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Im trying to better understand how banks work and one of the first thing that confuses me is central bank reserves.

Current understanding of central bank reserves:

  1. Central bank reserves never enter the real economy as they are different to the everyday money I use.

  2. These reserves are the only way banks can achieve final settlement.

  3. These reserves are in a closed system, so although these reserves move around between the banks the total quantity never increases/decreases.

If I was a billionaire and wanted to start my own bank. What is the process for getting these central bank reserves. What do I have to give to the Fed to get these special reserves and what quantity do the Fed give me to be able to handle the volume of interbank settlement.

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    $\begingroup$ If you get a license and you take in deposits, assuming there are reserve requirements, you simply send a fraction of that money to the central bank. $\endgroup$
    – Alex
    May 15, 2023 at 14:45
  • $\begingroup$ So if the reserve was 10%, every time I get a new deposit I take 10% and send it to the central bank. This is not a closed system though and they make a big point explaining it's a closed system where no new money leaves or enters. $\endgroup$ May 15, 2023 at 16:13
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    $\begingroup$ Note that central bank reserves are simply cashless cash. They are fungible with cash, minus a small printing fee. You can deposit cash into the central bank, or you can convince another bank to withdraw your money as reserves instead of cash. $\endgroup$
    – user253751
    May 16, 2023 at 14:43
  • $\begingroup$ Good question which was not answered by either @Alex or in the answer below which just describes how reserves work after you already have them. To expand on this question (I'm also curious) imagine that a new bank wants lend, but has not yet taken in any deposits. How can it fund the loan without reserves? Does this mean that it absolutely must first receive deposits (which bring reserves) before lending can begin? Or is it the case that denovo institutions already start with reserves somehow (maybe that's how they are initially capitalized?) $\endgroup$
    – Solaxun
    Jul 27, 2023 at 23:05
  • $\begingroup$ Yeah it seems no one really knows. It's seems to me that the amount a bank can loan is tied to reserves. The more reserves, the more loans. So I was just wondering whether there is a process where banks can just increase their reserves without borrowing from another bank. $\endgroup$ Jul 28, 2023 at 11:41

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Reserves held by commercial banks are really just current account balances at the central bank, akin to current accounts of individuals at commercial banks.

Most banking transactions between customers of different banks are ultimately settled through transfers between reserve accounts at the central bank. Technically, it is possible for commercial banks to perform such transactions without a central bank, but this would require correspondent accounts between the respective commercial banks. Additionally, it exposes the banks to credit risk. Therefore, centralized payments via central banks are the preferred mechanism for settlement between commercial banks.

While any individual commercial bank is free to choose between reserves and other assets, the system wide quantity of reserves is determined by accounting identities on the central bank’s balance sheet only. If an individual bank decides to add reserves, it can reach out to the central bank and engage in a few transactions, the most common being a REPO: a sale and repurchase agreement where an asset is sold to the central bank (frequently government bonds, but also eligible loans etc) in exchange for central bank reserves, while simultaneously agreeing to repurchase the asset for a predetermined price on a specific future date. On the commercial banks balance sheet, you have the additional reserves as assets, and the repo as a liability.

To understand the way system wide reserves work, it helps to think of a model economy with only two banks. A new bank (call it N), and an old bank (O). If someone decides to deposit at N, they must have had the money at O beforehand. Therefore, deposits transfer from bank O to N, which simultaneously requires that reserves move from O to N. This implies that there is no impact on the total quantity of reserves.

Edit A repo still adds reserves. Additionally, some REPOs are very long term, e.g. TLTROs which were immediatly deposited as reserves by banks. In the end, reserves change all the time. See for example the official series for total reserve balances maintained plus vault cash used to satisfy required reserves on FRED.

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A pivotal element is that if a central bank does not provide or allow extra reserves in the system, then any increase in holdings must come at the expense of another commercial banks reserves. However, modern central banking largely operates under an ample reserves framework, where reserves are supplied in amounts that leave most commercial banks with reserve balances well above what is required for payments purposes. The TLTRO example above is such a system where banks hold large amounts of excess liquity (ECB: Balance sheet size and interest rate control).

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Helpful reading:

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  • $\begingroup$ With a repo doesnt the bank have to repurchase the bonds back, which will mean giving back the reserves they just gained?? $\endgroup$ May 15, 2023 at 22:26

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