The importance of central bank reserves: History, Present and Future

The monopoly to creare reserves gives central banks all the aura and the power. There is a reason they were named as Federal Reserve, Reserve Bank of India/Australia/New Zealand and so on….

Andrew Bailey, Governor of Bank of England gives a lecture in honour of Charles Goodhart at the London School of Economics.  The lecture focuses on the importance of central bank reserves in monetary and financial stability.

What is the history of central bank reserve money?

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.

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.

He the goes on to discuss how the views on optimal central bank reserves has changed over the years:

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.

  Some continue to emphasise the case for a return to a small balance sheet. The case for ‘renormalisation’ puts great weight on the benefit of putting liquidity management squarely in the hands of private institutions and markets. And it points to the risk that banking system behaviours may change in undesirable ways over time the longer the central bank balance sheet remains large, for example if the level of runnable deposits in the banking system were to increase. Indeed, Raghuram Rajan made similar points when the Financial Markets Group hosted him for this event last year. At the BIS, Claudio Borio has made the case particularly forcefully, setting out the principle that the central bank balance sheet should start out as small as possible, flexing up only in times of stress.

Others see benefits of the central bank supplying reserves relatively freely, sometimes referring to a ‘new normal’. Jeremy Stein, for example, has argued that a larger central bank balance sheet can improve financial stability by ‘crowding out’ excessive risk taking in the private sector. Such thinking is not new per se – Milton Friedman’s essays on “The Optimal Quantity of Money” come to mind. What is relatively new, perhaps, is for such thinking to be adopted on a broad basis amongst the central bank community. It is part of a debate with many nuances. As the Federal Reserve’s Annette Vissing-Jørgensen has pointed out, how reserves are supplied will matter for the cost and benefits of larger central bank balance sheets.

What I think is emerging as a mainstream view amongst central bankers is that we need to thread this middle path. Before the financial crisis, monetary policy was implemented with a much lower level of reserves than we have today. That worked well enough for monetary policy. But as we discovered to our cost, the level of liquid assets in the system, including central bank reserves, was too low for financial stability purposes, and this contributed to the scale of the financial crisis.

The financial Crisis has changed the thinking on reserves:

And much has changed in the world since the financial crisis. The demand for reserves is much larger than it was. Both the deposit base and regulatory requirements have grown, increasing demand for liquidity. The recent fate of Silicon Valley Bank has demonstrated that the size and speed of potential outflows has increased over time, not least because of technological developments with bank runs accelerated by social media and online platforms. There are limits to the capacity of private markets and contingent facilities to convert banks’ assets into reserves to meet their payment obligations, and these limits need to be reflected in the standing stock of reserves.

Equally, at some point the costs of an increase in reserve supply are likely to outweigh the benefits. Generally speaking, as reserves levels grow, the incentives for the banking sector to manage its own liquidity falls. And to the extent that reserve supply crowds out healthy market intermediation in normal market conditions, a large part of the financial system’s ability to manage its liquidity will be affected. Mindful of these costs, we do not seek a larger balance sheet than is strictly necessary.