Bank A
| Assets | Liabilities + equity | ||
|---|---|---|---|
| reserves | 100 | deposits | 300 |
| loans | 200 | borrowing | 0 |
| bonds | 40 | equity | 40 |
| Total | 340 | Total | 340 |
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Monetary systems · Lesson 4
How payments cross bank boundaries
Track customer deposits and central-bank reserves separately.
By the end: Explain settlement, netting, and why one bank can lose liquidity while system reserves stay constant.
Within one bank
Alice pays a shop 60 and both use Bank A. Bank A subtracts 60 from Alice's deposit and adds 60 to the shop's deposit. Its total deposit liabilities do not change, and there is no necessary reserve transfer between banks. The bank must still authenticate and reconcile the payment. A payment instruction is not the same thing as final settlement.
Across two banks, Bank A reduces Alice's deposit while Bank B credits the shop. To settle the interbank obligation, A transfers reserves to B in the simplified real-time gross settlement model used here. The central bank reduces its reserve liability to A and increases its reserve liability to B. Its total reserve liabilities are unchanged.
Follow the customer's claim and the bank's payment separately
Start with an additional paper example involving individual accounts. Alice has a deposit of 90 at A and a shop has a deposit of 10 at A. After Alice pays 25, her account contains 65 and the shop's contains 35. Add the balances before payment, then afterward. Both sums are 100. A still owes customers the same total amount, but now owes more to the shop and less to Alice. Alice's payment instruction changes who can demand payment from A. It does not move a reserve balance into either customer's ownership.
Now put the shop at B instead. Assume each bank begins with the model's opening stocks: reserves 100, loans 200, bonds 40, deposits 300, and equity 40. A settles Alice's payment of 25 by reducing its reserves to 75 and total deposits to 275. Its assets are now 75 plus 200 plus 40, totaling 315. Deposits of 275 plus equity of 40 also total 315. B increases reserves to 125 and deposits to 325. Its assets and claims both total 365. Neither bank has earned or lost 25 through this payment alone.
At the central bank, A's reserve account falls by 25 and B's rises by 25. The central bank still owes banks 200 in reserve balances altogether. The shop receives a claim on B, not a direct claim on the central bank. This is why there are several records for one purchase. Alice and the shop record a sale and payment, their banks record changes in customer liabilities and settlement assets, and the central bank records the reassignment of reserve liabilities. The economic purpose is one purchase, even though several institutions must make consistent entries.
Compare those entries with loan origination. Granting a new loan increases the originating bank's loan assets and deposit liabilities together. Settling a payment between banks instead reduces one bank's deposits and increases another's. The payment can follow a loan, but it can also use wages or savings that were already in the account. Without the initial transaction and the boundaries of the money measure, a payment record cannot tell you whether money was created earlier. In the two-bank model, settlement itself leaves the combined customer deposit total unchanged.
A card approval, an account display saying pending, and legally final settlement need not occur at the same moment. A bank may make funds available before every underlying obligation has settled, according to its rules and the payment system. That can create credit exposure, meaning a risk that another party fails before completing payment. Our completed ledger entries describe the assumed settled result. They do not represent fraud screening, a merchant refund, a disputed card purchase, or the legal moment after which a transfer cannot be unwound. Those questions require the particular payment arrangement.
One payment, several ledgers
For a 60 payment, A loses 60 of reserves and 60 of deposit liabilities. B gains 60 of reserves and 60 of deposit liabilities. Both balance sheets still balance. Total customer deposits are unchanged by this payment, and total reserves are unchanged. Their distribution changes. A bank that loses deposits cannot dismiss its liquidity problem by observing that another bank gained them.
Actual systems may batch payments, net obligations, use correspondent banks, or provide intraday credit subject to rules. If A owes B 90 and B owes A 70, their net obligation is 20 from A to B. Netting economizes on settlement liquidity, but introduces timing, legal, and counterparty questions. It does not erase the underlying customer payments.
Payment order changes the liquidity needed
Netting compares obligations over a chosen window rather than treating each instruction as a separate final transfer. Consider an additional paper case. A must send B 75 and B must send A 55. The customers' gross payments sum to 130, but subtracting the opposing obligations leaves 20 payable by A. If the system's rules permit these obligations to be settled as a single net amount, A needs 20 for that settlement. Netting does not reduce what the customers bought. It changes how the banks discharge the resulting obligations to each other.
Payment order matters under gross settlement. Give A opening reserves of 30 and B opening reserves of 70. If A's 75 instruction must settle first, A is short by 45. If B's 55 instruction settles first, A's reserves become 85 and B's become 15. A can then send 75, ending with 10 while B ends with 90. The same final distribution results from settling the net 20 directly. The opening system total was 100 throughout. Gross volume of 130 therefore does not establish that banks needed 130 in opening reserves.
This comparison does not mean banks can always choose a convenient order. A time-critical payment may be due before an incoming transfer arrives. Queued instructions can delay other payments that depend on their receipts. An incoming payment may fail altogether. A system that extends intraday credit, meaning credit repayable within the day, can reduce waiting but must specify who supplies it and bears any loss. Collateral and limits can restrict that credit. The arithmetic identifies a timing problem; it does not supply authority to overdraw an account.
