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Part 12. How central bank settlements work

Now we have introduced the central bank, we can look at how banks settle when there is an amount outstanding at the end of a period of trading.

Let's continue with our banks and sets of accounts from Part 11 and look at how central banks facilitate interbank settlements, by carrying out two interbank deposit transfers, one for £10,000 and one for £5,000, and settling between banks at the end of the period.

For our first deposit transfer, we will assume that the house seller transfers funds of £10,000 to a new account at 1st Bank called Deposit Account #3. The transfer is shown in Figure 12.1.

House Seller's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £100,000 (CR) Transferred to Account #3 £10,000 £90,000 (CR) Deposit Account #3 1st Bank Description Debits Credits Balance Starting balance £0 Received from House Seller £10,000 £10,000 (CR)

Figure 12.1 First deposit transfer.

The deferred settlement double entry that goes with this transfer is shown in Figure 12.2.

2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £10,000 £10,000 (DR) 1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £10,000 £10,000 (CR)

Figure 12.2 Deferred settlement for the first deposit transfer.

And the balance sheets of 1st Bank and 2nd Bank are shown in Figure 12.3.

1st Bank's Assets Mortgage Loan Account #1 £100,000 2nd Bank's Loan Account £10,000 Mortgage-backed Securities £50,000 Total assets £160,000 1st Bank's Liabilities Deposit Account #2 £50,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £160,000 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 £90,000 1st Bank's Deposit Account £10,000 Total liabilities £100,000

Figure 12.3 Balance sheets after the first deposit transfer.

For our second deposit transfer, the owner of Deposit Account #2 transfers funds of £5,000 to a new account at 2nd Bank called Deposit Account #4. The deposit transfer is shown in Figure 12.4.

Deposit Account #2 1st Bank Description Debits Credits Balance Previous balance £50,000 (CR) Transferred to Account #4 £5,000 £45,000 (CR) Deposit Account #4 2nd Bank Description Debits Credits Balance Starting balance £0 Received from Deposit Account #2 £5,000 £5,000 (CR)

Figure 12.4 The second deposit transfer.

And the deferred settlement double entry is shown in Figure 12.5.

1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £5,000 £5,000 (DR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £5,000 £5,000 (CR)

Figure 12.5 Deferred settlement for the second deposit transfer.

The balance sheets of all banks, after these transfers, are shown in Figure 12.6. The blue arrows indicate the amounts that need settling between banks. Central Bank is also included but remains unchanged at this stage.

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 2nd Bank's Loan Account £10,000 Mortgage-backed Securities £50,000 Total assets £160,000 1st Bank's Liabilities 2nd Bank's Deposit Account £5,000 Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £160,000 2nd Bank's Assets 1st Bank's Loan Account £5,000 Equity Release Loan Account £50,000 Digital Reserves £50,000 Total assets £105,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 1st Bank's Deposit Account £10,000 Deposit Account #4 £5,000 Total liabilities £105,000

Figure 12.6 Balance sheets after both deposit transfers.

Next we will settle between banks. We can see from Figure 12.6 that 2nd Bank owes 1st Bank £5,000, and if we transfer £5,000 from 1st Bank's Deposit Account to 2nd Bank's Deposit Account, obligations between 1st and 2nd Bank will cancel each other out. 2nd Bank can now do this transfer in exchange for reserves, as shown next.

First we transfer the £5,000 as shown in Figure 12.7.

1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £10,000 £10,000 (CR) Transferred to 2nd Bank £5,000 £5,000 (CR) 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £5,000 £5,000 (CR) Received from 1st Bank £5,000 £10,000 (CR)

Figure 12.7 Transfer from 1st Bank's Deposit Account to 2nd Bank's Deposit Account.

As this is an interbank transfer, the double entry won't stand by itself, but we can carry out two more double entries involving Central Bank. The first is to reduce 2nd Bank's reserves, as shown in Figure 12.8.

Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £50,000 (DR) Transfer reserves £5,000 £45,000 (DR) 2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £50,000 (CR) Transfer reserves £5,000 £45,000 (CR)

Figure 12.8 Double entry to reduce 2nd Bank's reserves

And the second is to increase (or in this case add) reserves for 1st Bank. For this we will need a new account we will also call Digital Reserves at 1st Bank, and a new account we will call 1st Bank's Digital Reserves at Central Bank. The double entry is shown in Figure 12.9.

1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Starting balance £0 Transfer reserves £5,000 £5,000 (CR) Digital Reserves 1st Bank Description Debits Credits Balance Starting balance £0 Transfer reserves £5,000 £5,000 (DR)

Figure 12.9 Double entry to increase 1st Bank's reserves.

Notice that the transaction above involved accounts from three different banks. We can see that each account is involved in two double entries, satisfying the rule of interbank transfers as highlighted in Part 3.

The balance sheets, after the reserves transfer, are shown in Figure 12.10, the blue arrows indicating we have achieved our aim of being able to cancel obligations between banks.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £5,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 2nd Bank's Loan Account £10,000 Mortgage-backed Securities £50,000 Digital Reserves £5,000 Total assets £165,000 1st Bank's Liabilities 2nd Bank's Deposit Account £10,000 Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £165,000 2nd Bank's Assets 1st Bank's Loan Account £5,000 Equity Release Loan Account £50,000 Digital Reserves £45,000 Total assets £100,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 1st Bank's Deposit Account £5,000 Deposit Account #4 £5,000 Total liabilities £100,000

Figure 12.10 Balance sheets after reserves are transferred.

Starting with 1st Bank, we can transfer the £10,000 in 2nd Bank's Deposit Account to 2nd Bank's Loan Account to reduce both balances to zero as shown in Figure 12.11.

2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £5,000 £5,000 (CR) Received from 1st Bank £5,000 £10,000 (CR) Transferred to loan account £10,000 £0 2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £10,000 £10,000 (DR) Received from deposit account £10,000 £0

Figure 12.11 Transfer to reduce 2nd Bank's loan and deposit account balances to zero.

And with 2nd Bank, we can transfer the £5,000 in 1st Bank's Deposit Account to 1st Bank's Loan Account to reduce both balances to zero as shown in Figure 12.12.

1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £10,000 £10,000 (CR) Transferred to 2nd Bank £5,000 £5,000 (CR) Transferred to loan account £5,000 £0 1st Bank's Loan Account 2nd Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £5,000 £5,000 (DR) Received from deposit account £5,000 £0

Figure 12.12 Transfer to reduce 1st Bank's loan and deposit account balances to zero.

Finally, all banks are settled, with balance sheets shown in Figure 12.13.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £5,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Digital Reserves £5,000 Total assets £155,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Total liabilities £155,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £45,000 Total assets £95,000 2nd Bank's Liabilities House Seller's Deposit Account £90,000 Deposit Account #4 £5,000 Total liabilities £95,000

Figure 12.13 Balance sheets after settling.

So, as we can see, the central bank has facilitated interbank transfers by making reserves available to banks that can be used to settle outstanding obligations. Reserves have to be either deposited with the central bank or borrowed in exchange for assets and so do not necessarily represent an endless source of money.

Having a central bank makes it easier to demonstrate the more involved transactions in the parts that follow that would have been otherwise harder to do. We will start by looking at the repayment of debt that has been securitised, next.

back to Part 11