The importance of central
bank reserves by Andrew
Bailey
Lecture in honour of Charles Goodhart, London School of Economics
Published on 21 May 2024
Central bank reserves play a key role in delivering the Bank of England's core
mandates of financial stability and monetary policy. In this lecture, the Governor
discusses implications for the future of the Bank's balance sheet.
Lecture
It is a great pleasure to be here at this event, hosted by the LSE's Financial Markets Group in
honour of Charles Goodhart.
This evening, I am going to talk about central bank balance sheets and in particular the Bank of
England's balance sheet. An esoteric topic perhaps, but an important one, now more than ever.
And it is a topic on which Charles has written extensively.
Charles worked at the Bank for nearly two decades, of course, before his distinguished career as
a professor here at the London School of Economics. His article "The importance of money",
published in the Bank's Quarterly Bulletin in 1970 and available on the Bank of England's website,
was a milestone in the study of the predictability of money demand.[1] At the time this was an
important issue in debates over monetary control mechanisms and the relative merits of monetary
'rules' and policy 'discretion', a debate he masterfully summarised in his 1975 book on "Money,
Information and Uncertainty".
In this and later work, Charles brought his deep understanding of the nature of financial markets, of
banking and of monetary assets to bear, the historical perspective always present. In his 1988
book "On the Evolution of Central Banks" he discussed "how the role and functions of Central
Banks have evolved naturally over time, and play a necessary part within the banking system".
Fast forward two more decades - across a long list of significant contributions covering the full
spectrum of monetary economics - it was with more foresight than most that he turned to "A
Central Bank's Optimal Balance Sheet Size?" in 2017, discussing principles for 'monetary policy
renormalisation' after a decade of central bank balance sheet expansion.[2]
I should not fail to mention that Charles was a policymaker too. He served as an inaugural external
member of the Monetary Policy Committee, from June 1997 to May 2000. When he left Bank Rate
was at 6.0%. It is tempting to bring up r* at this point. But I will resist and conclude instead that the
Bank of England's balance sheet seems a fitting topic for a lecture in Charles's honour this
evening.
It may not be a topic for dinner table conversations, but the central bank balance sheet plays a
crucial role in everyday economic life. Its main liabilities - central bank reserves, the deposits that
commercial banks hold at the central bank - serve as the ultimate means of settlement for
transactions in the economy. Central bank reserves, in other words, are the most liquid and
ultimate form of money. They underpin nearly all other forms of money such as the deposits
individuals or businesses hold at commercial banks. The Bank issues physical bank notes directly
to the public too, of course, but they are a smaller part of overall money stock.
Some transactions can happen simply by moving money from one account to another at the same
commercial bank. In that case, the central bank need not be involved. But whenever money has to
be transferred from an account at one commercial bank to an account at another commercial
bank, that transaction has to be settled between them. That is where the central bank's balance
sheet comes in. Commercial banks hold reserves at the central bank. So transactions can be
settled by moving these reserves - claims on the central bank - across the central bank balance
sheet by debiting one commercial bank's reserve account and crediting another's. It is the
confidence that payments can be settled in this way that ultimately gives commercial bank money
its value.[3] It ensures the singleness of money, that people can be confident that money is fungible
at equal value - that the money they hold in their account is as good as any other.
In practice, transactions are processed through our Real-Time Gross Settlement (RTGS) service.
This delivers final and risk-free settlement of transactions across the financial system with central
bank reserves at its centre. Incidentally, this means that central bank reserves exist predominantly
in digital form. So the road to a 'digital pound' is not as long as you might suspect. One way to
think about wholesale Central Bank Digital Currency is as just another form of digital central bank
reserves. Meanwhile, a new and improved RTGS is nearing completion. This will deliver an
enhanced settlement service, supporting innovation in payment services. This is an exciting and
important work programme, but not the subject for today.
Instead, I want to talk about the key role that central bank reserves play in delivering our core
mandates of maintaining financial stability and implementing monetary policy, and what those
roles imply for the future of the Bank of England's balance sheet.
Starting with financial stability, central bank reserves are the safest and most liquid of financial
assets, the ultimate means of settlement. This makes them an essential anchor for the stability of
commercial banks and the wider financial system. Commercial banks can create money simply by
extending loans to their customers. It is worth pausing at that sentence. It is the answer to one of
the simplest but most teasing questions I get asked, particularly when I visit schools: "how is
money created?" The majority of money is created when banks make loans to their customers.[4]
But banks need to hold sufficient reserves, or 'liquidity', to meet the potential outflows of money
from their customers' accounts. So by ensuring that all transactions can proceed smoothly, central
bank reserves play an important role in maintaining financial stability.