Suppose B lends A 45 of existing reserves before the first payment. On A's books, reserve assets and borrowing liabilities each rise by 45. On B's books, reserves fall by 45 and a loan claim on A rises by 45. Neither bank's equity changes at that moment. Combined reserves remain 100 because the central bank has only reassigned existing balances. After receiving the loan, A can send the 75. It still owes B the separate borrowing, even if the subsequent customer payments leave A with enough reserves to repay it.
A central-bank loan has a different aggregate counterpart. If it lends A 45, A gains reserves and borrowing of 45, while the central bank gains a loan asset and creates reserve liabilities of 45. System reserves rise from 100 to 145. Whether the central bank offers that operation depends on its framework and facility rules. A bank's need to settle is not itself permission to borrow without limit. Distinguish the payment obligation, the funding contract, and the institution issuing the settlement asset before drawing a conclusion about total reserves or bank risk.
Work through the accounts and assumptions
Inspect both banks' books
Currency units. Both banks remain visible. Δ means change from the opening snapshot. Choose a named experiment; changing it resets playback and all balances.
Opening balance sheets
Bank B
| Assets | Liabilities + equity | ||
|---|---|---|---|
| reserves | 100 | deposits | 300 |
| loans | 200 | borrowing | 0 |
| bonds | 40 | equity | 40 |
| Total | 340 | Total | 340 |
System deposits: 600. System reserves: 200.
Each bank has 340 assets, 300 deposit liabilities, and 40 equity. No cash or other banks are included.
Step 0 / 2
All stages and totals
| Stage | Deposits | Reserves | A equity |
|---|---|---|---|
| Opening balance sheets | 600 | 200 | 40 |
| A grants a loan of 60 | 660 | 200 | 40 |
| The borrower pays a customer of B | 660 | 200 | 40 |
Opening balance sheets. Each bank has 340 assets, 300 deposit liabilities, and 40 equity. No cash or other banks are included.
A grants a loan of 60. A adds a loan asset and deposit liability. The borrower gains a deposit and owes a loan. Reserves and bank equity do not change.
The borrower pays a customer of B. A transfers 60 reserves and removes 60 deposits. B adds 60 reserves and deposits. No further money is created by settlement.
| For a 60 payment | Bank A | Bank B | System total |
|---|---|---|---|
| Customer deposits | −60 | +60 | 0 change |
| Reserve assets | −60 | +60 | 0 change |
| Equity | 0 change | 0 change | 0 change |
Read the transfer in the displayed sequence
The Loan and payment experiment begins with 600 total deposits and 200 total reserves. After the loan of 60, A has loans of 260 and deposits of 360. Its reserves remain 100, and B has not changed. System deposits are 660 because the borrower received a new bank liability. At the final stage, A has reserves 40, loans 260, bonds 40, and deposits 300. Its assets total 340 and its deposits plus equity total 340. A's deposit total has returned to its opening level, but that does not reverse the loan.
B ends with reserves 160, loans 200, bonds 40, and deposits 360. Its total assets are 400, matched by deposits 360 and equity 40. Add the two banks' deposits to obtain 660, then add their reserves to obtain 200. The new money remains in the recipient's deposit at B. The borrower still owes A 60. Looking only at A's deposit change would miss both the recipient and the system-wide increase created at origination. Consolidation answers the total question; separate bank books explain which institution must fund the outflow.
Compare the displayed amounts with their change labels carefully. The labels measure changes from the opening snapshot, not from the immediately preceding stage. A's final deposits show no opening-to-final change because the increase of 60 at origination and decrease of 60 at payment offset. A's loans still show an increase of 60. B's reserve and deposit increases both show 60. Reading those labels as changes in only the last step would falsely suggest that the final payment had no deposit effect at A. Compare complete snapshots to reconstruct an individual transition.
For a contrasting sequence, select Withdrawal pressure. This replaces the previous experiment rather than continuing from its balances. After 80 leaves A, its reserves are 20 and deposits are 220. The attempted additional payment of 40 cannot settle, so that stage makes no entries. The assumed central-bank loan then raises A's reserves to 60 and borrowing to 40. Finally A sends 40, ending with reserves 20, deposits 180, borrowing 40, and equity 40. B ends with reserves 220 and deposits 420. Combined reserves are now 240, reflecting the funding operation rather than the customer transfers.
The named experiments supply fixed transactions; there is no control here for changing transfer size, adding customers, choosing a netting window, or ordering arbitrary payments. Use the separate numerical cases above on paper for those comparisons. Reset returns the current experiment to its opening snapshot; choosing another experiment starts that sequence from the same initial bank balances. The model's blocked payment is an explicit constraint of this simplified reserve-funded system. It does not mean every real payment system blocks at exactly the same point or lacks intraday credit.
