What it means
A central bank has a balance sheet like any other institution, and it balances the same way: assets equal liabilities plus capital. What makes it unusual is that it creates its own liabilities.
When it buys a bond, it pays by crediting the seller's bank with newly created reserves, which is a liability it can issue at will. This matters to businesses because the balance sheet is the mechanism behind quantitative easing and quantitative tightening.
Large-scale bond buying pushes down long-term interest rates and fills the banking system with reserves, which tends to loosen credit conditions for everyone. Reversing the process drains reserves and typically tightens them.
Reading the statement is mostly a matter of watching a handful of lines. On the asset side: Treasury securities and mortgage-backed securities.
On the liability side: currency in circulation, bank reserves, overnight reverse repurchase balances and the Treasury's own account. The composition matters as much as the total.
A shift from short-dated Treasury bills to long-dated bonds changes the shape of the yield curve even when the total does not move at all. A swelling reverse repurchase balance, similarly, signals that money market funds have more cash than they can place elsewhere.
Two nuances are worth carrying into a meeting. The central bank does not need capital in the way a commercial bank does, so accounting losses on its bond portfolio do not threaten its ability to operate.
The balance sheet is also not the money supply: reserves sit inside the banking system and only become broad money when banks actually lend.
In practice
Real-world examples.
Example
A corporate treasurer watching the balance sheet shrink through a tightening programme decides to fix the rate on a five-year loan rather than keep it floating. Her reasoning is that draining reserves usually goes alongside higher short-term rates and thinner credit availability.
Example
A mortgage lender tracks the central bank's holdings of mortgage-backed securities specifically. When those holdings stop growing, the spread between mortgage rates and Treasury yields tends to widen, which changes the pricing on the products the lender offers.
Example
A money market fund manager watches the overnight reverse repurchase balance as a gauge of surplus cash in the system. A rapid fall in that balance tells him that cash is finding better homes elsewhere and that his fund's yield advantage is eroding.
Formula
Calculation
Assets = Liabilities + Capital
The figures below are illustrative round numbers chosen to show the structure, not reported balances. Assume Treasury securities of $4,200 billion, mortgage-backed securities of $2,300 billion and other assets of $500 billion. Total assets are $4,200 + $2,300 + $500 = $7,000 billion, or $7 trillion.
On the other side, assume currency in circulation of $2,300 billion, bank reserves of $3,200 billion, overnight reverse repurchase balances of $900 billion and a Treasury account of $550 billion. Those total $2,300 + $3,200 + $900 + $550 = $6,950 billion, and adding capital of $50 billion gives $6,950 + $50 = $7,000 billion, which balances against total assets.
Now apply quantitative tightening at a runoff pace of $60 billion a month for twelve months. Total runoff is $60 x 12 = $720 billion, so assets fall to $7,000 - $720 = $6,280 billion. If currency and the Treasury account are unchanged, the whole $720 billion must come out of reserves and reverse repurchase balances, which fall from $3,200 + $900 = $4,100 billion to $4,100 - $720 = $3,380 billion.Case study
Seen in the real world.
The following is an illustrative and fictional example. Selkirk Regional Bank, an invented commercial bank with $4,000,000,000 of assets, had built its funding plan during a period when the central bank balance sheet was expanding and reserves were plentiful. Deposits were cheap and abundant, and the bank had let its share of longer-term borrowings drop to almost nothing.
When the central bank began letting bonds run off, system-wide reserves fell steadily. Selkirk found that its larger depositors were moving cash into money market funds paying materially more, and its deposit balances dropped by 9% over three quarters. Because it had no term funding in place, it had to bid up deposit rates just as its loan book was still earning older, lower yields.
The bank's asset and liability committee changed its approach: it added a standing tranche of one-year to three-year borrowings, tested its access to the discount window so the operational path was proven, and started monitoring aggregate reserve balances as a leading indicator for its own deposit pricing. The illustrative lesson is that central bank balance sheet policy reaches ordinary businesses through funding conditions long before it appears in headline interest rates.
Watch out
Common mistakes.
- Treating the size of the balance sheet as the money supply. Reserves are held by banks at the central bank and only become money in the wider economy when lending expands.
- Assuming a shrinking balance sheet automatically means higher interest rates. It tends to tighten conditions, but the policy rate is set separately and the two can move in different directions.
- Reading paper losses on the bond portfolio as a solvency problem. A central bank can operate with negative accounting capital because it issues the currency its liabilities are denominated in.
Questions
People also ask.
What is the difference between quantitative easing and quantitative tightening?
Easing means buying assets and expanding the balance sheet; tightening means allowing assets to mature without reinvesting, which shrinks it.
Why does currency in circulation appear as a liability?
Because a banknote is a claim on the central bank, and issuing notes is how the central bank funds part of its asset holdings.
How often is the balance sheet published?
The central bank releases a summary statement weekly, which is why market commentary frequently references week-on-week changes in reserves.
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