This post is reproduced from the website of the New Economics Foundation, which has a new report out today suggesting that the problem of paying many billions of interest to commercial banks in the central bank reserve accounts needs to be addressed as a matter of urgency, with which I agree. That is why I share their proposal here. The report is by Frank van Lerven and Dominic Caddick:
As the UK recovers from the economic fallout of the pandemic, we now face a mounting cost of living crisis. Underpinning this crisis is a changing set of macro-economic dynamics giving policymakers a new set of factors that may slow the growth of the economy. After a decade of dangerously low levels of inflation, interest rates at their zero to lower bound, and nearly £1tn in quantitative easing (QE), inflation has risen to its highest rate for 40 years and is set to increase even more. Greater inflation would traditionally prompt the Bank of England (the Bank) to raise interest rates to alter credit conditions and dampen aggregate demand. But policymakers face a colossal problem – the Bank's monetary policy toolkit is dangerously out of date and not designed to address today's changing macro-economic circumstances. As a result, while so many families across the UK struggle with a soaring cost of living crisis, interest rate changes mean the Bank will be boosting the profits of banks through billions of pounds worth of payments (income transfers).
An innocuous change to the Bank's monetary policy framework in 2009 now means commercial banks are remunerated, at the Bank's policy interest rate, for all of their holdings of central bank money. But paying out interest to the banking sector for holding money in this way is an exception, not a historic norm. Given the lack of policy alternatives at the time, this method of conducting monetary policy may have been expedient in 2009. But with the banking sector now holding nearly £1tn in central bank reserves, higher inflation, and rising interest rates, three traditionally distinct issues have become needlessly conflated at an unnecessarily expensive cost to the government. The adjustment of the Bank's interest rate – aimed at altering credit conditions – now has enormous repercussions increasing both the amount of government interest payments and the profitability of the banking sector.
The consequences of increased interest rates on government spending are well documented. In his recent 2022 Spring Statement, Chancellor of the Exchequer Rishi Sunak has warned how a further 1% increase in inflation and interest rates could add £18.6bn to the amount of interest the government has to pay on its debt in 2024 – 25 and £21.1bn by the end of the forecast. These increased costs may threaten to hamper – at least politically, even if not economically – both the government's attempts to further stimulate the economy given a slowing recovery as well as the transition to net-zero emissions.
Meanwhile, far less attention has been given to the fact that interest rate changes will considerably boost the profits of the banking sector at the government's expense. Given the Bank controls interest rates by paying out money to the banking sector, rate rises will result in the Bank making significant income transfers to banks, substantially improving their potential profit margins. Looking at different potential ranges for interest rate pathways, even with the Bank's plans to unwind QE, an average interest rate of between 0.75% and 3% could mean the Bank making an income transfer to banks of between £6.9bn and £27.62bn by March 2023. Over the Office for Budget Responsibility's (OBR) five-year forecasting horizon, an interest rate of between 0.75% and 4% would mean the banking sector cumulatively receiving between £30.34bn and £161.80bn.
To offer a more precise estimate of the Bank's income transfers to the banking sector, we cross-reference market expectations for interest rates against a stock of reserves consistent with the Bank's current plans for unwinding QE. Markets expect interest rates will rise to 2.5% by summer 2023, before gradually falling to 2.0% by January 2025. Based on this implied pathway of interest rates, the Bank would have transferred £15.08bn by FYE 2022 – 23 to the banking sector – equivalent to reversing all cuts to welfare payments since 2010 – and a total of £57.03bn by FYE 2024 – 25 – enough to fully retrofit over 19 million homes in the UK or to send every household in the UK a cheque of £2,000.
Given current financial conditions, there is good reason to believe that these income transfers will most likely be directly passed on into banks' bottom-line profits, rather than being paid to customers holding bank deposits. Not only will these income transfers boost banks' profits at a time when many families across the UK are struggling with rising costs of living, but they will also go to an already heavily subsidised banking sector that in the last year has seen its pay growth more than treble the wage growth in the rest of the UK economy. The income transfers will be for no extra credit risk taken and arguably for no additional services rendered; they come about by virtue of the banking sector's exclusive ability to hold central bank reserves.
