Bank Reserves: What Banks Hold at the Central Bank

A bank reserve is the balance a commercial bank keeps in its own account at the central bank. The commercial bank holds that balance as an asset and the central bank carries it as a liability. The pattern is the deposit relationship moved one rung up. Three things put money there: banks pay each other in it, a part of it is required, and the rest is the bank's own cushion.

Every amount below belongs to Suvarna Commercial Bank Limited, an invented bank, across one stated year, and each is worked out again where it is used. Every requirement this subject touches appears further down as a labelled row carrying an authority and a web address in place of a number. A requirement stops being correct the moment the authority that sets it changes the figure, and the reserve balance itself is not a published amount at all.

Two customers of two different banks settle a bill between them, and that leaves the two banks with something to square between themselves as well. The squaring happens at the central bank, from one bank's account to the other's. Settlement between banks is what makes a reserve balance necessary rather than optional, and everything that follows is a consequence of it. A bank with nothing in that account cannot pay another bank, however good its loan book looks.

Start with a street version, exact rather than merely friendly. Two food stalls stand outside the same office. All week they send each other change, borrow gas cylinders, cover each other's supplier. On Friday they square up. The stalls cannot square up in samosas and cannot square up in goodwill. Both stalls square up in the one thing each of them accepts and each of them can carry away. The stalls need a settling medium they hold in common, and so do banks, except that a bank's version of it is an account balance rather than a note in a tin.

What exactly is a bank reserve, and whose is it?

Before asking what a reserve is for, look at what the entry actually is. A reserve is a balance in an account. The account is held by a commercial bank, the account is kept at the central bank, and the number in it is the reserve. There is no vault involved and no separate pile of notes tied to it. The reserve is a line in a ledger, and the ledger belongs to the central bank.

Which means it has two sides at once, and the pattern is a familiar one rung lower. The reserve balance is an asset belonging to the commercial bank and a liability sitting on the central bank's own books, exactly as a household's deposit is something the household holds and something its bank owes. A household hands money to a bank and gets a claim on the bank. A bank places money at the central bank and gets a claim on the central bank. Same shape, one rung higher, and the direction never flips.

Because it is one claim seen from two sides, the two sides always cancel. A single rupee of that balance shows it. On Suvarna Commercial Bank Limited's books it is an asset of Rs 1.00/-. On the central bank's books it is a liability of Rs 1.00/-. Added together across the pair, the two entries come to nothing at all. The same test is worth running on any claim: where a rupee shows up on one side it shows up with the opposite sign somewhere else, and a rupee whose opposite sign cannot be found means something has been misread.

Why do two banks need a third one in order to pay each other?

Because a payment between customers of two different banks is not finished when the two customers are satisfied. Somebody pays a supplier, the supplier's balance goes up at a different bank, and now one bank has taken on a claim it did not have and the other has shed one. The two banks have to square the difference between themselves, and settlementThe act of two parties actually squaring what they owe each other, so that nothing is left outstanding between them. Settlement is the moment a payment stops being a promise. is the name for the moment they do.

The two banks square it by moving balances at the central bank. One bank's balance there falls, the other bank's rises, and the two banks are level again. The arrangement is the samosa stalls on Friday, one rung up. The settling medium has to be something both banks hold and both banks accept without argument, and a claim on the central bank is that medium.

However many advances, premises or investments a bank holds, a bank with no balance at the central bank cannot pay another bank. This is worth sitting with, because it cuts against the instinct that a large institution must be able to pay. Suvarna Commercial Bank Limited carries advances of Rs 1,44,000 crore and investments of Rs 60,000 crore. Not one rupee of either can be handed to another bank this afternoon. An advance is a promise from a borrower stretching over years; it is valuable and it is not a means of payment. The balance at the central bank settles today, and only that balance does.

How much of that balance does the bank not get to choose?

Part of it. A portion of a bank's deposit base has to be held at the central bank rather than lent, and a further rule obliges the bank to keep prescribed assets besides. So a bank does not decide the whole of what it keeps there. Both of those are requirements in the strict sense: an amount a bank must hold, not an amount it worked out for itself.

The teaching here is that such requirements exist and that they bite on the deposit base, and the amounts are the Reserve Bank of India's to set and to change. Those requirements are the cash reserve requirement, with the base it is worked on and the period it is maintained across, and the statutory liquidity requirement, with the schedule of assets that discharge it.

A remembered requirement and a checked one read identically on paper, and only one of them survives the next revision. The five rows below name the authority instead of the amount, so the figure a bank is actually held to comes from whoever sets it. The reasoning behind the requirement is the part worth carrying away.

Why would a bank hold more than it has to?

Because the required part is worked out against yesterday and the payments arrive today. Over any given morning more money can leave a bank than arrives at it, for reasons nobody at the bank controls: a large customer settles a bill, salaries go out, a season turns. So beyond whatever is required, a bank keeps a cushion of its own judgement, sized so that an ordinary bad day stays an ordinary bad day.