This of course comes with a package of macro-prudential policy and micro-prudential regulation.
Macro-prudential policy works to ensure that the whole financial system is robust and that people
can have confidence that their money is safe. And micro-prudential regulation, among other
things, incentivises banks to take relatively more stable term deposits and to ensure that they hold
an adequate amount of high-quality liquid assets, so-called HQLA which includes central bank
reserves, to meet their payment obligations at all times. This regulation underpins the important
singleness of money.
This does not imply that banks need to hold reserves for all eventualities. They can borrow liquidity
from each other in the so-called money market, for example, to smooth out demands. And central
banks stand ready to provide additional liquidity, in the form of central bank reserves, as needed
for the system to operate smoothly. Effectively, banks can borrow the reserves they need from the
central bank, by pledging other assets as collateral for the loan. As Charles put it in a paper he
published in 2011: "the essence of central banking lies in its power to create liquidity, by
manipulating its balance sheet" in this way.[5] I will have more to say about this later.
But first to the second important role that central bank reserves play in today's monetary system:
central bank reserves are remunerated at the official policy rate and as such they provide an
essential anchor for the implementation of monetary policy. The Bank's Monetary Policy
Committee sets the level of Bank Rate to meet its 2% inflation target. The Bank puts these
monetary policy decisions into effect through the remuneration of reserves at that rate. By pinning
down the near-end of the interest rate curve, this is the first step in the transmission of monetary
policy through financial markets to the real economy and thus influencing inflation.
There are other ways of affecting short-term interest rates for monetary policy purposes, but all
involve the use of central bank reserves in some way or another. Before the global financial crisis,
most central banks operated with a much lower level of reserves than today and an interest-rate
'corridor' between official rates on a borrowing and a deposit facility. The approach involved
managing the 'scarcity' of reserves such that the money market rate was in the middle of the
corridor. The Bank of England operated a variant of this approach that required firms to specify
the quantity of reserves they wanted to hold on average each month and then incentivised them to
manage their holdings to this target by paying Bank Rate only on this target.
In the system we have today, the much larger supply of reserves drives money market rates close
to the 'floor' determined by Bank Rate. If money market rates were to fall much below Bank Rate,
banks would have an opportunity to profit by borrowing reserves from other banks, for example,
and earning Bank Rate on their reserve accounts. This 'floor' system has been successful in
keeping money market rates very close to Bank Rate.
While in principle we could implement monetary policy with a much smaller level of reserves than
we have today, I will argue this evening that financial stability considerations point towards an
increased reserve demand since the financial crisis, one that the central bank has very good
reason to meet. But how many reserves do we need in the system to secure financial stability as
well as to implement monetary policy effectively - what is the optimal level? And given that level,
we are faced with another question: which assets should the Bank hold to back it? These two
questions are the topic of today.
Decisions on how we supply reserves will affect where it intersects demand. We need to account
for potential market distortions from our choices, and what they imply for the balance between
liquidity provision directly through the Bank's facilities and indirectly via the money market, both in
normal times and in stress. And we need to consider where interest rate risk sits within the system
and what the implications are of that. These are important questions. How we answer them will
shape the Bank of England's balance sheet for years to come.
It is useful to start with some history.
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.[6]
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.
In his 1972 book on "The Business of Banking" of this time, Charles showed that banks held more
in the form of bankers' balances than they needed purely for settlement purposes. Banker's
balances were unremunerated and would remain so until 2006. That does suggest some
precautionary liquidity motive. But Charles also found evidence that banks held a certain level of
balances to keep good relations with the Bank should they need additional liquidity, and that some
banks pre-positioned collateral for that purpose. I will come back to both these points later in a
modern context.
As Chart 1 shows, at the turn of the 20th century, on top of bankers' balances (in orange), banks
also held safe investment assets in the form of government securities (in blue) and a frontline
reserve of cash in their tills to meet immediate customer demands (in green).[7] This provided an
adequate safety buffer given the nature of banking at the time. Banks largely provided working
capital finance to firms. Their private assets were bills, short-term loans and overdrafts. They
would not enter the mortgage market until the 1980s. So the banking system was relatively safe
with little risk from maturity transformation.
