Central Bank Reserves #primers

Bank reserves are interbank money, and constitute how banks transact with one another. When we say that "the Fed prints money out of thin air," we don't mean they literally print a pallet of cash (only the US Treasury can do this) but that they create bank reserves. These reserves are created when the Fed buys financial assets (like Treasury bonds) or makes loans. The total amount of reserves in the system (at $3 trillion today) is determined by the Fed.

If the Fed purchases Treasuries from a commercial bank, then the bank's Treasuries are exchanged (swapped) for reserves from the Fed (in an asset swap). If the Fed purchases Treasuries from a non-bank (like a primary dealer in QE), the reserve balance of the dealer's bank would increase, and the bank would add this to the dealer's account in the form of bank deposits.

A bank can spend its reserves on anything (with some regulatory constraints), and the transaction will proceed through the interbank payment system.

In practice, banks must hold a certain level of reserves to meet regulatory liquidity thresholds, which is usually the Liquidity Coverage Ratio (LCR). The LCR is designed to ensure that banks hold a sufficient reserve of high-quality liquid assets (HQLA) like Treasuries or reverse repos to allow them to survive a period of significant liquidity stress lasting 30 days. Banks that spend their reserve levels will thus only buy other HQLA assets.

#primers