As the ECB begins this week its Public Sector Purchase Programme (PSPP), also known as QE, banks in the Eurozone begin selling a variety of sovereign bonds and securities from European institutions and national agencies to their National Central Banks. The sales will be settled in “central bank money“. So the question today is: Do we know what central bank money is?
This is my brief explainer (forthcoming in The Encyclopedia of Central Banking, coedited by L. Rochon and S. Rossi).
1. What is central bank money?
Central bank money (CBM) is a liability on the balance sheet of the central bank denominated in units that are given the name that defines the currency. So, one dollar is a unit of liability of the Federal Reserve System, and one euro is a unit of liability of the Eurosystem. This central bank liability is an asset to anyone holding it, either in the form of a credit balance in the holder’s account at the central bank or in the form of a physical object (a banknote).
In either form, CBM is valuable because it is, by law, the only means of settlement of any payments due to the central bank or to the government. This means that CBM is redeemable by using it as a means to reduce our debts to the central government. This makes it a generally desirable settlement asset also with parties other than the central bank or government, as its holder trusts that it will be accepted by others as a means of fulfilling payment obligations. In addition, there may exist legal tender laws declaring that the legal system recognizes banknotes as a means that, when offered in payment of any debt denominated in the currency unit, must be accepted as payment and that extinguishes the debt.
We now turn to the differences that exist between the two forms of central bank money: banknotes and credit balances at the central bank.
A banknote is a physical object that provides a means of extinguishing debt with no intermediary. It is typically preferred for small-value payments when the transaction cost of alternative means is proportionally large or to prevent the tracing of transactions when parties desire anonymity of payment for privacy, tax evasion, or other illegal reasons. Note that coins function in the same way except that coins are typically issued directly by the treasury office of governments and therefore are technically “state money,” not CBM.
The quantity of banknotes outstanding at any given time includes banknotes in circulation held by the non-bank public and vault cash in banks’ storage. This quantity is demand-driven: the central bank supplies banknotes to the banks to remove unfit banknotes and coins and to meet bank clients’ requests.
Because a banknote is an object and must be produced, the central bank provisions itself with printed banknotes and ships them to banks when needed. Banks distribute banknotes to their clients as they demand them. When banks need more banknotes to meet the public’s demand, they request them from the central bank and have their accounts at the central bank debited for the corresponding amount. When banks hold more banknotes than desired, they return them to the central bank, which in turn credits their accounts.
3. Credit balance at the central bank
A credit balance at the central bank is a claim on the central bank that may be held only by a limited range of entities to which central bank accounts are available. These typically include licensed banks, the government, foreign central banks, and international financial institutions such as the International Monetary Fund, or the Continuous Linked Settlement Group (for foreign currency settlement). Authorized holders of accounts at the central bank can transfer their balances to other holders, in which case the central bank will debit the account of the payer and credit the account of the recipient. Thus, the main difference from banknotes is that banknotes circulate freely, while credit balances can be transferred only between authorized holders. One can view banknotes as a credit balance at the central bank that circulates as a physical document that may be handed directly to others as a settlement asset.
Not being physical objects, credit balances are not manufactured like banknotes and come into being as credit entries recorded on the account of the holder. A newly credited unit of CBM in this form (namely one that is not a counterpart of an equivalent debit on the account of another holder) comes into being only when the central bank makes a payment (like a purchase, a loan, or an interest paid) to one authorized holder. Likewise, a net reduction of balances results from every payment that the central bank receives from its account holders (like a sale, a loan paid off, or interest charged).
Those credit balances that are held by licensed banks provide banks with a settlement asset for their bank-to-bank transactions. The accounts where banks hold such settlement balances are known as “reserve accounts” or “bank reserves.” Although the term “reserves” suggests the notion of funds set aside for future contingencies, banks use such balances daily to fund payments. They are preferably designated “bank liquidity balances.”
A bank uses these assets as settlement balances with other banks through the interbank funds transfer system, an infrastructure that permits the storing of records of balances owned by banks and the transfer of funds from one bank to another. In such a system, banks hold funds at a common agent (the central bank acting as “settlement institution”), while payments between banks are made by exchanging the liabilities of the central bank. A bank is normally permitted to loan such assets to other banks.
Accordingly, bank liquidity is a component of the overall credit balances at the central bank. Its overall amount changes in response to every payment banks make to or receive from the central bank or other non-bank holders of central bank money, notably, the government. Hence, an expense incurred by the government adds to bank reserves, while a tax paid to the government or the purchase of newly issued government securities drains bank liquidity.