Both World Wars would see a major increase in the amount of government securities held by the
banks, reflecting the banking system's role in funding the Government's deficit. As Chart 2 shows,
at the end of World War 2 around three quarters of the banking system's sterling assets were in
the form of direct or indirect holdings of government debt instruments (in blue). The 1950s and
1960s saw the composition of bank assets move firmly back towards private sector lending (in
green). But in this period, frequent balance of payments crises under the Bretton Woods system
led to attempts to control bank lending. Pressure was applied to banks' liquid asset ratios to
reduce their illiquid
private-sector loan assets, and the Government applied direct controls on credit provision. In other
words, credit provision to the economy was actively discouraged.
Then during the 1970s and 1980s, financial liberalisation and the removal of controls on the banks
and building societies led to a significant decline in the public sector liquid assets ratio.
Chart 3 illustrates how the clearing banks had entered the mortgage market and maturity
transformation increased. Banks increasingly became liability managers and competed for funds
in wholesale markets. Restrictions on building societies were also removed in the early 1980s
and they were allowed both to access wholesale funding and offer many of the services of banks.
By the early 2000s only the bare minimum of reserves required for day-to-day settlement were
held - and very few public sector liquid assets, which could be used as collateral to obtain more
reserves from the Bank when required. That left banks dependent on the availability of wholesale
funding markets. As it turned out, this was not a good situation.
As the global financial crisis unfolded later in the decade, wholesale funding markets dried up
and it became increasingly difficult for banks to sell securities backed by mortgages or other
assets, or to use them as collateral to borrow cash. Banks were now left with an 'overhang' of
illiquid assets on their balance sheets. The Bank had to widen the collateral it was prepared to
accept in its money market operations, and it introduced schemes to allow banks to swap what
had become illiquid private securities for UK Treasury bills.
The other leg of the policy response, of course, was the introduction of Quantitative Easing, or QE.
As Chart 4 illustrates, QE has been the dominant driver of reserves creation and the significant
increase in the level of reserves over the past two decades, including in response to the Covid-
pandemic. But further reserves were added to the stock with term funding schemes, including the
launch, in March 2020, of the Term Funding Scheme with additional incentives for Small and
Medium-sized Enterprises, or TFSME for short. Until it closed for new loans in April 2021, the
scheme offered multi-year funding at close to Bank Rate for banks that increased lending,
especially to SMEs, in order to avoid that their lending rates would edge up.
As Chart 4 also shows, the process of reserve expansion has now gone into reverse. Asset
purchases are being unwound through Quantitative Tightening, or QT, while TFSME loans are
maturing. [8] It is this reversal that gives rise to the question of what the level of reserves should be
in the future.
As we look to the future and answer that question, we need to make an important distinction
between the monetary policy and financial stability purposes for reserve creation.
The primary purpose of QE was to stimulate the economy by pushing down longer-term interest
rates through the purchase of mainly government bonds, financed by the issuance of renumerated
central bank reserves - or, if you like, to create money directly as Chart 5 illustrates (in the red
bars), to avoid a drop in the money supply resulting from banks repairing their balance sheets
through both a contraction in bank lending and issuing non-monetary liabilities such as debt and
equity (the blue and purple bars). But viewed from today, this direct money creation also served
the secondary purpose of re-building the level of reserves and safe public sector liquid assets
from what had proven to be an inadequate level during the global financial crisis. What was a
monetary policy intervention had a necessary and positive financial stability effect in this way. As
Chart 1 also showed, public sector liquid assets as a ratio of the sterling deposits of households
and companies are now at similar levels as they were in the 1960s.
The distinction is important for two reasons. First, we should see the process of QT as having two
parts, consistent with phases where each of the two purposes of money creation comes to the
fore. I will explain this later. Second, the distinction opens the question of what assets the Bank
should hold on its balance sheet in the future. I will come back to that too.
But, returning to the first question, 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.[9]
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.[10] 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.[11] 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.[12]
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.
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.
I will not speak for Charles in this debate. But as he has pointed out in his work, the decision
should be based on a clear set of principles. At its highest levels, we are looking to set up an
operating framework that: a. delivers on our core monetary policy and financial stability mandates,
and subject to that; b. minimises risk to our balance sheet; c. minimises market distortions, and; d.
is transparent and accountable.
