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Nonbanks drain M1/M2 deposits

Nonbanks decrease vault cash and M1/M2 deposits via the long term withdrawal of currency from the aggregate bank. Banks pay for vault cash using reserve balances at Fed. So the long term currency drain would deplete banks of vault cash and reserve balances if Fed fails to service the currency drain (buy securities equal to or slightly greater than its currency liabilities) before late 2008. After late 2008 Fed provides excess reserves via LSAP and no longer needs to service the currency drain as shown in the graph above of securities held compared to currency liabilities.

Prior to the financial crisis of late 2008 Fed buys securities in the open market which are roughly equal to the level of its currency liabilities. This means the Nonbank sector has the option of holding securities, which earn interest, or currency, which earns no interest, because Fed would do an asset swap with the Nonbank sector to satisfy its demand for currency versus other financial assets. Prior to late 2008 Fed would purchase primarily Treasury securities and other Agency debt issued by or guaranteed by the federal government. After 2008 Fed began large scale asset purchases and paid interest on excess reserves created via LSAP open market operations. Before 2008 Fed would service the currency drain to ensure banks did not become depleted of reserve balances and vault cash do to the net withdrawal of currency over time.

Simplified model for the aggregate Bank sector (Depository Institution) balance sheet.

Prior to the financial crisis of late 2008 Fed buys securities in the open market which are roughly equal to the level of its currency liabilities. This means the Nonbank sector has the option of holding securities, which earn interest, or currency, which earns no interest, because Fed would do an asset swap with the Nonbank sector to satisfy its demand for currency versus other financial assets. Prior to late 2008 Fed would purchase primarily Treasury securities and other Agency debt issued by or guaranteed by the federal government. After 2008 Fed began large scale asset purchases and paid interest on excess reserves created via LSAP open market operations. Before 2008 Fed would service the currency drain to ensure banks did not become depleted of reserve balances and vault cash due to the net withdrawal of currency over time.

Simplified Chart of Accounts for the aggregate Bank sector (Depository Institution) balance sheet.

Fed generates net new reserve balances and M1/M2 deposits when it purchases securities from Nonbanks. The aggregate Bank debits reserve balances for an increase and credits M1/M2 deposits held by the Nonbank sector for an increase to clear payment between Fed and Nonbank units. Before late 2008 Fed used these open market operations to offset the currency drain (withdrawal of currency) from the Bank sector and to provide banks with just enough reserve balances so a few banks would show up at the discount window to borrow overnight funds. By monitoring the discount window activity Fed has information about the efficiency of the fed funds market and by keeping the aggregate Bank sector a little short on reserve balances Fed can control the fed funds interest rate.

After late 2008 money markets were seriously disrupted, discount window borrowing went up significantly, and initially Fed sold Treasuries from its balance sheet to "sterilize" the increase of reserves provided at the discount window. However this strategy would deplete Fed of its best asset class, Treasury securities, if the aggregate Bank sector kept demanding more reserve balances via borrowing from Fed. So Fed went to Congress for authority to pay interest on excess reserves and switched to providing excess reserves via large scale asset purchases (LSAP) in late 2008 into early 2009. If Fed does LSAP purchase with Nonbanks then Banks would debit reserve balances for an increase and M1/M2 deposits for an increase caused by the increase of Fed Credit.

Fed generates net new reserve balances when it purchases securities from a Bank or makes discount window loans to a Bank. Banks do not debit or credit M1/M2 deposits when dealing directly with Fed so there is no change in M1/M2 money for these transactions. When Fed purchase securities, either from a Bank or Nonbank, this provides so-called "non-borrowed reserves". When Fed lends to Banks this provides so-called "borrowed reserves."

Nonbanks drain M1/M2 deposits

Simplified model for the aggregate Bank sector (Depository Instution) balance sheet.

When a bank expands Bank Credit it would initially debit a financial asset account for an increase and usually it would credit a checkable deposit account for an increase. The checkable deposit category is a major component of the M1 money supply. So the expansion of bank credit increases the money supply in most cases initially as M1. However in the complex banking sector a bank can induce its customers to move funds from M1 to time/saving deposits which are in M2 money supply. So the basic idea is that a bank or bank sector increases the money supply by the expansion of financial assets other than its vault cash or reserve balances.

If the checkable deposit is spent to another customer of the same bank then the bank will credit the deposit account of the payee for an increase and debit the account of the payor for a decrease with no change in total deposits. So the money supply does not increase or decrease for this type of transaction and the bank does not have to pay reserve balances to transfer funds among its own customers.

If the checkable deposit or other deposit funds transfer to the customer of a second bank then the first bank must credit reserves balances (Cash in the paper above) for a decrease and debit deposits for a decrease. The second bank would debit reserve balances for an increase and credit deposit funds for an increase. These transactions do not change levels of reserves or deposits they simply move reserves and deposits from a first bank to a second bank by the payment instructions and double-entry accounting customs applies at each bank. Note each bank is like a "node" in a communication network which receives payment messages and executes the accounting operations necessary to change its records. This is how the payment mechanism works whether kept in books of account or electronic records stored in digital media.