While many organisations, like the OBR and the Treasury, may often refer to central bank reserves as a form of public debt, we show that they are not debt instruments (ie loans from the banks to the Bank). Instead, they are a form of government money, like notes and coins. No money was ever borrowed or needs to be paid back, and therefore the Bank does not need to pay out any interest. Paying out interest and thus making significant transfers to the banking sector, is just one of many policy choices available to the government.
One possibility to avoid making such considerable income transfers to banks would be for the Bank to rapidly sell off its current bond holdings accumulated through its substantial QE programme, which would drastically reduce the amount of central bank reserves held by the banking sector. In addition to jeopardising monetary and financial stability, this would substantially increase the net interest servicing costs of the government and would result in the Bank making significant losses that would have to be covered by the Treasury. Given the Bank bought the majority of government bonds when interest rates were low, selling them when interest rates are higher means the Bank will receive less than what it bought them for. These losses could amount to anywhere between £105bn and £265bn.[v] A rapid sale of government bonds by the Bank would also dramatically increase interest rates while reducing the government's profits from the Bank's holdings of government bonds and thus considerably increase the government's net debt servicing costs.
Under the existing monetary policy framework, the Bank is caught between a rock and a hard place: it can either continue making considerable income transfers to the banking sector or it can dramatically increase the debt- and interest servicing costs to the government. The Bank's monetary policy framework is unnecessarily expensive, politically impalpable, and results in the Bank making fiscal transfers to one specific sector of the economy (to which other sectors are not privy).
There is a policy alternative and precedent, known as ‘tiered reserves', which is employed in other countries (in the Eurozone, Japan, and previously in the UK). This permits the distinct separation of the Bank's policy rate from the government's interest servicing costs and the profitability of the banking sector. Importantly, a tiered reserve system would mean the Bank would not have to unwind QE or sell any government bonds at the expense of the taxpayer, and monetary and financial stability.
Grounded in the experience of the Bank of Japan (BoJ) and the European Central Bank (ECB), we offer an illustrative proposal – with three distinct possibilities for remunerating central bank reserves – for how such a framework could work in the UK. Based on market expectations of interest rates, even with QE unwinding a tiered reserve system could save the government between £10bn and £15bn in income transfers to the banking sector by March 2023 and between £25bn and £57bn by March 2025.
Transitioning to such a framework would entail important policy decisions that should not be taken lightly. Given that a tiered reserve system would result in a dramatic reduction of interest costs to the government, the Treasury and the Bank have criticised this reform proposal as fiscal policy through the back door. These censures, however, neglect that the alternative – billions of pounds in income transfers to the banking sector during a cost of living crisis – is a form of fiscal policy that is surely less aligned with the public good and societal interests.
Another issue to consider is that withdrawing these significant income transfers from banks will affect their profit margins, which might lead them to pass on losses to their customers, by raising the cost of borrowing. However, this issue only materialises under conditions that would normally warrant the Bank to raise interest rates and drive up the cost of credit. As noted by a recent IMF (2022) paper that advocates for such a tiered reserve system, passing on the higher cost of borrowing to customers “would be a feature, not a bug, as it would amplify the desired contractionary effect”. The transition and trade-offs would need to be managed carefully, but this problem is hardly insurmountable given that increasing interest rates and raising the costs of borrowing is exactly what the Bank is trying to do.
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A good statement of the issues and simple, easily executed solutions. (Although I would say that as they are the same solutions posted on this blog a couple of days ago)
Why aren’t the BoE doing this? The strength of the banking lobby.