But where does this leave us in terms of the actual level of reserves? It is time to introduce you to a
Bank of England neologism: the Preferred Minimum Range of Reserves (PMRR), coined by our
former Executive Director for Markets, Andrew Hauser, now Deputy Governor at the Reserve
Bank of Australia.[13]
Illustrated in Chart 6, the PMRR is an estimated range for the minimum level of reserves that
satisfies commercial banks' aggregate demand, both to settle their everyday transactions and to
hold cash as a precaution against potential outflows in times of stress. In a nutshell, this is the level
consistent with treading a middle path.[14] When reserves supply exceeds the PMRR, reserves
are 'ample'. In this case, banks' demand behaviour is determined by the rate of return relative to
other liquid assets so that money market rates are effectively determined by Bank Rate through
arbitrage (some falling only slightly below owing to the cost of trading). If reserves supply were to
fall below the PMRR, however, reserves would become 'scarce'. In this case, banks would be
likely to respond by seeking to borrow reserves in money markets, bidding up the price in the
process and thereby causing short-term interest rates to rise relative to Bank Rate. Our incentive
as a central bank is to ensure that we have liquidity provision facilities to prevent this from
happening and maintain effective control of short-term money market rates.
Quantifying the PMRR is easier said than done. It cannot be objectively observed, it is likely to
evolve over time, and it will be affected by our decisions. It will depend on banks' business models
and choices over the mix of their liquid assets as well as any future developments in liquidity
regulation. It will also be affected by our choices in how we supply reserves. This includes not least
the price terms of our facilities, but also the assets we choose to hold to back them, and other
non-price terms like tenor and eligible collateral. In making these decisions, we need to align the
private interests in terms of the reserve demand of individual banks with the public good of
maintaining a sufficient aggregate stock of reserves for financial stability purposes - as I will
come back to in a moment.
A starting point is simply to ask the banks what they think the reserves level in aggregate should
be - as we do in biannual surveys. We do have to recognise the uncertainty around any answer
we get, and check against our own assessment of the liquidity risk banks face. But the answers
clearly point to a significantly larger balance sheet than we had before the financial crisis, with the
latest assessments falling in the range of £345bn-£490bn.
The current level of reserves of around £760bn is still comfortably above this range. But the
continuing processes of unwinding the stock of QE assets and the TFSME mean that the level of
reserves is falling.
So when will we get there? That will depend not least on how quickly these unwind processes
progress. Chart 7 shows scenarios based on contractual TFSME maturities and two alternative
assumptions on the future pace of QT. These are strictly illustrative, based on the past MPC's
decisions on the pace of QT. But they do suggest that we may reach the PMRR as soon as the
second half of next year.
While reserves remain in 'ample' supply, the current 'floor' system will continue to operate
smoothly. But as we approach the minimum level of reserves demanded by banks, things get a
little more complicated. We cannot be sure exactly where it is, and as we approach it, we may
face a few bumps in the road with temporary frictions in money markets as firms adjusts to the
falling supply of central bank reserves.
To maintain full monetary control throughout this process, and pick up any emerging reserves
scarcity, the Bank introduced a new weekly Short-Term Repo facility back in 2022, complementing
our other reserve supply operations - including our Indexed Long-Term Repo, or ILTR, which
supplies reserves for six-months at a price related to demand, against wide a range of collateral.
The STR allows banks to borrow unlimited amounts of reserves, against gilt collateral only, at
Bank Rate. In combination, these facilities will allow the unwind of QE and the TFSME to continue
without the risk of any loss of monetary control on the way to the PMRR.
The supply-driven 'floor' system will gradually become a 'demand-driven' one, where the level of
reserves is driven not, on the margin, by the supply of reserves for monetary policy purposes, but
by the demand for reserves for prudential purposes. This allows us to reduce both the risk of
supplying too few reserves and the risk of providing too many, given the system's true financial
stability needs.
In recent months, we have seen an uptick in the usage of the STR. As the cost of liquidity in the
money market edged-up temporarily relative to Bank Rate, more banks turned to the facility to
borrow reserves from the Bank. This is encouraging. The Bank is open for business and our
facilities should be used as a way for counterparties to access reserves as necessary. It does not
mean that we have reached the PMRR just yet, however. Temporary factors were at play,
particularly in the gilt repo section of the money market. But is does illustrate the benefits of a
having tried and tested liquidity facilities as we get closer to the PMRR.
