4.3. Payment: using central bank reserves for interbank payment If you and I both have an account at the same bank, it is a very simple process for me to transfer £500 to you. I simply instruct my bank to do so and it makes an accounting entry on its computer that shows £500 leaving my account and £500 entering your account. There is no need for any cash to be handed over, or any reason to involve the Bank of England. This clearing or payment function within the same bank has, as we saw in Chapter 3, been going on since Babylonian times. All that is required is for some numbers to be typed into a computer (or written on a clay tablet, in former times) and removed from another account. But what if we bank with different banks as in the example in Figure 11? Given that a demand deposit, as we have seen, is no more than a contract with a promise to pay, how does it get transferred, as a means of final payment, from one bank to another? One option is for me to withdraw £500 in the form of cash and give it to you to pay into your own account. Most of us would find this highly inconvenient. Principally, there are two ways for banks to get around this problem. The first is for banks to use their accounts with other banks to settle transfers directly, having netted out transactions in opposite directions. This is called ‘bilateral settlement’. An alternative method is for banks to use their accounts with the central bank. The Bank of England has its own clearing system with its own equivalent of demand deposits that have the status of final means of payment, just as cash or legal tender. Just to recap on Section 2.3, we call this type of money central bank reserves. Together with currency in the form of notes and coins which is circulating outside the banking sector, this makes up high-powered money, also known as base money, monetary base, or central bank money. In the same way that you have a bank account with a particular bank, the banks themselves have bank account(s) with the Bank of England called reserve accounts (Figure 12). Just as you must maintain enough balance in your account to ensure all your payments go through, so private banks must maintain reserve balances in their Bank of England account in order to enable payments to other private banks requested by customers. It should be noted that commercial banks have been using central bank reserves as means of settlement with other banks since the 1770s, as discussed in Sections 3.4 and 3.5. I n Figure 11, Richard makes a payment of £500 to his landlord Stuart. The result, as shown in the simplified graphic, is simply a transfer between their respective banks’ reserves accounts (HSBC and Barclays).
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