Discussing Reserves: Sources, Utility and Why QE Doesn't Work

Understanding the Economic Utility and Market Perception of Bank Reserves and Why QE Reserves Are Inferior and Dangerous

Discussing Reserves: Sources, Utility and Why QE Doesn't Work

In the complex world of banking and finance, liquidity is a crucial concept. It refers to the ease with which an asset can be converted into cash without significantly affecting its value. Two prominent assets in the banking sector are reserves held at the Federal Reserve and U.S. Treasury bills (USTs). This blog post explores the economic utility, market perception, and practical implications of these assets, particularly focusing on the differences between reserves obtained through Quantitative Easing (QE) and those from customer deposits, as well as comparing the liquidity of reserves to On-the-Run (OTR) Treasury bills.

Understanding Bank Reserves

What Are Bank Reserves?

Bank reserves are the deposits that commercial banks hold at the central bank plus any physical cash they keep in their vaults. Reserves are crucial for maintaining liquidity, meeting regulatory requirements, and facilitating interbank payments.

Types of Reserves

Reserves from customer deposits are created when customers deposit money into their bank accounts. These reserves are essential for meeting withdrawal demands, facilitating interbank payments, and managing the bank's liquidity. Their flexibility is notable, as they directly influence the bank's ability to lend and engage in transactions like repos. On the other hand, reserves from QE transactions are created when the Federal Reserve purchases securities from banks during QE. These reserves are used primarily for regulatory compliance, interbank settlements, and overall liquidity management. However, they come with certain restrictions: they cannot be directly used for customer withdrawals or in repo transactions.

While reserves from customer deposits and QE transactions are the primary types discussed, it's important to recognize that reserves can also be influenced by other banking activities and financial transactions. Banks can borrow reserves from other banks in the federal funds market. These interbank loans adjust the reserve balances between banks without changing the total reserves in the banking system. This source of reserves is critical for banks needing short-term liquidity and helps stabilize the interbank lending rates.

In repo transactions, a bank sells securities with an agreement to repurchase them later. The cash received from selling these securities temporarily increases the bank's reserves. Conversely, in reverse repo transactions, the bank buys securities and agrees to sell them back later, which temporarily decreases its reserves. These transactions are commonly used for short-term liquidity management and can impact the bank's reserve levels temporarily.

Banks can borrow reserves directly from the Federal Reserve through the discount window, usually at higher interest rates than interbank borrowing. This source is often used as a last resort when banks face significant liquidity challenges. When central banks engage in foreign exchange operations, such as buying or selling foreign currencies, these transactions can affect the reserve balances of banks involved in such trades. Rehypothecation refers to the practice of banks and brokers using assets pledged as collateral by clients for their own purposes, such as securing loans or engaging in other transactions. While this practice primarily involves securities and not directly the creation of reserves, the liquidity generated can influence reserve management indirectly.

Comparing Reserves and OTR Treasury Bills

Reserves have immediate availability within the banking system and are primarily used for interbank settlements and regulatory compliance. However, they are not directly tradable or usable as collateral in the broader market. On the other hand, Treasuries are highly liquid and actively traded in financial markets, especially the shortest terms (Treasury bills) and the most recent issuances (On-the-Run OTR). They can be used as collateral in repo transactions, providing short-term liquidity. Additionally, OTR Treasury bills provide interest income and are considered safe assets with stable market values.

U.S. Treasuries (USTs) and Mortgage-Backed Securities (MBS) offer greater flexibility compared to reserves. They can be used in repos, sold for cash, and generate interest income. These securities serve as reliable collateral and contribute to regulatory capital requirements. In contrast, reserves offer immediate liquidity but are restricted to the banking system. They provide essential support for regulatory and liquidity needs but lack the broader economic utility that USTs possess.

In this context, QE is far from being a stimulus. It creates reserves in the system but suppresses market dynamism. By converting USTs into reserves, banks lose the flexibility and income potential that come with holding treasuries. This shift can lead to a more fragile market environment, as the liquidity provided by treasuries in the open market is significantly reduced. To address this issue, banks will tend to replace the USTs the Federal Reserve took via QE.

Practical Implications and Conclusion

Reserves from customer deposits directly support withdrawal demands, enhancing customer trust and market stability. These deposits are seen as a sign of strength and good management practices. In contrast, reserves from QE provide indirect support for liquidity but may raise concerns about financial health. The perceived reliance on QE can lead to adverse outcomes, including difficulty in sourcing liquidity and potential bank runs.

The comparison between bank reserves and U.S. Treasury bills reveals significant differences in their economic utility and market perception. While reserves are vital for liquidity management and regulatory compliance within the banking system, their source—whether from QE or customer deposits—can influence how they are perceived and utilized. Reserves from QE, although technically fungible within the banking system, they are not practically fungible, especially in banking crises, they carry a stigma that may affect a bank’s financial health and market reputation. On the other hand, U.S. Treasury bills offer greater flexibility, serving as collateral, generating income, and being highly liquid in financial markets.

The implications of holding reserves from QE versus customer deposits are profound, impacting both a bank's operational flexibility and its market perception. If a bank's reserves are heavily reliant on reserves from QE it inherently affects their liquidity management, especially during periods of financial stress or increased withdrawal demands. Just the fact that they have so many inert reserves can make liquidity precarious. The market will perceive the bank as dependent on central bank support. If you expand this perception to the entire banking industry, you can see why banking crises seem to erupt out of nowhere. September 16, 2019's Repo Rumble for example, or the March 2023 deposit flight leading to Silicon Valley Bank and First Republic going bust.