That is not the end of the story, however. Once we get to the PMRR, we face an open question
about the assets we should hold to back the stock of reserves we need to provide to support
financial stability, while maintaining monetary control. We have some important choices to make,
and we are actively working on the options while we approach the PMRR.
Chart 8 provides a simple illustration of how this could play out. QE assets are held in a special
vehicle on the Bank's balance sheet, the Asset Purchase Facility (APF). Given these assets were
purchased for monetary policy purposes, decisions over them are taken by the MPC according to
a set of principles, including a commitment to make the process gradual and predictable, and to
use Bank Rate as the active monetary policy tool. The MPC has also noted the benefit of building
headroom should QE be needed in the future. As this QT process progresses, the gilts held in the
APF may eventually fall below the PMRR. Lending through the STR in the first instance, and
eventually alongside our other facilities, will start to pick up the shortfall in reserves supply, to meet
prudential needs for reserves and maintain monetary control through the setting of Bank Rate. The
QT process enters a new phase. QT now changes the mix of assets that back central bank
reverses as the APF unwinds, but not the level of reserves itself.
We face a choice at that point between providing central bank reserves above the level of the
APF through repos - that is lending reserves against collateral - and outright purchases of safe
assets such as gilts, or some combination of the two.
For much of the Bank's history we have lent on a secured basis, primarily against government
securities and trade bills. Perhaps it is time to return to such an approach.
A key consideration is how much interest rate risk - the exposure to swings in the value of assets
as interest rates change - should reside on the central bank balance sheet. QE involved an
increase of long-term assets, long-dated gilts, on the Bank's balance sheet and an increase in
short-term liabilities, reserve liabilities remunerated at Bank Rate. This removed interest rate risk
from the private sector and transferred it to the central bank balance sheet. QT is now reversing
this process and unwinding the interest rate risk held by the central bank. And while we will meet
the demand for reserves, it does not mean that we should retain the interest rate risk. So hand in
hand with the discussion of the assets held by the central bank, comes a discussion of how
interest rate risk is managed across the financial system.
While outright asset purchases bring interest rate risk on to the central bank, a portfolio of repos -
effectively loans against a wide range of collateral - does not. There is still some risk associated
with repos - the contingent risk that the borrower will default on the loan. But this risk can be
mitigated with conservative 'hair cuts' to the collateral provided to ensure that it is sufficient to
recover any losses. So the absence of interest rate risk substantially mitigates the financial risk on
the central bank balance sheet (principle b. above).
And in line with the fundamental principle of minimising market distortions from central bank
operations (principle c.), financial risk is best managed and distributed by the financial sector
unless there is a strong policy case for the public sector to take on the risk (as was the case with
QE). So from this perspective, providing central bank reserves through repo-operations has much
appeal.
In fact, repos score very well against all of our principles. Notably on a. on delivering our core
mandate, and d. on transparency and accountability, repos provide a lot of flexibility around
monetary control choices. Say if Bank Rate were ever to return to its effective lower bound, a repo
portfolio could quickly be displaced by asset purchases, or a funding scheme, for monetary policy
purposes. By contrast, outright gilt holding are less straightforward to unwind.
In addition, a repo portfolio can offer a reliable and flexible source of additional high-quality liquid
assets for the financial system. That is because our repo facilitates liquidity upgrade transactions,
where firms gain the most liquid asset, central bank reserves, when undertaken against illiquid
collateral.
We should recognise, however, that a move from a supply-driven system where reserves are
created through outright asset purchases to a demand-driven one where reserves are created in
repo operations would amount to a substantial change in how we and commercial banks operate
and interact. Not only would financial firms be able to source liquidity directly from the Bank at a
much greater scale, they would also need to do so as part of their business-as-usual liquidity
management. We at the Bank of England have much work ahead of us too, in deciding on the
appropriate assets as we go forward, in reviewing our facilities to enable this, and in ensuring that
both we and firms are ready for them.
And even if we do eventually settle on an approach based on repos, there are important issues to
consider when determining the terms on which liquidity is provided, related to the endogeneity of
reserves demand. Should we, for example, incentivise firms to hold higher levels of reserves in
normal time through generous terms of supply - or should we incentivise more active liquidity
managements by firms and greater 'recycling' of a smaller