Finality and obtaining funds
A bank short of reserves can try to borrow from another bank, sell an asset, attract funding, or use an eligible central-bank facility. An interbank reserve loan redistributes existing reserves and creates a borrowing liability for the recipient. A new central-bank loan increases aggregate reserves and creates a matching bank debt to the central bank. These are different balance-sheet changes.
A cash withdrawal is another kind of conversion. If a customer withdraws 20 of notes already in the bank's vault, the bank loses 20 of vault cash and 20 of deposit liabilities. The customer swaps a deposit for currency. Broad money need not fall if both instruments are included. Obtaining additional notes from the central bank can instead swap the bank's reserves for vault cash, without creating bank equity. The lab omits cash to isolate interbank settlement.
Access is not unconditional. Collateral, haircuts, solvency assessments, facility terms, and law constrain central-bank lending. A haircut means a lender advances less than the assessed collateral value as protection against losses. A solvent bank can have a temporary payment shortage; an insolvent bank has a deeper asset-value problem. Next we will separate those risks.
Cash conversion and the limits of funding
Cash requires accounts omitted from the displayed experiment. For an additional paper example, give a bank reserves of 80, vault notes of 20, loans of 200, deposits of 260, and equity of 40. Assets total 300. A customer withdraws 15 in notes. Vault notes fall to 5 and deposits fall to 245, leaving assets of 285 matched by deposits 245 plus equity 40. The customer's deposit falls by 15 while cash held outside the bank rises by 15. If the chosen money measure includes both customer deposits and currency held by the public, this conversion does not reduce that combined amount.
If the bank first obtains another 30 in notes from the central bank using reserves, its reserves fall by 30 and vault notes rise by 30. That asset exchange leaves its total assets and equity unchanged. On the central bank's books, reserve liabilities fall and note liabilities rise under the simplified treatment here. Delivering physical notes, keeping them secure, and satisfying withdrawal requests involve operational constraints beyond having enough aggregate central-bank money. Neither obtaining notes nor handing existing notes to a customer generates bank profit equal to their face amount.
A funding promise also needs enough acceptable collateral. Suppose a facility values a bond portfolio at 50 and applies a 20% haircut. Twenty percent of 50 is 10, so the maximum advance under this rule is 40. If the bank needs 45, the collateral supports 5 less than required. If the assessed value falls to 40 with the same haircut, the permitted advance falls to 32. These are paper calculations, not additional model outputs. The laboratory assumes eligibility and adequate collateral rather than measuring either.
Selling an asset and borrowing against it are different transactions. If a bond recorded at 50 sells for 50, the bank exchanges the bond for a liquid asset without changing equity. Borrowing 40 against that bond retains the bond asset and adds liquidity alongside a borrowing liability. If the bond instead sells for 42 when its recorded value is 50, the bank realizes a loss of 8. That can reduce its capacity to absorb further losses even while the sale helps it settle today's payments. Funding and asset valuation must therefore be evaluated separately.
When reading a payment explanation, identify whose account falls, whose rises, and whether the settlement asset was transferred or newly issued. Then identify any unpaid obligation that remains. An interbank loan can leave the system reserve total unchanged while changing both banks' risks. A central-bank loan can increase that total without repairing a bank's equity. A cash withdrawal can lower deposits without lowering a measure that also includes public currency. Each conclusion follows from specified counterparties and boundaries, not from treating every movement described as money leaving a bank as the same transaction.
Exercises
Net the obligations
During a settlement window, A owes B 90 and B owes A 70. How much reserve transfer settles the net obligation? How does this compare with gross payments?
Hint
Subtract reciprocal obligations, but retain the gross amounts as payment activity.
Worked answer
| Measure | Amount |
|---|---|
| A to B instructions | 90 |
| B to A instructions | 70 |
| Net reserve transfer A to B | 20 |
| Gross volume | 160 |
A transfers 20 to B. Gross instructions total 160, while net settlement is 20. Gross settlement liquidity needs depend on payment order and reuse, so 160 is gross volume, not necessarily a required opening reserve balance.
Where did the reserves go?
A begins with reserves 50 and B with 80. A settles a 35 payment to B. Is the system now short of 35 reserves?
Hint
Compare both banks before and after.
Worked answer
| Bank | Before | After |
|---|---|---|
| A | 50 | 15 |
| B | 80 | 115 |
| Total | 130 | 130 |
No. A now holds 15 and B holds 115; the system still has 130. A may need liquidity for its next payment, and B need not be willing to lend. An unchanged aggregate does not guarantee the right distribution.
Sources and further reading
These references support the mechanisms and identify institutional context. They are optional; the explanations and worked answers above stand alone. Numerical examples are teaching cases, not live financial data or personal financial advice.
- Bank of England: Money creation in the modern economy, 2014
Bank lending, deposit creation and destruction, constraints, and asset purchases. UK institutional explanation, not a universal timetable or a current rate announcement.
- Federal Reserve: Policy normalization
Official framework statements on ample reserves and balance-sheet operations. Frameworks and operating decisions can change; lesson rates are hypothetical.