I have had a number of people draw my attention to an article by the National Institute for Economic and Social Research (NIESR) in which they claim:
The proposal to reduce public spending by ceasing immediately to pay commercial banks interest on their reserve balances, while superficially attractive, is very dangerous and likely to be counterproductive, for two kinds of reason.
That's a big suggestion, and the NIESR is often taken seriously, so it seems worth examining. This is their first argument:
First, it would imperil financial stability. Commercial banks' reserve balances are a large part of the stock of liquid assets that they are required to hold as part of the Basel 3 regulatory apparatus, to ensure that they can withstand a rush of deposit withdrawals without needing to be rescued. If no interest were paid on reserve balances, banks would want to get rid of a large proportion of them and, in order to avoid a surge of inflation, each bank would have to have a minimum quota of non-interest-bearing required reserves assigned to it. It would not be allowed to let its balance go below the quota, and the quota would ipso facto become an illiquid asset. The banking system would be less well protected against a liquidity crisis than it is now; if a crisis was threatened, the minimum quotas would have to be reduced or eliminated and government revenues would consequently fall.
All this does is reveal a complete misunderstanding of the issue being looked at. Central bank reserve accounts (CBRAs) do not exist because of Basel regulations. They do instead exist because the government chose to spend more into the economy than they chose to claim back as tax or gilt subscriptions. CBRAs are central bank created money injected into the economy by government choice. Commercial banks have no choice but to hold these balances. And collectively they cannot be rid of them: they can only transfer them to another bank, but their gross value will remain the same. They are, in that case, already a deeply restricted asset. The NIESR seems to know none of this. They should read my blog on this issue.
Their second claim is:
A further financial stability concern is that locking up bank assets in non-interest-bearing required reserves would aghttps://www.niesr.ac.uk/blog/dont-stop-paying-interest-banks-reserve-balancesgravate already evident shortages of liquidity in sterling financial markets. Financial markets have become accustomed to plentiful liquidity with strategic positions and assumptions based on that continuing. If the banks' assets become suddenly less liquid, they will be faced with an acute mismatch in the liquidity profile of assets and liabilities. Therefore, they will reduce the liquidity of their assets, which means extending less liquidity to the markets. As we have seen in gilt bid-ask spreads and in the pension fund LDI crisis, liquidity is already in short supply. The proposal would make this acutely worse, and thereby increase the risk of a full-blown financial crisis.
Again, this reveals a deep misunderstanding as to what these balances are.
Third, there is this:
Moreover, the imposition of minimum non-interest-bearing-balance requirements[2] on banks would be a tax on banks, the size of which would increase as interest rates went up. It would make banks less competitive in the market for financial intermediation, and financial flows would be diverted from the banking system into other less visible and less highly regulated channels, which lack depositor protection – shadow banking. This too would undermine financial stability.
This is absurd. The banks were gifted these assets since, as the Bank of England correctly says of itself when describing QE, it decided to create these reserve account balances, and yet it is claimed that to restrict the resulting unearned gain to the banks would be tantamount to an unfair tax. The logic is bizarre. First, why should the initial gift of liquidity be compounded by interest added, and second why should that be tax-free? The reasoning is not explained. Instead, having dealt with three issues we then get to their second point:
Second, implementing the proposal would involve what would amount to a default on the indemnity that the Treasury has provided to the Bank of England in connection with quantitative easing. The interest that would be withheld is currently paid by the Bank of England to the commercial banks, on reserve balances whose aggregate amount has been determined by the Bank of England, which has created the balances to pay for gilt-edged securities purchased in its quantitative easing programme. The gilts are held in the Asset Purchase Facility, a Bank of England subsidiary which is financed by a loan from the Bank of England proper. The Asset Purchase Facility is indemnified against losses by H M Treasury, which also gets the benefit of any profits (it has already received £120 billion).
There is more on this same theme, bewailing a breach of undertaking by the Treasury to the Bank of England and how calamitous this might be, all backed by a comment that the terms of the indemnity between the parties is unknown.
First, the terms of the indemnity are absolutely clear and have been known ever since QE began. The Treasury completely indemnifies the Bank of England for any losses it might make from undertaking QE operations. As a result it has also always taken the profit from them as well (albeit with a delay in early years). As a consequence, for accounting purposes, the Bank of England subsidiary that supposedly owns the bonds acquired by the QE programme (the Asset Purchase Facility, or APF) is not consolidated into the accounts of the Bank of England as law would usually require. There is good reason for that. It is clearly not a Bank of England-controlled company, even if legally owned by the Bank. Instead, it is obviously controlled by the Treasury. And we know that to be true: the Treasury has always had to provide prior written approval of QE operations. These letters are on public record. The only task delegated to the Bank is the micro-management of the programme. The real decisions are all taken at the Treasury.
As a result, the Treasury cannot be in breach of its indemnity to the Bank by not paying interest, because the reality is that QE is a Treasury operation, hidden behind a sham veneer of Bank independence, the lack of substance to which is revealed within the accounting treatment for the APF. To suggest that the Bank is in any way imperilled by a failure to pay interest on reserves, as the NIESR dies, is in that case absurd. That interest has never been Bank of England property and the accounting proves it.