Frank and I have discussed this issue
“While many organisations, like the OBR and the Treasury, may often refer to central bank reserves as a form of public debt, we show that they are not debt instruments (ie loans from the banks to the Bank). Instead, they are a form of government money, like notes and coins. No money was ever borrowed or needs to be paid back, and therefore the Bank does not need to pay out any interest.”
We keep coming back to the same inter-connected, fundamental issues. Notice also that van Lerven and Caddick observe: “The Bank’s monetary policy framework is unnecessarily expensive, politically impalpable, and results in the Bank making fiscal transfers to one specific sector of the economy (to which other sectors are not privy).”
This monetary policy framework is not just a matter of interest payments or the status of the commercial banks’ Central Bank Reserves; but – as I keep trying to emphasise, this is a specially designed system through which Sovereign Government exercises its public money policies, which is deliberately a closed system of privileged central banks, dealers and their commercial, institutional clients, which not only executes Government/Central Bank policy but possesses a special membership reward of unimagined value: exclusive, first access to make their own self-interested profit and rent-seeking arrangements before anyone else, and especially the public (the same public to whom the sovereign Government is responsible but increasingly is reluctant to deal with, save through rent-seeking financial intermediaries, who may also fund the Government political Party), and a public whom are not “privy” to the monetary arrangements made, or possess direct access to it, save through the rent-seekers. This is a strange way of governing a free, democratic electorate.
I promise, we are listening John
Well put John. We are in a right old mess and I’m sorry to say, I don’t see it getting better any time soon.
Just keep saying it John – it’s the truth after all.
And for the rest of us – Fascism.
To keep us fearing each other, at each other’s throats, competing with each other for the meagre financial morsels left after the central bank feeding frenzy, to keep us from looking at and understanding what is really going on.
In a book about Medieval England I once had as a boy, I read that that at banquets the rich nobles would wipe their hands on pieces of bread which they would then give out to the poor. Did that sort of thinking ever stop?
Our central bank has certainly been hijacked by the rich. And now we know why we can’t get the money we need.
At least everybody at a mediaeval banquet knew where the stood, or rather, sat at the long table. The telling status was defined by whether you were placed above, or “below the salt”. Below the salt meant you were not important; considered yourself lucky to be there, kept quiet unless spoken to, and ate whatever may be left over; and the food was probably cold by the time it arrived at your lowly end of the table. In modern terms? Think of the public now as sitting, “below the salt”; while in the case of banking; the central banks, dealers commercial banks and their specially priviliged clients, we may think of as those who are “above the salt”; not only feasting first and best, but probably having already cornered the salt market.
Well put
So, the Government instructs the Central Bank (it’s own bank, the Bank.of England) to print £1tn. The Central Bank then asks the commercial banks to hold that money for them safely (which is easy as it is just a number on a computer). The Central Bank then says let us borrow our money back. For that service we will let you charge us Billions of pounds in interest for the privilege. This will make the banks very profitable so the bankers will be afford to pay themselves big bonuses for their hard work. The Central Bank does set the minimum rate of interest for everyone, but very helpfully it’s increasing the rate and does not even seem to negotiate any special terms for iteslf?
Asking on behalf of a 12 year old….who is interested in a career in banking.
They don’t even borrow the money back…
How do the commercial banks end up with large cash balances held by the Bank of England? And why is the Bank of England paying anything more than a notional return on those funds?
Sorry if you have done this before, but I think I might need it explaining again very slowly (sorry, getting old and dense). Is there a link I can read?
This? https://www.taxresearch.org.uk/Blog/2022/06/11/money-debt-and-thin-air/
Thanks, but no – I understand that money is a debt, and bank lending creates money. And the third part – on central bank reserve accounts – does not really answer the question. Where exactly do these central bank reserve balances come from? Perhaps I need to see some T accounts or a narrative explanation of how they arise.
I think is related to the simple but naive proposition that the banks simply buy gilts in the market, and by selling the gilts back to the BOE APF they are simply swapping one asset (gilt) for another (cash, or central reserve deposit). But we need to take a more holistic view of where the gilts (and the money paid to acquire them on issue, and to buy them back) came from in the first place.
