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Part 11. How central banks work

Modern central banks act as both lenders of last resort and clearinghouses or clearing banks, and we will consider this to be the case in our examples. They lend money to banks in the same way banks lend money to people and businesses, that is, through ledger entries. As well as lending digital money, central banks also lend physical cash in the form of notes and coins. Both are referred to as cash reserves. We will focus on digital reserves in this part and look at physical cash in part 20.

Let's continue with our banks and sets of accounts from part 10 and see how a central bank provides liquidity. To demonstrate this, we will introduce a new central bank called Central Bank, and 2nd Bank will exchange its £50,000 mortgage-backed security for reserves at this central bank.

To transfer 2nd Bank's mortgage-backed security, we will need to introduce a mortgage-backed security account at Central Bank. We will again call it Mortgage-backed Securities (since the account also has the bank's name on it so it won't cause confusion). The security transfer is shown in Figure 11.1.

Mortgage-backed Securities 2nd Bank Description Debits Credits Balance Previous balance £50,000 (DR) Transferred to Central Bank £50,000 £0 Mortgage-backed Securities Central Bank Description Debits Credits Balance Starting balance £0 Received from 2nd Bank £50,000 £50,000 (DR)

Figure 11.1 The security transfer from 2nd Bank to Central Bank.

To transfer reserves, we will need two new accounts, one at Central Bank called 2nd Bank's Digital Reserves, and one at 2nd Bank we will just call Digital Reserves. The transfer of reserves from Central Bank to 2nd Bank is shown in Figure 11.2 (this forms the second double entry required by the rules of interbank transactions).

2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Starting balance £0 Transferred to 2nd Bank £50,000 £50,000 (CR) Digital Reserves 2nd Bank Description Debits Credits Balance Starting balance £0 Received from Central Bank £50,000 £50,000 (DR)

Figure 11.2 The digital reserves transfer from Central Bank to 2nd Bank.

And the balance sheets of all banks, including Central Bank, are shown in Figure 11.3.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £50,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Total assets £150,000 1st Bank's Liabilities Deposit Account #2 £50,000 Mortgage Loan Account #1 Security £100,000 Total liabilities £150,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £50,000 Total assets £100,000 2nd Bank's Liabilities House Seller's Deposit Account £100,000 Total liabilities £100,000

Figure 11.3 Balance sheets after the central bank mortgage-backed security purchase from 2nd Bank.

So, 2nd Bank now has digital reserves of £50,000. This type of borrowing is generally short term under a sale and repurchase agreement, and so the security may eventually be purchased back by 2nd Bank. But as long as a central bank has a non-zero balance sheet, which is usually the case, banks will have reserves available to use to facilitate lending (as well as earnings) as discussed next.

back to Part 10

Continue to Part 12:
How clearing works