Date: Mon, 3 Jun 1996
Everything you need to Know about Fractional Reserves' "Smoke and Mirrors".
1.4 BANK RESERVES -
tutorial (compiled by Frank T. Brady)
"The Federal Reserve System Purposes and Functions" publication states that
the Federal Reserve requires that ALL banks (as of 1980) must:
"hold a certain fraction of their deposits in reserve, either
as cash in their vaults or as non-interest-bearing balances at
the Federal Reserve."
There are (at least) two alternatives when trying to guess the real meaning
of the above sentence:
ALTERNATIVE #1
(What the Federal Reserve WANTS us to conclude):
A percentage of all member banks deposit balances must be transferred from
the member bank demand deposit accounts to their Reserve accounts at their
Federal Reserve Bank Branch (i.e., that a percentage is debited from their
demand deposit accounts and credited to their Reserve account.)
ALTERNATIVE #2
(What the sentence REALLY means):
A percentage of all member banks deposit balances are recorded as a
"balance" in their Reserve account at their Federal Reserve Bank Branches.
Nothing is debited from the member banks demand deposit accounts. The
initial "Reserve Balance" is called "Excess Reserves." If the Fractional
Reserve Requirements are set at 10%, the "Excess Reserve" balance is reduced
by 10% of the loan principal each time the member bank creates new money by
making a loan. This oversimplification is accurate only if there is only
one commercial bank. In reality, the "Excess Reserves" of the banking
system as a whole must be considered (because the demand deposit accounts
and the corresponding "Excess Reserve Balances" move between all the banks
of the system as checks are cleared.
One very important detail must be clarified. "Modern Money Mechanics"
(Federal Reserve Bank of Chicago) states that a Federal Open Market
Committee (FOMC) Treasury Bill purchase increases the balance of a member
bank's "Reserve Account" at that member's Federal Reserve Bank (by an amount
equal to the funds created by the Federal Reserve when the check it wrote to
pay for the Treasury Bill was deposited at the Securities Dealer's bank).
Federal Reserve Publications would have us believe that "money" is actually
"deposited" to increase a Reserve Account balance, but these accounts should
be viewed as nothing more than a bookkeeping system to track the fractional
reserve process rather than an actual deposit account. "The Federal Reserve
System Purposes and Functions" states that the Federal Reserve requires that
ALL banks (as of 1980) must "hold a certain fraction of their deposits in
reserve, either as cash in their vaults or as non-interest-bearing balances
at the Federal Reserve." The term "non-interest-bearing balances at the
Federal Reserve" means that "Reserve Accounts" are nothing more than
bookkeeping tallies representing the portion of the member banks deposit
account balances that may be used as a base to extend new money creation
credit. Member banks do NOT physically transfer ("deposit") a percentage of
their demand deposit account balances to their Reserve accounts at their
Federal Reserve Bank branch. In practice, a percentage of all member banks
deposit balances must appear as a balance in their Reserve account at their
Federal Reserve Bank Branch.
The "Reserve" accounts at the Federal Reserve Bank branches are nothing
more than a tracking system for the fractional reserve expansion policy. I
believe these "accounts" were designed to further the appearances of a
gigantic system of "reserves" mandated by the Federal Reserve System to
"force" prudent banking.
In some of the following descriptions, I am paraphrasing material published in:
The February 1994 revision of "Modern Money Mechanics" -- Chicago Fed.
How do open market purchases add to bank reserves and deposits?
Suppose the
FOMC buys $10,000 of Treasury bills from a government securities dealer.
The Fed pays for the T bills with an "electronic" check drawn on itself [ON
NONEXISTENT FUNDS]. Via the "Fedwire" transfer network, the Fed notifies
the dealer's designated bank (Bank "A") that payment for the securities
should be credited to (deposited in) the dealer's account at Bank A.
AT THE SAME TIME, BANK A's RESERVE ACCOUNT AT THE FED IS "CREDITED" FOR THE
AMOUNT OF THE SECURITIES PURCHASE.
That is, the T bill purchase CREATED funds in the dealer's bank account -- a
demand deposit account that IS PART OF THE MONEY SUPPLY. At the VERY SAME
TIME, the dealer's bank "automagically" get ITS Reserve Account at ITS
Federal Reserve Branch "CREDITED" with a "balance" increase identical to the
dollar amount that was created in the dealer's account.
