It is recommended to read about real economy money creation before reading this article.

What is financial and interbank money?

Let’s look again at the T-account again. This is a simplified balance sheet of all US banks portrayed as one.

We have established that private sector money is created through a combination of debt governments owe ‍and loans banks have issued, which both created deposits (see the liability side of the balance sheet).

But… what about bank reserves?

Reserves can only be held by authorised institutions. Reserves are really just a ledger entry at the central bank. Thus, we can say that central bank reserves are the most measurable and direct form of interbank money.

Reserves are the truly liquid part of a commercial bank. If a customer were to request cash, the bank would in essence call up the central bank, redeem the reserves and receive cash from them. The cash would arrive at the bank, replace reserves with cash on the asset side, upon which the customer would withdraw the cash. Both sides of the balance sheet are reduced as a result. Consequently, deposits in the form of real economy money have left the banking system.

Here we see the balance sheet of all US Commercial banks

Most components of the balance sheet expand proportionally over time – a consequence of banking regulation - except cash/deposits, which was handed out by the government frivolously during the covid crisis.

This mechanism, again, can incorrectly lead you to the conclusion that increasing reserves creates money for the private sector. But it doesn’t. Creating and destroying reserves just changes the mix of assets held by banks. The deposit comes first, the bank reserve is the initial and one possible result of a contra account to that deposit, but it could also be a loan or some high quality collateral like a government bond.

We see from the chart that from c. 2015 to 2020 the percentage backing of reserves has decreased, while the proportion of treasury backing has increased. Since 2020 this has dramatically changed – the central bank has markedly injected reserves into commercial banks by monetizing (purchasing) treasuries and MBS.

The Balance Sheet of the US Federal Reserve

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So why issue reserves?

Day-to-day function of the monetary system

As the bank’s balance sheets grow, more reserves are required to keep a steady ratio of reserves in commercial banks. Sufficient reserves ensure banks have the liquidity to meet their liabilities and regulatory requirements.

We have displayed a consolidated balance sheet of all banks in one; however, in reality deposits frequently move from one bank to another. To manage these in-and-outflows, banks need to have access to sufficient reserves on the asset side - hence they frequently trade those in the interbank market.

Timing difference

Other times, reserves are created to offset the time lag between when the government creates money and when the subsequent government bond that is issued is auctioned to authorised financial institutions. This typically takes a few days to a week.

How does the government create money instantly? Just like the commercial bank reserve holdings are recorded at the central bank, the government has its own ledger (in the US called the Treasury General Account – TGA) at the central bank. They can unilaterally increase that account and create money. When this money is spent/distributed, it ends up as deposits in commercial banks.

We see that the government has created the money (bank deposits), but its liability (government bond) has not been released to the market yet. The government bonds are then auctioned to authorised financial institutions after the money has been created. This leads to an increase in the liability side of bank balance sheets, which might not be met by sufficient corresponding high-quality assets such as a government bond or mortgage. This delay can create liquidity problems when large amounts of debt are created, as the liability side of the balance sheet of the commercial banks increases, but a suitable corresponding asset (the government bond) has not been issued yet.

In normal circumstances, the central bank allows for the creation of reserves to be used to fill that time difference. This is why you see so-called monetary policy always in conjunction with fiscal policy.

In short: (excess) bank reserves help banks absorb government debt issuance and reduce the liquidity risks for the financial system.

The central and interbank market

There is a prevailing notion at the central banks and in financial markets that ample reserves grease the financial system and markets. The central bank can do this by incentivising banks to hold ‘excess reserves’, i.e. reserves beyond the minimum requirement.

This is part of the market between the central and commercial banks. Reserves can be posted at the central bank to earn the interest rate set by the central bank (IOER) or alternatively, the banks can buy assets such as government bonds or mortgages to earn a potentially higher yield at an only marginally higher risk. This is one of the mechanisms between the central bank and commercial banks, which is its own market. By setting a policy interest rate for reserves, the central bank can incentivise a desired bank asset mix – if the rate is much lower than assets in the open market, banks (within their regulatory limits) sell reserves and buy higher-yielding assets that qualify as high-quality liquid assets (HQLAs), and vice versa.

Another market exists between commercial banks; banks trade assets (to a large extent HQLAs such as reserves) among each other for liquidity management and liability management purposes.

Throughout most historic periods, central banks have created a reasonable number of reserves to satisfy the reserve requirements and basic short-term liquidity needs of commercial banks. Many bank crises (notably the great depression) have been exacerbated by inssuficient reserves.