The NIESR then extends this argument implying that non-payment would be breach of an implicit agreement with the commercial banks:
The commercial banks collectively have no control over the aggregate of reserve balances. The cost of the cessation of payments would be borne by bank shareholders, including pension funds, bank employees and bank customers. It would amount to a default and would pose a serious risk to the government's credit standing.
It is very odd that by this stage of the article the NIESR knows the restrictions on reserves that it apparently did not in the first part of it (were there two authors who did not understand each other, or read what the other wrote?). More tellingly, given that the Bank of England has commercial freedom to set whatever rates it likes this is simple nonsense. Nor can it in any way threaten government creditworthiness.
But then we get to this argument which is from cloud cuckoo land, so absurd is it:
None of this is to suggest that the practice of paying interest on commercial banks' reserve balances need continue forever. If the commercial banks were free to determine the size of their reserve balances, then it would be entirely reasonable for the Bank of England to say that it would not pay interest on them. That will be the case when, and only when, quantitative easing has been fully reversed. The banks' demand for reserve balances will probably be much larger then than it was before QE began, because many of the changes that have taken place in financial practices since then have required institutions such as clearing houses to hold accounts with central banks. And it would be possible for the Bank of England to say now that it intends to cease paying interest on reserve balances when the reversal of QE is complete.
And that is it. On the basis of fantasies based on beliefs about situations that do not actually exist and probably never will in the last case, the NIESR wants to justify paying commercial banks a sum equivalent to 20% of the health budget over the next few years.
They did not use arguments I expected, like this being necessary if the Bank is to influence market interest rates. I presume they did not do so because they know that this is not true. We know that because interest on these reserves have only been paid since 2008, during which period rates were effectively zero until the last year, and so we have no way of knowing as yet whether this argument can be justified. It is however my suggestion that if signalling an interest rate costs this much then either the rate or the signal, or both, is wrong.
There was also no discussion on the links between monetary and fiscal policy.
Instead, there was just a misrepresentation of what the reserves are and a total misunderstanding of how they are managed.
I sincerely hope others trying to make this case do a lot better than this.
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One minor point: The decision by the Bank of England to pay Base Rate on current accounts (CBRA, but I guess also on the accounts of the 45 or so foreign countries that keep their Sterling reserves at the BoE) was in May 2006, so before the financial crisis. I understand they never paid interest on these accounts before then.
The current commercial bank reserves are running at over twenty times what they were pre-2008 (typically under £40 billion then compared to £900 billion now), so it is quite hard to see how NIESR can argue there is a financial stability issue. Just to take a specific, RBS Plc (the Scottish part of Natwest Group) had a balance sheet of £102 billion in its last accounts and £32 billion on deposit at the BoE. That is 31% reserves. What would likely happen if interest was not paid on the reserve balances, is that the banks would use some of those funds to buy gilts (as many gilts qualify as reserve assets under the regulatory rules). So they would still get interest, but would solve any possible funding problem the Treasury might have. The demand for gilts might also drive down the interest rate by pushing up the prices of those gilts.
You are right on the date Tim, but I put that in the financial crisis, with that clearly starting well before 2008 E.g, Northern Rock.
Your point re gilts is what the BoE is, of course, trying to make them do with QT but they are seeking to reduce prices which oddly precipitates their technical losses
Northern Rock sought liquidity support from the BoE in September 2007, triggering a bank run, and it was nationalised in early 2008.
Are you suggesting that the BoE knew there was going to be a global financial crisis when they started to pay interest on the reserve accounts in 2006? A prescient reaction to anticipated contagion from problems with the overheated subprime market in the US?
There is no need for the bank to pay any (let alone substantial) interest on the reserve accounts. If it wasn’t necessary before 2006, why should it be necessary now?
It would be a fascinating piece of research
My answer is I think they did know what might happen
Was QE already in design?
Richard, in response to your statement at 5:37pm (“My answer is I think they did know what might happen”), I have a son who worked in corporate banking for a major bank in the City and at least 18 months ahead of the 2008 Crash, he was warning me about its likelihood. He had colleagues who worked in investment banking and had been talking with them about the packages of mixed derivatives being traded there whose credit-worthiness could not be verified. So fore-knowledge of the potential for a major crisis was certainly known about in the City. As my son said at the time “if the banks don’t know what’s good and what’s bad in the packages, there’s no way the regulators or auditors will find out, so get ready for a crisis.”
Agreed
That knowledge did exist
I was warning against markets well before the crash because it was apparent that opacity meant no one knew what was going on
7th February 2007. This was the day that HSBC announced a USD 17bn loss in its US subsidiary (Household) on sub prime mortgages. (In those days USD 17bn was VERY serious money). Up until that point there had been a general feeling that the party could not go on – indeed, the head of Citibank Chuck Prince, when asked “surely this will end in badly”, answered “yes, but while the music plays we have to dance”. But February 2007 was when the subprime losses were first acknowledged and noted by the world outside the US mortgage market … but not by the Stock Market (I remember betting big that stocks would fall only to see them keep going up until October 2007).