I may have to write a blog….
Give me a day or so
I just posted a link to the NEF paper in my comment on the interest rate rise on the “Economy Hub”, a form of public consultation run by the BoE.
Not seriously expecting any formal reply, but maybe some others on the Hub may find it of interest.
I think anyone can join this interesting experiment on this link:
https://bank-of-england.citizenlab.co/en-GB/
Good idea
Andrew, all the cash balances at the Bank of England come from state spending. This is all what is called Base Money and only the State can create Base Money. Let’s suppose the State Pension costs £10 billion per month. The Treasury will debit the Consolidated Fund account at the BoE and credit all the relevant commercial bank Reserve Accounts with what is due to their customers, all marked as ‘for onward credit to Joe Bloggs’. The Reserve Account balances will increase by £10 billion. When those pensioners pay any tax bill due then the reverse happens. The pensioner will make a payment to HMRC which will debit their bank account which will debit their bank’s Reserve Account and credit the Consolidated Fund. You can reduce the Reserve Account balances in two ways. Levy a tax, which will debit the various RAs and credit the Consolidated Fund each time it is paid, or persuade the banks to use some of the RA balances to buy gilts instead. Tax destroys the RA money, while the gilt route just switches it to what is really a Term Deposit account instead of a Current Account (the RA).
There isn’t any easy way for any commercial bank to remove their Reserve Account balance from the BoE. They could ask for it in BoE notes and coins, switch it to a Gilt, or use it to buy a foreign currency (e.g. Dollars, which would move the RA balance across to the BoE account of the US Fed, but still leave it sitting within the BoE). In Gold Standard days they could have asked the BoE to pay them in gold, but that option ended in 1931.
Agreed, barring the last para
Commercial banks can only switch their CBRA to another commercial bank – overall reduction is entirely at the discretion of the government
I would find it helpful if Tim Rideout could clarify something in his post that confuses me. I am afraid I keep asking questions in my quest to understand economics. (Apologies RIchard if such a query is a misuse of your blog).
The example is pertinent since I am a pensioner. My state pension is presumably credited to my bank’s reserve account. So how does it get to me if (for example) I withdraw cash from a “hole in the wall”?
I guess what I am struggling to understand is the concept of Base Money, and how it functions if it isn’t interchangeable with regular money as used by us ordinary folk.
I will add this to the blog I am writing
From a regulatory (liquidity) perspective notes held by banks are equivalent to Reserves at the CB. I think it is convenient to think of notes as non-interest bearing reserves that can (and usually are) be held by non-banks (outside the BoE). Banks hold very few notes; I think stocks of new notes held by banks are not “theirs” until they are dispensed to customers (but not certain of that).
One more thought on the “free lunch” the banks get on reserves. Whilst I am deeply sceptical of CB digital currency – partly because nobody has clearly defined what it is – but if it is, in effect, the chance for individuals and corporations to hold current accounts at the BoE directly (rather than via a commercial bank account) then we, the citizens would be directly renumerated with interest on the reserves. It is possible that a digital CB currency might aid transmission of monetary policy without rewarding banks. Just a thought.
Let me see if I’ve got this right.
Bankers ‘create’ money.* They then give it to their mates. They then raise the interest rate so they have to pay more to their mates.
Those mates do nothing with the ‘money’, but trouser the profits from it.
Presumably those who ‘created’ it are trousering a bob or two as well?
Is that too simplistic?
*In reality, just a number on a computer somewhere.
Pretty much it
I noted in an FT article on this the BoE response was that it refused to reduce interest on reserves because they would make banks put up interest rates!
It is hard to believe they peddle such nonsense and expect to get away with it. Besides, as we have covered here before the BoE only started doing this in 2001 and even then it was a tiered approach.
The banks do not lend reserves in any case so they really need to start teaching the staff how the money system works at the BoE.
Agreed
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