Offsetting debt creation: QE

Central banks increasingly felt inclined to go beyond the pure offset of government deficits and provide ‘ample’ reserves in the hope of ‘stimulating the economy’. The desired result they wish to achieve is the portfolio rebalancing effect. It is believed that providing ‘too many reserves’ pushes banks to take more risk and issue loans more aggressively, as they have improved the quality of their balance sheet with plenty of safe assets. Some argue that an excess of those safe assets insulates financial institutions from financial stress and provides them with liquidity.

QE is a simple asset swap: the central bank buys HQLAs from commercial banks and in turn records additional reserves under that banks’ register. By acting as a buyer for mostly government debt, the asset swap ensures that governments can create excessive money. Undertaking QE or QT appears to help manage the asset mix (reserves vs. other HQLAs) in the financial system.

However, central banks know they don’t do real economy money, they are to some extent a PR agency that tries to incentivise banks to actually create money and to absorb short-term shocks of fiscal expansion – when useable money is created. Nonetheless, Central banks heavily influence financial markets through various funding programs, influencing short-term interest rates on reserves and engaging in asset swaps (QE) as well as emergency funding programs for financial institutions, leading to the more recent obsession with central bank policy as an indicator of global market liquidity.

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Measurements of Money

Let’s assess how money supply is measured currently. This is not an easy task. In fact, the financial system has evolved tremendously, particularly since the 1950s with the colossal increase in international trade, economists have lost their ability to define money, let alone measure it (see Stephen Goldfeld - The Case of the Missing Money 1976). The task has become so daunting, that economists have really given up measuring real money supply. The most recent money supply measurements we have are: M1, M2, and M3.

• - M1: currency in circulation and cash overnight deposits
• - M2: M1 + mid-termed deposits, deposits redeemable in <3 months
• - M3: M2 + repo, money market funds (MMFs), debt securities with a maturity <2 years

The main issue is the M measures mix many types of money into the same bucket. For example, private and financial sector deposits (pension funds, sovereign wealth funds etc.) are combined and additional financial sector money such as RePos are added to M3. Recall that most of the asset side of the bank balance sheet consists of some form of accepted interbank money (general collateral).

So it’s really a big mess.

Money in the financial world comes in many forms. While most financial instruments can be traded and swapped, two main instruments lubricate the financial system and are constantly used to trade and manage liquidity: bank reserves and other HQLAs, i.e. typically some generally accepted collateral (GC).

While reserves cannot be used in RePo transactions, GC and bank deposits are each one side of RePo transactions. A repurchasing agreement is essentially a collateralised loan, without being called a collateralised loan. The RePo market is the most important short-term funding market in the world and a major source of international Dollar funding. These global RePo trades cannot be directly measured and hardly be inferred. Overnight RePo transactions in 2024 now make up some $1.5bn in daily volume while the international Eurodollar market makes up tens of trillions. Stress in those international funding markets pose significant risks to our financial system - some consequences of which we saw in the GFC of 2007 and its aftermath.

So how do we go about measuring financial money? As everyone’s attempt at directly measuring those has failed, probably the best we can do is stick to indirect measures of liquidity. Here are some examples of indicators of financial stress & illiquidity:

• - Lack of bank reserves
• - Lack of (or too much) government debt issuance
• - A deterioration in the quality of other general collateral (GC) such as MBS
• - Increased bond market volatility; impacts the haircut required in RePo transactions; a larger haircut = higher funding costs
• - The Dollar exchange rate; since Dollar internationaldebt and trade flows are significant, appreciations in the dollar often cause globalfunding issues
• - Various statistics on the funding markets (some of which can be seen here: https://www.financialresearch.gov/) such as failures to deliver the security in RePo transactions

Conclusion

Attempting to estimate financial sector money is an extremely challenging exercise.

It appears that an ample supply of bank reserves and on-the-run government bonds contribute to the well-functioning of financial markets. Remember though that the swap the central bank engages in with the banks merely provides interbank money for financial institutions.

On the flip side, central banks swapping HQLAs for bank reserves (engaging in QE) enables governments to take on more debt than the market could otherwise absorb, leading to excessive government money creation. QE is a financial operation (greasing) for the money that the government has already created.

Even though I cannot give you a definite guide to measuring interbank and financial sector money, I hope that this excursion into the functioning of the financial system has animated you to explore these topics. In another article, I will dive into the real causes of money debasement,inflation, and recessions.

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