The Federal Reserve System has added $10,000 of securities to its assets,
which it has paid for, in effect, by CREATING a liability on itself in the
form of bank reserve balances.
These "Reserves" on Bank A's books (at its Federal Reserve Bank) are matched
by $10,000 of the dealer's deposits that did not exist before.
Money created by the FOMC operations (as part of the Fed's monetary policy
to increase the money supply) is CREATED as demand deposits in the account
of the dealer who sold the Securities to the FOMC.
AT THE SAME TIME -- A MAGICAL BOOKKEEPING SYSTEM AT THE FED ALSO CREATES AN
IDENTICAL INCREASE IN THE "RESERVE ACCOUNT" FOR THE BANK AT WHICH THE
DEALER'S ACCOUNT WAS CREDITED.
"Reserves" are nothing more than a shadow tracking system for bookkeeping
money created BY THE FED. They are an accounting method to keep track of
how much NEWLY CREATED BOOKKEEPING MONEY AT MEMBER BANKS can be used as a
base for the member banks themselves to create more bookkeeping money within
the limits of the reserve ratio set by the Fed.
The Federal Reserve Publication "Modern Money Mechanics" states:
The expansion process may or may not begin with Bank A, depending on what
the dealer does with the money received from the sale of securities. If the
dealer immediately writes checks for $10,000 and all of them are deposited
in other banks, Bank A loses $10,000 in BOTH its demand deposit account AND
its Reserve Account at its Federal Reserve Bank. In other words: BANK A
LOSES BOTH DEPOSITS AND RESERVES and shows no net change as a result of the
System's open market purchase. However, other banks HAVE received an
aggregate increase of $10,000 in their demand deposit accounts AND an
aggregate increase of "$10,000" in their Reserve Accounts at their
respective Federal Reserve Bank branches.
NOTE:
If the securities dealer were to immediately request Federal Reserve Notes
in exchange for the entire balance of his demand deposit account at Bank A,
that bank would end up with a ZERO increase in the dealers demand deposit
account AND a ZERO increase in its Reserve Account at its Federal Reserve Bank.
It does not really matter where this money is at any given time. The
important fact is that these deposits do not disappear (unless, of course,
the securities dealer demanded currency for the transaction). They are in
SOME deposit accounts at ALL times. All banks together have $10,000 of
reserves against the $10,000 of deposits AND reserves that they did not have
before. However they are not required to keep $10,000 of reserves against
the $10,000 of deposits. All they need to retain, under a 10 percent
reserve requirement, is $1,000. The remaining $9,000 is "excess reserves."
This AMOUNT can be loaned or "INVESTED."
In summary:
The Fed increases the Reserve Account "Balance" whenever it CREATES
bookkeeping (demand deposit) money to pay for securities purchases.
The member banks, CREATE more new bookkeeping money in the accounts of their
customers by loaning money. The maximum amount they can loan is dictated by
the "Excess Reserves" portion of their Reserve Account. Each time they make
a loan, their "Excess Reserve" balance at their Fed Branch is (effectively)
reduced by a small percentage of the actual loan amount (the percentage is
determined by the fractional reserve ratio set by the Federal Reserve Banks).
This is where most of us have gotten confused about Reserve Accounts. The
commercial banks can loan out (create) money up to the dollar amount
recorded as "Excess Reserves" in their Reserve account AT THEIR FED BRANCH.
Also, ONLY the FED can increase the Reserve accounts.
Assuming a starting Excess Reserve Balance of $10,000 and a 10% Minimum
Reserve Requirement, a commercial bank can grant loans totaling up to
$90,000 -- all with NO further additions to its reserves.
I am ignoring the CURRENCY (paper FRN's and COINS) component of Reserve
Accounts in all of the above for simplicity.
Are the "Reserves" held by the Federal Reserve Banks part of the Money Supply?
"Reserves" (currency or bookkeeping balances) are NOT part of the money
supply!
"RESERVE BALANCES" ARE ONLY A NOTATION (unlike demand deposit balance
notations that really do function as "money"). "RESERVES," therefore, are
NOT PART OF THE MONEY SUPPLY. The "checkbook money" created by the
commercial banks BASED upon "RESERVES" ARE MOST DEFINITELY PART OF THE MONEY
SUPPLY.