Money · Credit · New Zealand · Part 21

Why do banks buy government bonds if they can create credit themselves?

Because creating a deposit is not the same thing as creating capital, liquidity, collateral or a safe asset.

This question goes right back to Part 2.

When a bank makes a loan, it can create a matching deposit.

So why would that same bank ever need to buy a government bond?

Why not simply create more credit instead?

The answer is that a mortgage, a business loan, settlement cash and a government bond perform very different jobs on a bank balance sheet.

Banks create deposits when they lend. They do not create every asset their balance sheet needs.

A loan and a government bond are both assets — but they are not interchangeable

Suppose a bank makes an $800,000 mortgage.

The bank records:

Asset: $800,000 mortgage loan.

Liability: $800,000 customer deposit.

The mortgage can earn interest for decades.

But it is not necessarily easy to turn into cash tomorrow morning.

It carries borrower credit risk.

It may be difficult to sell quickly without a discount.

And it requires regulatory capital.

A New Zealand Government Bond is different.

It is a tradable claim on the Crown.

It has an observable market price.

It can be sold in the secondary market.

It can be used as collateral in Reserve Bank liquidity operations.

And under the current standardised capital framework, an NZ-dollar claim on the Crown or the Reserve Bank carries a 0% credit risk weight.

Reserve Bank — Capital and credit risk requirements ↗

That does not mean the bond has no risk.

Its market value can fall when interest rates rise.

It can create interest-rate risk.

And a bank still has to manage concentration, liquidity and overall balance-sheet risk.

But its credit-risk treatment and market liquidity are fundamentally different from an ordinary private loan.

The first reason banks buy government bonds is liquidity

Banks promise customers access to deposits on demand.

But many of the assets banks hold are long-term.

Mortgages can run for twenty or thirty years.

Business loans may also be illiquid.

That creates a maturity mismatch.

The Reserve Bank therefore requires banks to maintain sufficient liquid assets to survive stressed cash outflows.

Under the current liquidity policy, liquid assets include securities that can be sold quickly and at a reliable price, including New Zealand government debt.

Reserve Bank — Liquidity policy for banks ↗

A mortgage earns income. A liquid government bond helps a bank survive the day when customers want cash now.

This is happening in the banking system right now

The Reserve Bank's May 2026 Financial Stability Report says banks have been rebalancing their liquid-asset portfolios toward increased holdings of government securities.

Why?

Because banks' settlement-account balances have been declining as the Reserve Bank unwinds the extraordinary liquidity created during the LSAP and Funding for Lending programmes.

Reserve Bank — Financial Stability Report May 2026 ↗

This is a very useful real-world example.

Banks are not buying more government securities because they have suddenly forgotten how credit creation works.

They are adjusting the composition of their liquid assets as the monetary system moves away from the unusually abundant settlement-cash environment of the pandemic era.

Settlement cash and government bonds are not the same thing

Settlement cash is held in Exchange Settlement Account System accounts at the Reserve Bank.

Banks use it to settle obligations with one another.

If a customer at Bank A pays a customer at Bank B, the banks ultimately settle the interbank leg using central-bank money.

A government bond cannot itself make that final ESAS payment.

But it can be sold or temporarily exchanged for settlement cash through a repurchase transaction.

That makes a government bond a bridge between a bank's investment portfolio and its immediate liquidity needs.

A government bond is not settlement cash. It is an asset that can help a bank obtain settlement cash.

This is the second reason: government bonds are powerful collateral

Since 2 April 2026, the Reserve Bank's weekly Open Market Operations have accepted a narrow set of eligible collateral:

New Zealand Government securities,

Reserve Bank Bills,

Local Government Funding Agency securities,

and approved Kauri securities.

Reserve Bank — Changes to Open Market Operations, April 2026 ↗

If a bank needs additional settlement cash, it can use eligible securities in a reverse-repo operation with the Reserve Bank.

The bank does not permanently sell the bond in the ordinary sense.

It provides the security under a repurchase arrangement and receives liquidity in return, subject to the facility's terms.

This is one reason a liquid government bond has balance-sheet value beyond its coupon income.

A safe asset is useful precisely because private loans are risky

A bank's job is to take credit risk intelligently.

Mortgages can default.

Businesses can fail.

