Bank reserves are normally obscure, even to bankers and professional investors. But this week they have hit the news when a shortage of them caused a key measure of borrowing costs—known as the overnight repo rate—to spike. That’s a worry, because typically these more wonky areas of finance only become interesting when something is going wrong.
The overnight repo rate, which is what banks and other financial players charge each other to lend cash in exchange for supersafe bonds, should be close to 2%, but it shot up almost as high as 10% on Tuesday. One of the underlying causes of this is a scarcity of reserves compared with the amount of Treasury bonds in the market. That has made banks less willing to lend to each other even in exchange for safe government bonds.
To settle markets down, the Federal Reserve Bank of New York has dipped into this market, conducting three auctions this week where banks could swap Treasurys (or bonds from institutions like Fannie Mae ) for new reserves. It conducted a third auction on Thursday morning and offered $75 billion in repos.
Here’s is a simplified rundown of what reserves are and how they’ve come to matter.
What are reserves?
Not many people realize this, but there are two basic types of money in the world. There is central bank money, which is known as reserves, and there is money that the rest of us use.
Central bank money can only be used by banks, governments and some government-linked institutions. They have this money in accounts at the central bank, where it is called “reserves.” The money that the rest of us use is private money that is created by ordinary banks.
There is also some special central bank money that everyone can use: The notes and coins in our wallets.
What are reserves for?
The main day-to-day function of reserves is for banks to make payments to each other that reflect transactions between the rest of us. When one person transfers money to another person, it looks like private money moves from one bank account to another.
But that’s not what really happens. In fact, the first person’s bank reduces the amount in the person’s checking account, which is really just a record of money the bank owes to them. It then sends an equivalent amount of reserves to the second person’s bank. That bank now owes the second person more money and so it increases the value of their deposit with private money.
The same is true when your employer pays you your wages (assuming you don’t get them in notes and coins anyway), or when you pay for your groceries with a debit card.
Where do reserves come from?
One way reserves find their way into the banking system is when a government spends money. Whether it wants to pay government workers’ wages or buy cruise missiles, it sends reserves from a government’s central-bank account to the central-bank account of the ordinary bank used by the person or company who is getting the money. That bank then increases the value of the deposit in the accounts of workers or cruise missile suppliers.
The government can get some of those reserves back by selling a Treasury bond to investors, which is done via primary dealers, banks who have a special role acting as market makers for government bonds. The bond sale is paid for, or settled, using reserves from the banks that have the deposit accounts of those investors.
Where does QE come in?
The whole point of QE—quantitative easing—was to ease the pain of the financial crisis by flooding the financial system with money, which would make all kinds of borrowing significantly cheaper.
Central banks did this by creating trillions of dollars (or euros or Japanese yen) worth of reserves to buy back government bonds from investors via banks. This gave banks vast amounts of reserves. In turn, the banks gave those selling the bonds equally vast amounts of new private money. That private money could then be spent in the economy or used to buy riskier corporate bonds for example. The higher demand for other forms of debt would make that debt cheaper for borrowers.
And then the Federal Reserve started to reverse QE?
Yes, the Fed stopped buying Treasurys when it felt the economy was on solid footing. When the bonds that it owned matured, the government had to repay the Fed. The government did this by handing reserves back to the Fed which the Fed then destroyed, reversing the process when it bought the bonds in the first place.
Reserves also leave the banking system when the government sells new Treasurys to private investors or when it collects taxes. Tax payments are special because governments, unlike companies or private citizens, deal directly in reserves. That means a tax payment involves reserves being transferred from an ordinary bank to a government account at the central bank. An equivalent amount of private money in the taxpayer’s bank account disappears.
The upshot: New sales of Treasury bonds and tax payments take reserves out of the banking system.
So why does this all suddenly matter now?
This is the trillion-dollar question. The answer, according to some analysts, is that the Fed isn’t sure how much reserves banks need these days. New rules since the crisis and the stress tests that banks have to beat have together increased the amount of reserves they want to hold.
But reserves have been shrinking because of the reversal of QE, increased government borrowing in the Treasury market, and a recent wave of tax payments, among other things.
One key cause of the crunch in overnight lending markets is that there are more Treasurys around than banks want to own, but some banks are still being forced to buy them. These are the so-called primary dealers who buy Treasurys from the government and then sell them to investors.
If banks don’t want to spend their own reserves to buy Treasury bonds they have to borrow those reserves from elsewhere. They can do that directly in specialist bank-only markets, or they can try to borrow private money in overnight lending markets, where rates spiked this week.
That is why the short-term fix has been for the Federal Reserve Bank of New York to offer to take some of those Treasurys in exchange for new reserves. The longer-term solution could be a more permanent arrangement where the Fed conducts regular auctions. Unless that is, it turns out that the problem isn’t just with banks, but that there is a real need for funding coming from somewhere else in the system that hasn’t yet been identified.
Write to Paul J. Davies at paul.davies@wsj.com