A household already runs this without naming it. The electricity bill clears on a date the household does not choose. So money that would do better in a fixed deposit stays in the current account anyway. The money sitting there is not laziness. The price of not being caught short is paid in the interest given up.

A bank pays for its cushion in exactly the same coin. Every extra rupee it keeps at the central bank is a rupee it did not lend. That is the trade, stated plainly: the cushion is bought with margin. The cushion buys the ability to meet a claim on the day it falls due, which is a liquidityWhether a party can meet a claim at the moment it falls due, using something it can actually hand over. A party can be perfectly solvent and still be unable to pay this morning. question. Against a loss on the loan book it buys nothing at all, and that is a capitalThe owners' stake in an institution: what they put in, plus whatever profit was left inside rather than paid out. Capital is the layer that takes a loss first, and it answers a different question from liquidity. question. The distinction between liquidity and capital holds: the whole failure set out below is built on people collapsing the two.

What actually moves when a payment leaves the bank?

One case makes it concrete. Suppose that on a given day Suvarna Commercial Bank Limited's customers pay Rs 1,000 crore more to customers of other banks than customers of other banks pay to them. The Rs 1,000 crore is a chosen size rather than a measured one, and any net figure behaves the same way, with only the size of the move changing.

Two entries move and they move together. The paying customers no longer have that money in their accounts, so the deposit liability falls by Rs 1,000 crore. A reserve balance is what was handed to the other banks, so the reserve asset falls by Rs 1,000 crore as well. Deposits go from Rs 1,92,000 crore to Rs 1,91,000 crore. Total assets go from Rs 2,40,000 crore to Rs 2,39,000 crore. Both sides of the balance sheet shrank by the same amount, so net worthWhat is left for the owners of an institution once every liability is met. Net worth moves when the institution earns or loses, not when its balance sheet simply gets bigger or smaller. stayed exactly where it was, at Rs 24,000 crore.

Nothing was earned and nothing was lost in that day. The bank is not poorer. The balance sheet is smaller. A shrinking balance sheet reads like bad news, and after a payment out it is not news at all, which is a distinction worth holding on to. And notice where the shrinkage landed on the deploying side: advances of Rs 1,44,000 crore and investments of Rs 60,000 crore were untouched, so the block that is neither of those fell from Rs 36,000 crore to Rs 35,000 crore. The block is now 14.64 per cent of the smaller balance sheet against 15.0 per cent of the larger one.

If one bank loses reserves, where did they go?

To the bank that received the payment. Readers skip that step, and skipping it produces a picture of reserves draining away somewhere. Nothing drained anywhere. The balance Suvarna Commercial Bank Limited keeps at the central bank fell by Rs 1,000 crore. Between them, the receiving banks saw their own balances rise by that same Rs 1,000 crore. The central bank did not have to create or destroy anything to make that work; it moved a number from one account to another in its own ledger.

An individual bank can lose reserves to a payment. The banking system as a whole cannot lose reserves to a payment made inside it. The pair test shows why: minus Rs 1,000 crore at one bank and plus Rs 1,000 crore at another sum to nothing, because the same claim just changed hands. The picture to hold is the wallet and the till. Money leaving a shopper's wallet at the vegetable stall has not left the street. The money is in the vendor's till, four feet away.

A bank's treasury desk therefore spends its day on a question that has no system-level version. The desk is not asking whether there are enough reserves in existence. The desk is asking whether enough of them are in this bank's account by the end of today. The question is about distribution rather than quantity, and the answer can be uncomfortable for one bank on a morning when the total across all banks has not moved at all.

Does a reserve balance earn the bank anything?

The honest answer comes in two parts, and both of them matter more than the number would.

The first part is the one that can be acted on. Whatever a balance at the central bank earns, it is not what an advance earns. Every rupee held there rather than lent turns up in the margin. That is true regardless of the terms, it is true across jurisdictions, and it is true in years when those terms change. A bank does not put money there because it is a good place to put money. A bank puts money there because payments settle there and because part of it must.

The second part is set elsewhere. Whether such a balance is remunerated at all, and if so on what basis and over what period, is set by the Reserve Bank of India and is revised, so it appears below as a name and a site rather than as a figure. RemunerationWhether a balance held somewhere pays anything to the party holding it, and on what terms. A balance can pay nothing, pay something, or pay differently on different parts of itself. is a rule set rather than a fact of nature, and a rule set is precisely the kind of thing a written reference gets wrong by fixing it in print.

Where does the reserve sit, and what does it do to the margin?

On the asset side, and outside both of the blocks that earn interest. Suvarna Commercial Bank Limited holds total assets of Rs 2,40,000 crore. Advances account for Rs 1,44,000 crore of that, investments for a further Rs 60,000 crore, so earning assetsThe parts of a balance sheet that actually pay interest to the institution holding them. For a bank these are its advances and its investments taken together. come to Rs 2,04,000 crore. Rs 36,000 crore is left over, and that leftover is 15.0 per cent of the whole balance sheet. The Rs 36,000 crore is where the central bank balance lives, sharing the block with cash and with the bank's premises and equipment, and this record never divides the block up.

