Banks, Bank Reserves and Deposits
- Read: Mishkin and Serletis, Ch. 15 and 16.
Ch. 14 Central Banking is covered in Assignment 1.
- Key concerns in this set of notes:
- How is the quantity of deposits (bank money) determined?
- How does the central bank affect the money supply in practice?
- How does the central bank affect the overnight interest rate?
Money and Deposits:
- We know that there are two main types of assets serve as money in a modern
economy:
(1) currency: coins and bills.
(2) (liquid) deposits at banks or ‘near banks’.
- We also know that most of the money supply is in the form of deposit money.
- Data from Bank of Canada website for August 2016:
Currency outside banks $77 billion
Chequable deposits $787 billion
The Payments System: (see Ch. 16. 391-92)
Payments system: method of conducting transactions in the economy.
- Exchanges with currency: sellers receive currency from buyers.
- Exchanges involving deposit money: transfers between deposits
- Settled internally if transfer is between deposits at the same bank.
- Between depositors at different banks?
(1) Automated Clearing Settlement System (small transactions)
- sum up today’s cheques, debits (withdrawals) from
Bank A paid to depositors at Bank B;
- sum up today’s cheques, debits (withdrawals) from
Bank B paid to depositors at Bank A;
- balance of the two sets of transactions is transferred
between Bank A and Bank B’s accounts at the
Bank of Canada.
(2) Large-Value Transfer System (LVTS): - concerned with transactions of $50,000+.
- Electronic, banks monitor their positions in real time.
- Can only make payments if sufficient funds at Bank of
Canada, sufficient collateral or lines of credit with
other members of the system (15 of them: banks,
near banks)
- Transfers between accounts at the Bank of Canada at
the end of each banking day.
Bank Reserves:
Reserves:
funds held by banks and near banks to meet their obligations to
depositors.
- Obligations? depositors’ may ask for some or all of their funds.
- Types of reserves:
- currency (coins and bills) at the bank or in its ATMs.
- balances (deposits) at the central bank (Bank of Canada)
i.e. to meet cheque-clearing / electronic clearing
obligations.
Reserve ratio (r): amount of reserves held as a proportion of deposits.
- Holding bank reserves imposes a cost on the bank:
- could be used for loans: interest on loans is foregone.
- So why do banks hold reserves? i.e. why isn’t r=0?
Why hold bank reserves?
- Compulsion!
In the past, banks had to maintain a minimum reserve ratio by law
(“required reserves”)
e.g., 1980 Bank Act required $1 of reserves for every $10 of demand
deposits (r=0.1 if banks met this requirement exactly)
U.S. still has requirements for most liquid deposits:
- larger deposits: r=.10, r=.03 for smaller deposits.
(
- Whyhave required reserves? may raise confidence that banks can
meet depositors demands for funds.
- Canada eliminated required reserves in 1994.
- Cost-benefit comparison:
- The benefit of holding reserves? (cost: foregone loan interest)
- avoid customer dissatisfaction (cash in bank machines!):
deposits are a bank’s raw material!
- avoid having costs of raising funds at short notice to meet
depositors demands.
- borrow from Bank of Canada (at Bank Rate or higher).
- borrow via markets, e.g. overnight market.
- sell securities or reduce outstanding loans.
- these are all costly.
- So: hold reserves if anticipated costs of a shortfall are larger
than the cost of holding reserves.
- Banks determine "r" taking into account :
- the possible costs of a reserve shortfall vs. cost of holding reserves
(foregone interest income)
- “r” reflects the behavior of the bank
- Some variables affecting the size of “r”:
- attractiveness of making loans:
- return on loans: opportunity cost of reserves.
- perceived creditworthiness of potential borrowers.
- consequences of shortfalls:
- borrowing rate for shortfalls
- ability to borrow (not an issue in Canada: Bank of Canada)
- likelihood of deposit withdrawals.
( A point about terminology
Text, p. 379: makes a distinction between reserves held in normal
times -- it calls these ‘desired reserves’ and reserves held in in times
of crisis – it calls these ‘excess reserves’. They both reflect bank
behavior – I will treat them as the same thing, i.e. my r=rd +e in text)
Deposit Expansion Process: a simple case
- See Mishkin and Serletis, Ch. 15
- Say that there is an increase in the quantity of reserves in the banking
system of $1000
- Let: r = .10(outcome of bank behavior)
Stage 1: Say that these new reserve funds are all deposited in Bank A:
Bank A sees both its deposits and reserves rise by $1000:
Change in Bank A’s balance sheet:
Bank A
Assets Liabilities
Reserves +1000 Deposits +1000
- Bank A has extra reserves of $900.