The first bank (like any bank) will be depleted of reserve balances if it expands bank credit but fails to expand interest paying deposit liabilities and/or paid-in equity claims which force a flow of reserves back into the bank to clear the interbank payment on its expansion of the balance sheet.

Suppose a bank cannot expand interest paying deposits and/or paid-in equity then how does it make interbank reserve payments? It either borrows reserve balances from another bank in the overnight market for federal funds; or it borrows from the central bank at the "penalty" rate also called the "discount window" rate which is usually set above the monetary policy target rate; or it sells securities out of its asset portfolio. The sum of total reserves and securities is the liquidity cushion which each bank holds to make interbank payments when it has difficulty expanding the liabilities and paid-in equity side of the balance sheet.

Levels of Private Depository Institutions

https://www.federalreserve.gov/apps/FOF/Guide/L110.pdf

Currently the first three lines are Total financial assets, Vault cash, and Reserves at Federal Reserve. Assume non-financial assets are negligible compared to the magnitude of financial assets. Then define Bank Credit:

Bank Credit = Total financial assets - Vault cash - Reserve balances

Depository institution liabilities are simplified by definition of Bank sector Liabilities* which are not classified as Checkable deposits:

Liabilities* = Total liabilities - Checkable deposits

The difference between bank assets and liabilities in the levels tables can be designated as equity claims or net worth to visualize a complete balance sheet:

Equity = Total Assets - Total Liabilities

Reasoning by analogy to the Monetary Authority balance sheet, which gives the factors supplying reserve balances and the factors absorbing reserve balances, the Depository institutions balance sheet would have factors supplying Checkable deposits and factors absorbing checkable deposits. We can write these factors in an identity as follows:

Checkable deposits = Reserve Balances + Vault Cash + Bank Credit - Liabilities* - Equity

where a transaction in the aggregate bank sector can increase or decrease Checkable deposit levels due to double-entry accounting customs. The sum of Checkable deposits and Currency outside banks is called the M1 money supply. The sum of Checkable deposits and items in Liabilities* is the M2, M3, etc. money supply. Liabilities* include items that are not counted in aggregate measures of the money supply so money supply is created, destroyed, or conserved depending on the nature of the transaction as a flow that supplies or absorbs or does not alter whatever definition of the "money supply" is applied for analysis.

Bank Credit Expansion or Contraction

${\Delta}$ Checkable deposits = ${\Delta}$ Bank Credit; or
${\Delta}$ Liabilities* = ${\Delta}$ Bank Credit; or
${\Delta}$ Equity = ${\Delta}$ Bank Credit;

In most cases the depository institution or bank sector originates credit by putting funds into the checkable deposit accounts of bank borrowers or bank customers who have sold financial assets to the bank. When bank sector sells a financial asset to units outside the sector, or when a bank customer outside the bank sector repays a loan the bank sector, the bank sector would reduce its sum of liabilities and equity and reduce assets listed in bank credit.

Changing the Mix of Depository Institution Liabilities and Equity

${\Delta}$ Checkable deposits + ${\Delta}$ Liabilities* + ${\Delta}$ Equity = 0

When banks induce customers to change the mix of liabilities and equity by offering interest on liabilities and dividends or hope for capital gains on equity this is a zero sum game which does not increase or decrease the bank balance sheet.

If a bank fails to expand Liabilities* and Equity as it expands Bank Credit then it would be depleted of reserve balances via the payments it does make and then it would unable to make interbank payments except to sell assets out of its Bank Credit portfolio. So a bank or aggregate bank sector grows via the increase of Bank Credit, Liabilities* (which are not Checkable deposits), and Equity.

Levels of Private Depository Institutions

https://www.federalreserve.gov/apps/FOF/Guide/L110.pdf

Currently the first three lines are Total financial assets, Vault cash, and Reserves at Federal Reserve. Assume non-financial assets are negligible compared to the magnitude of financial assets. Then define Bank Credit:

Bank Credit = Total financial assets - Vault cash - Reserve balances

Simplified model for the aggregate Bank sector (Depository Institution) balance sheet.

Reasoning by analogy to the Monetary Authority balance sheet, which gives the factors supplying reserve balances and the factors absorbing reserve balances, the Depository institutions balance sheet would have factors supplying M2 deposits and factors absorbing M2 deposits. We can write these factors in an identity as follows:

M1/M2 Deposits = Reserve Balances + Vault Cash + Bank Credit - Liabilities* - Equity

where a transaction in the aggregate bank sector can increase, decrease, or neither increase nor decrease M2 deposit levels due to double-entry accounting customs. Liabilities* include components of Bank liabilities that are not counted in aggregate measures of the M2 money supply.