The split inside that block is not reported anywhere. So the reserve balance has a known address and no known size, and an estimated split would sit beside arithmetic that reconciles to the rupee while resting on nothing.

The block it lives in does something to the headline measure. Net interest income for the year is Rs 7,440 crore. Set against earning assets of Rs 2,04,000 crore it reads 3.65 per cent for the year. The same Rs 7,440 crore set against total assets of Rs 2,40,000 crore instead reads 3.10 per cent for the year. Both are arithmetically correct, they sit about 0.55 percentage points apart, and nothing whatsoever about the bank changed between them. The whole of that gap is the Rs 36,000 crore of non-earning assetsThe parts of a balance sheet that pay the institution no interest at all. Non-earning assets still have to be funded, and the funding cost is why they show up in a margin they earn nothing towards., and that is the block in question.

The two readings are tied by one line of arithmetic, and it is worth working rather than trusting. The earning-asset share comes first: Rs 2,04,000 crore against Rs 2,40,000 crore comes to 85.0 per cent, exactly. The unrounded margin on earning assets, 3.6470588 per cent for the year, multiplied by that 0.85, lands on 3.10 per cent for the year, exactly. The same step with the rounded 3.65 gives 3.1025. Printed at two decimals that reads 3.10, and it is not the same statement. The shortcut looks exact and is not. Naming the base every single time is the second guard against it: state the base in the same sentence as the number, without exception, because the number alone is not a fact about the bank.

Can a bank hand its reserve balance to a borrower?

No, and this is the single most common wrong picture of the whole subject: a reserve is not a stock of money sitting ready to be given to a borrower, and a bank does not lend by handing over its balance at the central bank. When a bank makes an advance, what the borrower gets is a deposit at that bank. Nothing has left the bank at that moment. The bank's balance sheet got larger on both sides.

The reserve moves later, and only if the borrower actually pays somebody who banks elsewhere. The move may come days after the lending decision. The move may be a fraction of the amount rather than all of it. And it may never happen at all: if the borrower pays a supplier who banks at the same bank, the money simply moves between two accounts inside the same institution and not one rupee of reserve goes anywhere. The reserve responds to payments leaving the bank, not to loans being made, and those two events are separated in time and often in size.

Why does the wrong picture feel so right? Because the word reserve does the damage. In ordinary English a reserve is something set aside for later use, like a spare tyre or a reserve player. In this specific use it is nothing of the kind. A reserve is the working balance a bank pays other banks out of, and the everyday sense of the word points in precisely the wrong direction.

The work a bank does between the money it takes in and the assets it builds, including the way short funding supports longer lending, is maturity transformationFunding assets that run for years with money that can be asked for much sooner. Maturity transformation is a specific job an institution does, and a good deal of a bank's usefulness and its fragility both come from it. and it is covered separately. How a lending decision is reached, how a borrower is assessed and how an advance is priced are covered separately too.

Who watches a reserve balance in practice, and what for?

Three kinds of reader use this, and they use it for three different things. Watching who reaches for it, and what each of them is trying to settle, is what keeps the idea from flattening into bookkeeping.

A bank's own treasury desk watches it hour by hour, and its question is narrow and immediate: will enough be in this account by the close of business today. The desk is not thinking about the loan book at all. The desk is watching payments arrive and leave, and where the day is running short it borrows a balance for the night from somebody who has more than they need. The facilities available for that borrowing, and their terms, belong to the Reserve Bank of India.

An analyst reading the bank from outside uses it differently, and mostly through the block it lives in. When she sees a margin quoted, her first move is to ask what it was struck on. Rs 7,440 crore comes out at 3.65 per cent against earning assets and at 3.10 per cent against total assets, and those two sentences describe one bank in one year. When two people quote different margins for one bank, the most likely explanation is not disagreement about the income but a different denominator, and asking which one settles it in a single question.

And a household runs a version of it every month without any of the vocabulary. Rent clears on a date the household did not pick. So some money stays where it can be paid out immediately, even though it earns less there. The money looks idle. The money is not idle, and the job it does is one the better-paying option cannot do. A bank's cushion at the central bank is that same arrangement at a size where the giving-up shows in a published number.

What is worth keeping about bank reserves?

Four sentences, and they carry the rest.

1. A reserve is a balance in an account, and it has two sides. The commercial bank's asset, the central bank's liability, and the pair nets to nothing.
2. It exists because banks pay each other in it. Nothing else on a bank's balance sheet can settle a payment to another bank today.
3. Part of the amount is required and the rest is the bank's own judgement. The required part belongs to the Reserve Bank of India; the judgement part is bought with margin.
4. It is not lending capacity. It moves when a payment leaves the bank, which may be days after any advance and may never happen at all.