Commercial-property values can fall.

So a bank does not want every asset on its balance sheet to depend on private borrowers performing perfectly.

Government securities provide a lower-credit-risk asset that can diversify the bank's portfolio.

That is particularly valuable during periods of financial stress, when private credit risks can become correlated.

The capital treatment matters

Bank capital requirements are calculated partly against risk-weighted exposures.

Riskier exposures require more shareholder-funded loss-absorbing capital.

The Reserve Bank's current BPR131 standard says:

an NZ-dollar claim on the Crown or Reserve Bank receives a 0% credit risk weight under the standardised approach.

Reserve Bank — BPR131 Standardised Credit Risk RWAs ↗

Compare that with a mortgage or business loan, which attracts a positive risk weight depending on its characteristics.

That makes government securities relatively capital-efficient from a credit-risk perspective.

But again, 0% credit risk weight does not mean “risk-free in every possible sense”.

Market prices still move.

Interest-rate risk still exists.

And a bank's leverage and broader prudential constraints still matter.

Then there is return

A bank also wants its liquid assets to earn something.

Holding settlement cash at the Reserve Bank provides liquidity and earns the overnight deposit rate.

A government bond can provide a term yield.

The choice between settlement cash, government bonds and other securities depends on:

expected return,

maturity,

liquidity,

market risk,

capital treatment,

collateral value,

and the bank's expected future cash needs.

A treasury desk continuously manages those trade-offs.

This is asset-liability management

A bank is not simply a machine that makes loans.

It is constantly managing two sides of a balance sheet.

Assets:

mortgages,

business loans,

settlement cash,

government securities,

other bonds,

and other financial assets.

Liabilities and funding:

customer deposits,

wholesale funding,

issued debt,

and other obligations.

Shareholder equity sits underneath the structure as loss-absorbing capital.

The bank has to manage liquidity, profitability, maturity mismatch, interest-rate exposure and credit risk across the whole portfolio.

Credit creation explains how one asset can create one deposit. It does not explain how an entire bank treasury should be run.

Government bonds also help price the rest of the financial system

Government bond yields are widely used as benchmark interest rates.

The Reserve Bank's May 2026 Financial Stability Report notes that government bond yields are used as benchmarks for pricing credit and collateral throughout the financial system.

Reserve Bank — Government bonds as financial benchmarks ↗

The Reserve Bank itself publishes 1-, 2-, 5- and 10-year New Zealand Government Bond yields in its wholesale interest-rate statistics.

Reserve Bank — Wholesale interest rates ↗

This matters because many other interest rates are thought about as a government-bond yield plus a spread for:

credit risk,

liquidity,

capital usage,

term risk,

and profit margin.

Government securities therefore help create the reference curve against which private financial claims are priced.

Government bonds can rise or fall in value

Suppose a bank buys a long-term government bond yielding 3%.

If market yields later rise to 5%, the existing 3% bond becomes less attractive.

Its market price falls.

If the bank needs to sell it before maturity, it can realise a loss.

This is interest-rate risk.

So a bank does not simply load its balance sheet with infinite government bonds because they receive favourable credit-risk treatment.

The bank still has to decide how much duration risk it wants to carry.

Why not hold all liquidity as settlement cash instead?

Because liquidity has an opportunity cost.

A bank needs enough immediately available cash.

But it may be able to hold part of its liquidity buffer in securities that earn a different return and remain readily marketable.

Government securities provide that middle ground:

not as immediately final as settlement balances,

but highly liquid, tradable and usable as collateral.

This is also why the Reserve Bank's future liquidity framework is designed around tiers of qualifying liquid assets.

Its announced policy direction puts cash, ESAS balances, Reserve Bank Bills and New Zealand Government securities in the highest-quality Level 1 category, with limited Level 2 recognition for LGFA and highly rated Kauri securities.

Reserve Bank — Liquidity Policy Review ↗

Do banks need government bonds before they can make loans?

No.

This is the important correction.

A bank does not generally take a government bond, transform it into a pile of loanable money, and then lend that money to a household.

When a bank approves a loan, it can create the corresponding deposit.

After that, it has to ensure that the resulting balance-sheet position remains consistent with:

capital requirements,

liquidity requirements,

stable funding,

settlement needs,

risk appetite,

and profitability.