- only: r x 1000 = 100 of reserves are needed to back
the new deposits.
- Bank A lends out its excess reserves so at the end of Stage 1:
Bank A
AssetsLiabilities
Reserves +100 Deposits +1000
Loans +900
- Loans are spent by the borrowers.
- those paid by the borrowers take the $900 and
deposit it in their bank (say Bank B).
Stage 2: Bank B has $900 more in deposits and reserves
- New reserves are likely in the form of a transfer between Bank A's
account at the Bank of Canada and Bank B's account at the
Bank of Canada.
- Bank B needs .1x$900 in reserves to back these deposits: $90
- Bank B will have $810 to lend out so at the end of Stage 2:
Bank B
AssetsLiabilities
Reserves +90 Deposits +900
Loans +810
- The $810 of loans are spent by the borrowers.
- those paid by the borrowers take the $810 they are
paid and deposit it in their bank (Bank C).
Stage 3: Bank C has $810 more in deposits and reserves
- Bank C needs .lx$810 in reserves to back these deposits: $81
- Bank C will have $729 to lend out so at the end of Stage 3:
Bank C
AssetsLiabilities
Reserves +81 Deposits +810
Loans +729
- The process continues indefinitely.
What is the final effect of this deposit expansion process?
New Deposits created at each stage:
Stage:New deposits:
11000(Bank A)
21000x(1-r) = 900(Bank B)
31000x(1-r)2 = 810(Bank C)
41000x(1-r)3 = 729
.
.
N1000x(1-r)N-l
Total new deposits = 1000 + 1000x(1-r) + 1000x(1-r)2 + ...+ 1000x(1-r)N-l
= 1000x [ 1 + (1-r) + (1-r)2 + ...+ (1-r)N-l ]
= 1000 x 1 (if N approaches infinity 1-(1-r) see Appendix at the end of notes)
= l000 x (1/r)
- with r=0.1 a $1000 increase in reserves will ultimately raise the quantity
of deposits by:
1000/.1 = $10,000
Deposit multiplier: it is the multiple by which an extra $1 of reserves raises the
quantity of deposits.
i.e., the quantity of deposits that can be supported with $1 of
reserves.
- in the simple deposit expansion process the multiplier = 1/r
Deposit multiplier = 10 in the example (1/r = 1/.1 = 10).
- If the total quantity of reserves in the banking system was "MB" then the
total quantity of deposits (DD) in the system would be:
DD = MB∙ 1/r
- where “r” is the desired reserve ratio for the banking system.
- this suggests another way of looking at the relationship between
reserves and deposits:
MB = r x DD
i.e., DD amount of deposits that "uses up" all available reserves (MB)
given that the reserve ratio is ‘r’
- Total stock of reserve assets (MB) is called:
High-Powered Moneyor the Monetary base
Deposit Expansion and Multipliers: More Complicated Cases
- Case above is very simple: possible complications?
- Could allow for different types of deposits each with a different "r"
i.e. high turnover types of deposits may have a higher ‘r’
(a more complex multiplier could be found that depends on desired r
for each type of deposit and desired share of funds in each type
of deposit);
- Could allow households and businesses to hold some of their money as
currency rather than as deposits.
i.e. now: two uses for reserve assets:
(1) act as reserves for deposits;
(2) act as currency in hands of public.
- look at this case (text does a version of this case).
Deposit and Money Multiplier when the Public Holds Currency:
- In the case where reserve assets can be held as currency as well as reserves less
deposit money is created for a given value of MB.
Define: c = Currency / Deposits = Currency/DD (a desired ratio)
then when reserve assets are all "used up":
MB = r DD + c DD
and so:DD = MB x 1/(r+c)
where 1/(r+c) is the deposit multiplier when the public holds currency.
e.g. if r=0.1 (as above) and c=0.1 (in line with Cdn. data)
Deposit multiplier =1/(.1+.1) = 5 (vs. 10 in simple case)
- Size of the money supply in this case?
Money supply (M) = Currency + DD
= c DD + DD
= MB x (c+1)/(r+c)
(c+1)/(r+c) = is the money multiplier
Money multiplier: shows how much an extra $1 of reserves expands the
money supply.
(Reminder: the textbook is slightly different since it breaks MB into two types of
reserves ‘desired’ and ‘excess’ which have their own reserve ratios rd and e. So where I have ‘r’ they have rd+e )
Monetary Base, Reserves and the Money Supply:
- Deposit expansion - deposit multiplier story:
- gives relationships between the monetary base (MB) and the size of
the money supply.
- Implication:the Bank of Canada can affect the size of the money supply by
altering the supply of reserve assets (MB).
