound through Quantitative Tightening, or QT, while TFSME loans are maturing. footnote [8] It is this reversal that gives rise to the question of what the level of reserves should be in the future.

As we look to the future and answer that question, we need to make an important distinction between the monetary policy and financial stability purposes for reserve creation.

Chart 4: Quantitative easing has been the main driver of reserves creation

Bank of England reserves supply and backing assets

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Footnotes

  • Source: Bank of England.

The primary purpose of QE was to stimulate the economy by pushing down longer-term interest rates through the purchase of mainly government bonds, financed by the issuance of renumerated central bank reserves – or, if you like, to create money directly as Chart 5 illustrates (in the red bars), to avoid a drop in the money supply resulting from banks repairing their balance sheets through both a contraction in bank lending and issuing non-monetary liabilities such as debt and equity (the blue and purple bars). But viewed from today, this direct money creation also served the secondary purpose of re-building the level of reserves and safe public sector liquid assets from what had proven to be an inadequate level during the global financial crisis. What was a monetary policy intervention had a necessary and positive financial stability effect in this way. As Chart 1 also showed, public sector liquid assets as a ratio of the sterling deposits of households and companies are now at similar levels as they were in the 1960s.

The distinction is important for two reasons. First, we should see the process of QT as having two parts, consistent with phases where each of the two purposes of money creation comes to the fore. I will explain this later. Second, the distinction opens the question of what assets the Bank should hold on its balance sheet in the future. I will come back to that too.

But, returning to the first question, where does this history leave us on the reserve level we should aim for today?

Amongst those who take an interest in these matters, there is a lively debate. I have the pleasure of going to the Bank for International Settlements in Basel several times a year to meet and discuss with other central bankers.

Chart 5: Quantitative easing created money directly

Counterparts to broad money growth