Government securities are part of that broader balance-sheet management.

Banks do not need a government bond in a vault before creating a loan. They do need a balance sheet capable of surviving what happens after the loan is created.

What if the borrower spends the deposit at another bank?

This is where liquidity becomes concrete.

Bank A creates a loan and deposit.

The borrower pays someone who banks at Bank B.

Bank A must settle with Bank B.

If Bank A has sufficient settlement balances, the payment is straightforward.

If it needs liquidity, it may obtain funding from markets, attract deposits, sell securities or use eligible collateral in Reserve Bank facilities.

This is why the statement “banks create money” is true but incomplete.

The payment system still forces banks to manage claims against one another in central-bank money.

Does buying government bonds stop a bank lending to businesses?

Potentially at the margin, but not mechanically dollar-for-dollar.

A bank has finite balance-sheet capacity, capital, liquidity and management risk appetite.

Choosing to hold more government securities can affect how much room it has for other assets.

But a bank's lending decisions are also shaped by:

borrower demand,

credit quality,

expected returns,

capital requirements,

funding costs,

economic conditions,

and internal portfolio limits.

So it would be too simplistic to say every $1 of government bonds held by a bank “takes away” $1 that could otherwise have been lent to a business.

Could government borrowing crowd out bank lending?

It can under some conditions.

If government borrowing becomes very large, yields rise and banks find government securities increasingly attractive relative to private credit, portfolio allocation can shift.

Government borrowing can also compete for wholesale funding and investor demand.

But the effect depends on monetary conditions, economic capacity, credit demand and how much private investment the government spending itself enables.

There is no automatic one-for-one crowding-out rule.

Government bonds can also crowd private activity in

Suppose government borrowing finances electricity transmission that allows new factories and housing developments to connect.

Banks may then have more viable private projects to finance.

In that case public borrowing can support private credit creation rather than displace it.

Again, purpose matters.

The balance-sheet mechanics cannot tell us whether the underlying fiscal decision was good.

What does the current transition tell us?

The current New Zealand situation gives us a useful live demonstration.

During the pandemic-era LSAP and Funding for Lending programmes, settlement cash in the banking system became unusually abundant.

As those programmes unwind, settlement balances are declining.

The Reserve Bank's May 2026 Financial Stability Report says banks are responding by increasing holdings of government securities within their liquid-asset portfolios.

This is not a contradiction.

It is the banking system moving from one form of liquid asset toward another as the Reserve Bank normalises its own balance sheet.

My bank-balance-sheet hierarchy

If I wanted to explain why a bank holds different assets, I would separate them like this.

Settlement cash: final interbank settlement and immediate liquidity.

Government bonds: liquid securities, collateral, income, low credit-risk weighting and benchmark assets.

Mortgages: long-term private credit assets backed by residential property.

Business loans: private credit assets tied to firms and commercial risk.

Other securities: diversification, liquidity, collateral and return depending on the instrument.

Each solves a different balance-sheet problem.

My conclusion

Banks buy government bonds because bank credit creation does not eliminate the need to manage liquidity, capital, collateral, settlement and risk.

A mortgage may generate a higher return.

A business loan may support productive investment.

Settlement cash provides immediate payment capacity.

A government bond gives the bank something else:

a highly liquid, tradable Crown claim that can earn income, count toward liquidity management, carry favourable credit-risk treatment and be pledged for central-bank liquidity.

The fact that a bank can create a deposit does not make those functions redundant.

Money creation is one function of banking. Balance-sheet survival is the rest of the job.

Next

Now we can ask something even more fundamental:

What happens to bank credit when a loan is repaid?

Part 22 will trace principal and interest repayments through the bank's balance sheet, explain why principal repayment destroys broad money while interest does not disappear in the same way, and show how new lending and loan repayment continuously expand and contract the stock of bank deposits.

Primary sources

Reserve Bank — Liquidity Policy for Banks ↗

Reserve Bank — Financial Stability Report May 2026 ↗

Reserve Bank — Capital and Credit Risk Requirements ↗

Reserve Bank — Open Market Operations Changes 2026 ↗

Reserve Bank — Wholesale Interest Rates ↗

New Zealand Debt Management — Government Securities Funding Strategy ↗