- the effect of the change in MB on money supply will be quite mechanical
if the deposit and money multipliers are stable.
- for this to be so: ‘r’and ‘c’must be stable.
- these variables involve choices by the banks and the public.
- choices will likely change with time.
- desired r: depends on costs and benefits of holding reserves.
(can be affected by Bank of Canada's policies)
- currency in circulation (rather than as reserves):
- interest rates are an opportunity cost of
holding currency.
- size of the illegal/underground economies
(large then higher demand for cash)
- bank panics, crises: have raised currency demand
rapidly in past.
- Money Multipliers in times of crisis:
- US in the Great Depression
- bank panics: increased currency demand and higher r: reduced the money
multipliers.
- although MB was quite stable money supply fell.
(Cecchetti and Shoenholtz)
- Financial crisis in the US 2007-09:
- large increases in the monetary base;
- the increase in the money supply is much smaller;
- multipliers have fallen substantially.
St. Louis Federal Reserve website:
Aug. 2008Feb. 2009 Feb. 2014
Monetary base$875.2 billion$1624.6 billion $3869.4 billion
M1$1410.0 billion$1560.9 billion$2731.5 billion
M2$7794.5 billion$8343.4 billion$11,113.0 billion
What might explain this?
- Banks weren’t lending much of the extra reserves (r is rose)
- recession and crisis: borrowers regarded as riskier; repairing
bank balance sheets.
- deposit expansion wasn’t happening.
- Maybe public is holding more currency (did ‘c’ rise?)
It seems to be the first one (see also text Figures 15-1, 15-2):
- What happens next?
- US economy seems to have recovered from the post-crisis recession.
- will money supply now soar? i.e. will ‘r’ fall again and money multipliers
rise back to normal levels?
- if so will there be inflation? recall: Quantity theory of money.
- Can the US central bank soak up the reserves? (that’s the plan)
The Bank of Canada and Control of the Monetary Base and Money Supply
- See: Mishkin and Serletis, Ch. 15, pp. 365-72, Ch. 16, 403-12.
Deposit Expansion and Central Bank Control of the Money Supply:
- Key result:
Money Supply = (Monetary Base) x (Money Multiplier)
where: Monetary Base = quantity of reserve assets.
- To change the size of the money supply a central bank can either:
(1) Use policies that change the size of the money multiplier
How?
- In the past: changes in legally required reserves could be made.
- Without required reserves: changes in penalties for reserve
shortfalls can influence “r”.
- Policies targeting the multiplier are of secondary importance in
Canada or the US (even though US has required reserves).
- some countries do target multipliers e.g. China.
- US may target it when it's multiplier begin to rise to usual
levels.
(2) Change the supply of reserves in the banking system
- "reserve management"
The Bank of Canada’s Reserve Management Tools
- We will look at three in particular:
(1) Open Market Operations (buying or selling securities);
(2) Deposit shifts (moving Federal government funds between accounts at
the private banks and the central bank);
(3) Loans or ‘Advances’ by the central bank to private banks.
- Simple examples below (text provides a slightly different examples).
- Ideas are quite simple and can be generalized to other similar measures.
- Lots of experimentation since 2008 with variations of the usual policies.
(see text pp. 413-419)
(1) Open Market Operations (OMOs):
- The B of C can alter the quantity of reserves by buying and selling securities.
- Almost always Treasury Bills (T-Bill): short-term Federal government debt.
Case 1: Bank of Canada reduces it's T-Bill holdings by $100m
- B of C Sells T-bills to the “public”
- Public has $100 million additional treasury bills.
- Public pays by cheque or transfer of $100m to the B of C.
- Public’s deposits at their chartered bank fall by $100m
- Chartered bank’s deposits at B of C are reduced by $100m
General Public
AssetsLiabilities
T-bills +100m
Deposits at banks -100m
Chartered Banks
AssetsLiabilities
Deposits-100mDeposits -100m
at BofC
(reserves, settlement balances)
Bank of Canada
AssetsLiabilities
T-bills-100mDeposits-100m
(banks)
- End result? Bank reserves have fallen by $100 million.
- chartered banks have $100 million fewer deposits at the B of C.
- the quantity of deposits in the banking system will contract.
Case 2: Bank of Canada raises its Treasury bill holdings by $l00 million
- Say the B of C buys $100m in T-Bills from the public.
- B of C pays $100m to the public.
- The public has $100 million fewer treasury bills.
- Public receives $100m claim from the B of C (cheque, transfer).
- this is “deposited” into the banking system: public's deposits rise by $l00m.
- the chartered banks have $100m claim on B of C.
- the B of C credits the chartered bank's accounts with $l00m.
