Written by Derryl Hermanutz

Central Bank Reserves

Synopsis

In Part 1 we saw how commercial banks create the deposit account money supply by making repayable loans of newly created bank deposits to private-sector loan account debtors and to government bond debtors.

Debtors pay the new deposit account balances to payees within the bank-operated payments system, which creates the economy's deposit account money supply; then payees create the cash money supply when we make cash withdrawals and pay with debits to our deposit account balances.

We saw how commercial banks spend their reserve account balances settling our payments system payments of bank deposits to payees at different banks; and how commercial banks spend their reserve account balances buying currency from the central bank to get vault cash. But we didn't see how reserves are created: how commercial banks get reserve account balances in the first place.

How central bank reserves are created

Debtors' interest-bearing loan account and bond debts are banks' interest-earning assets.

Commercial banks create new spendable money (bank deposits) to buy new interest-bearing debts from debtors.

Commercial banks sell some of the interest-earning debt assets (mainly government bond debts) to the central bank, to get reserves in their reserve accounts.

The central bank pays for its asset purchases by typing numbers - central bank reserves - into the Credits column of the asset selling banks' reserve accounts. The Credits add to the commercial banks' reserve account balances.

That's where central bank reserves come from. Base money - reserve account balances - is numbers in commercial banks' reserve accounts. The central bank creates reserve account balances 'by typing'.

Then commercial banks get the other form of base money - vault cash - by paying reserves to buy currency from the central bank. 

"The central bank creates reserve account balances 'by typing'."

The central bank does not directly monetize the government's debts. The government does not sell new bonds to the central bank, and the central bank does not pay by typing spendable Credits into the government's central bank account balance.

Commercial banks directly monetize the government's new debts; then central banks monetize some of the commercial banks' interest-earning assets when commercial banks sell the bonds to the central bank.

Commercial banks "get bonds" by creating new spendable money (bank deposits) to buy new bonds from the bond-issuing government.

Primary dealer commercial banks purchase new issues of Treasury bills, notes, bonds ("bonds") from the government. The bond-buying bank pays for its asset purchase by typing a number - a bank deposit - into the Credits column of the bond-selling government's commercial bank deposit account. The Credit adds to the government's spendable bank deposit account balance.

That's where governments get their deficit-spending money. The money is a number in a bank deposit account. Tom repeat: commercial banks create the money "by typing".

The government typically transfers the bond sale Credits out of its commercial bank deposit accounts, into its central bank account, then spends the balances out of its central bank account (usually by check or direct deposit) within the central-commercial bank-operated payments system. 

"The central bank does not directly monetize the government's debts."

When the government makes a payment: the central bank debits the government's central bank account balance, and the payee's commercial bank credits the payee's commercial bank deposit account balance, in the amount of the payment. The balance has been debited out of the government's bank account and credited into the payee's bank account.

The primary dealer banks typically sell most of the government's new debts into the secondary markets, the capital markets. This is where:

• You and I (and our pension funds and insurance companies and mutual funds) buy bonds to hold as interest-earning assets in our brokerage accounts; and

• Where central banks buy-sell bonds to conduct their interest rate influencing "open market" monetary policy operations; and

• Where commercial banks sell bonds to the central bank to get reserves in their reserve accounts; and

• Where shadow banks buy bonds to hold on their balance sheets as risk-free collateral against all kinds of derivative credit-debt creation.

There is a complicated series of transactions that involves debiting and crediting cash account balances, deposit account balances, and reserve account balances:

• When we pay our cash account balances to buy bonds in the secondary markets, our invested money actually replaces and extinguishes the new money that a primary dealer bank had originally created to purchase the bond from the government.

• When we buy the government's debts in the secondary markets, we indirectly lend our money to fund the government's deficit spending.

If we buy newly issued bonds via a Treasury Direct program that is administered by our commercial bank, we direcly lend our money (deposit account balance) to the government.

In both cases - whether we pay our cash account balance and hold the bond in our brokerage account; or pay a deposit account balance and hold the bond in our commercial bank:

• The debtor government pays us (the creditor bondholder) the semi-annual bond interest; and

• When the bond matures the government pays us back the face value amount of the bond - the "loan principal".

The interest payments and bond redemption money are debited out of the government's central bank account and credited into our bank account: our brokerage (shadow bank) cash account; or our commercial bank deposit account.

Bonds (interest-paying debt assets) are by far the biggest asset class in the capital markets financial system. The bond market is enormous. Stocks (dividend-paying equity assets) are a distant second biggest asset class.

Bonds and stocks are dwarfed by derivatives (credit default swaps, interest rate swaps, and more exotic instruments that are created by shadow banks and their counterparties). But derivatives are more accurately classified as insurance policies that don't payout unless the insured event occurs: debtor defaults, or an interest rate changes. 

"Bonds (interest-paying debt assets) are by far the biggest asset class in the capital markets financial system." 

Bonds and stocks, by contrast, are income-paying financial assets that regularly pay interest income and dividend income to the bondholders and stockholders.

"Risk-free" debt assets

"Primary dealer" banks are primary dealers in government debt.

Primary dealer commercial banks purchase new bonds directly from the government, then sell the interest-earning debt assets to the central bank, to non-primary dealer commercial banks, and to shadow banks, in the secondary markets.

Government bond debt is considered a "risk-free" banking system assets: free of default risk, assuming the government can always get money to pay its bond interest (and to redeem its bonds when they mature and the loan principal amount comes due for payment) by taxing money from its citizens and businesses; and by selling the public assets - infrastructure, land, resources - to get money to pay to the creditor banks and investors - the bondholders who loaned the government money by buying the government's debts.

Private sector debts are banks' risk assets because people and businesses can and do default on repaying their bank loans.

Under QE programs, central banks buy all kinds of risk assets {like mortgage-backed securities (MBS), which are securitized bundles of debtors' defaulting mortgage loan debts; and collateralized debt obligation (CDOs), which are securitized bundles of debtors' defaulting car loan debts and student loan debts} from commercial banks, and pay with newly created money assets: reserve account balances.

Government-issued bond debts are the "risk-free" interest-earning assets that underpin the central-commercial banks' entire debt-based "reserve-backed" money supply creation monopoly. Bonds comprise the main financial asset class - and provide the stable base of "risk-free" collateral assets - for the shadow banking system.

The banking system - the central-commercial bank monetary system; and the shadow bank financial system - is built on a foundation of government-issued debt, not government-issued money.