(these are reserves or settlement balances)
- Bank reserves have risen by $100 million
- chartered banks have $100 million more deposits at the Bank of
Canada.
- the quantity of deposits in the banking system will expand.
(Text examples:
Case 1 version p.369 but T-Bills are sold in return for currency – this lowers
the monetary base by taking currency out of circulation
Case 2 version p.368 buys T-Bills from the banking system not the public:
but has the same effect)
Open Market Operations (cont’d):
- In Canada OMOs are typically done through:
“Purchase and Resale Agreements” (PRAs, "repos") or
“Sale and Repurchase Agreements” (SRAs, "reverse repos").
- PRAs and SRAs are self-reversing OMOs.
- Common tools since the mid-1990s.
- T-Bills are the usual asset for OMOs but any purchase or sale by B of C can have
the same effect.
- why use T-Bills?
Avoid private assets and possible favoritism;
T-Bill market is well-developed and liquid.
- During the 2007-08 Subprime crisis:
- willingness to consider securities other than T-Bills.
- US right in recent years: "Quantitative Easing" (QE)
- OMOs buying longer-term assets
e.g. QE II 5-yr. government bonds
(2) Government Deposit Shifts:
- The Government of Canada has bank accounts at the major chartered
banks as well as the Bank of Canada (B of C).
- B of C acts as the Federal government’s banker
- Shifting funds between government accounts at chartered banks and the B of C
changes the quantity of reserves.
Moving funds to Chartered Banks:
- This is typically done by auction (banks bid to receive the deposit).
- Bank of Canada transfers $l00m from government accounts at the Bank
of Canada to government accounts at the chartered banks:
Bank of Canada
AssetsLiabilities
Deposits-100m
(gov't)
Deposits+l00m
(banks)
Chartered Banks
AssetsLiabilities
Deposits+l00mDeposits+l00m
at BofC (gov't)
(reserves)
-This action raises the quantity of reserves in the banking system by $l00m
- deposit expansion will occur.
Moving Funds from Chartered Banks to the B of C:
- A transfer of $l00m from government deposits at the chartered banks to
government deposits at the B of C would reduce reserves by $l00m.
(reverse signs on changes in example above)
(3) Lending by Bank of Canada:
- Advances: loans by the Bank of Canada to members of the payments system
e.g. banks, dealers.
- B of C stands ready to lend in this way.
- Minimum rate charged: “Bank rate”.
- Typically:
Bank rate = overnight rate + 0.25% (top of the 0.5% operating
band for the overnight rate)
- Typically securities act as collateral for advances.
- An increase in B of C loans to chartered banks raises reserves
- loan creates additional chartered bank deposits at the B of C.
- Bank rate is the minimum rate charged on advances.
(via effect on advances the Bank rate could be an important policy
tool; US equivalent: Discount Rate)
- Advances can be used as part of the day-to-day functioning of the payments
system.
- fill shortfalls a chartered bank may have on a given day.
Lender of Last Resort: Loans or Advances in Crisis
- Advances can also be used as part of the B of C’s “lender of last resort” role.
- Discretionary “emergency” lending to financial institutions.
- Discretionary?- BofC must judge importance to the financial system;
- discretion over rate charged and collateral required.
- Origins as a tool vs. banks runs: a method of providing banks with
funds to meet depositor demands.
- “Lender of last resort” role is of most importance during a “crisis”:
- US: Sept. 11, 2001 ; Black Monday 1987.
- Subprime crisis:
- Bank-like institutions experiencing the equivalent of a bank
run.
e.g. unable to sell (roll over) their paper as it comes due.
- US central bank (Federal Reserve) effectively extended
the “lender of last resort” function to these FIs.
- Similar steps in Canada.
- Goal of "lender of last resort" role: stability of financial system
- consequences for reserve management a secondary consideration.
- B of C uses all three reserve management tools above:
- OMOs: main tool (flexible, under BofCs control).
- Government Deposit transfers for day-to-day reserve management:
- mainly to neutralize changes caused by other factors affecting
reserves e.g. government-public transactions, changes in public
demand for currency.
- Advances are always possible at the Bank rate (or higher in discretionary
cases).
- Much of the day-to-day reserve management is concerned with
“neutralizing” or "sterilizing" the effect of changes in reserves
produced by actions other than monetary policy.
Monetary Policy, the Overnight Rate and Reserve Management
- Reserve management affects the size of the money supply.
- Size of the money supply is typically not the intended target.
(it has been in the past: 1970s, 1980s and ‘Monetarism’)
- Immediate (operational) objective?
- Short-term interest rates: affected by changing reserves and the
money supply.
- Ultimate objectives?
- Prices and inflation rates;
- Levels of aggregate output and employment.