Given all the preparatory work required I don’t think the update to the “Red Book” (The guide to Sterling Money Market Operations) in 2006 where interest was paid on reserves for the first time was in any way a response to some impending crisis. That process was just a major overhaul to bring the process of managing money markets into the modern age. If I recall correctly (and that is a big IF) it included the payment of interest on reserves to reduce the volatility of overnight rates. Forecasting reserve balances exactly is difficult for a bank. Too high and you are left trying to place a deposit in the interbank market at low rates; too low and you are going cap in hand to the BoE to borrow. Paying interest on reserves allows banks to carry extra reserves without there being a penal cost to it. It did – and still does – make sense for operational reasons. What has changed is the size of reserve balances and the politics.
Noted
I’m afraid the technical details of your argument with the NIESR are somewhat beyond me.
All I would say is that your proposition seems to me to boil down to an argument that in order to plug the continuously widening gap between public expenditure and what is recovered through taxation — the government should be able & allowed to borrow enormous sums (i.e. QE = central bank reserves) at zero external interest rates.
The main problem I see with that is: if its correct now, why shouldn’t it be continued and increased indefinitely? Why shouldn’t the BoE/APF buy up all the remaining outstanding government bonds in the market and the whole of any further future issues that the government needs to make? Forcing the commercial banking sector to support this by maintaining ever-increasing reserves with the central bank (at zero interest) — until that represents the whole of the (continually increasing) government debt?
Doesn’t strike me as intuitively right. Possibly it might be technically feasible, but only at the expense of devaluing the currency to an extent that we would have perpetual very high inflation.
a) Look at Japan
b) There is only gain fir banks in being liquid – this is effectively free capital
c) What is your alternative? Why don’t you want a functioning society?
a} Yes, Japan seems to get away with it — to date. Nominal debt interest amounting to 30% or more of total public expenditure, which they seemingly almost completely ignore, by virtue of just issuing further government debt to more than cover that debt-servicing cost. A bubble straining to burst?
Somehow they have managed to persuade the 30% or so of ‘external’ (real) govt bondholders (to date) to accept a yield way below typical current global interest rates. I can only guess that is primarily due to a solid demand from international investors willing to accept such low (or negative) returns — for the benefit of maintaining some diversity in their gilt-type holdings, away from US and Europe. I can’t see Britain being able to pull off that trick.
Also — Japan’s outlier financial policy hasn’t done much for their growth, has it?
c) Although I believe our mix of taxes is inequitable — overall I reckon tax is still too low. Would also suggest targeting a moderate level of inflation — say 5%. 2% seems unrealistically low. And start increasing the state pension retirement age, fairly sharply, to address the changing demographic ratio of consumers to producers.
Why is Japan, for now?
And why is growth so important?
I am not convinced by 5% inflation but 2% seems too low
Mr Howard,
I must preface my observations by confessing I am not well informed about Japan’s financial history. Neverthless, Here is my problem with your approach, which seems to me simply to beg the question, and assume an answer that fits your thesis.
“Japan seems to get away with it — to date”
First, I understand Japan introduced QE in 2001; over twenty years ago. ‘Getting away’ with something for twenty years is beginning to ring hollow; notably following the Western Financial Crash, 2007-8; twelve years of austerity, followed by another near miss crash over the LDI pension fund crisis, requiring expensive BoE intervention with “hours” to spare (something is badly wrong with the regulatory system), the comic mini-Budget, and now the promise of another twelve years of austerity. The point here surely is ths; we are clearly no longer ‘getting away’ with it. Who is finding their way more surefootedly through turbulent times? I doubt if the Japanese wish to be in our shoes.
Second,: “Japan’s outlier financial policy hasn’t done much for their growth, has it?”. I admire your chutzpah, throwing that one in. I am struggling to find the “growth” arising from our economic policies (past or present); and there is little prospect offered for the future. Indded we have a long history of failing to achieve significant growth, still less productivity. The little we had came from oil, and now we live off a cycle of property asset bubbles and rentier captialism.
As I said, I am no expert on Japan, but your argument appears to rest on risibly overselling whatever ‘upside’ you can find out of the utter mess to which we have neen reduced. Your problem is, our predicament is substantially self-inflicted (between 1999-2022 we even managed to encourage Putin’s aggression and disdain for Western fortitude, by embracing hordes of oligarchs into the heart of Brtitish society, and even the Governing Party; then doing effectively nothing about the Litvinenko horror 2006, Syria, Donbas 2014, Crimea 2014, Syria, until he finally delivered a full-scale invesion of Ukraine; because he judged we were so weak).
The real problem is that thinking along your lines leads nowhere good. In short; Physician, heal thyself.
🙂
Richard
I posted a graph on Twitter, suggesting an alternative view of the interest the Government pays on its bonds. Since 2008 the BoE base rate has fairly consistently been below the rate of inflation. The discrepancy is temporarily 8%. Surely this means that in real terms, even after interest, the Government will have to pay back far less than it borrows?
This is another way of looking at your argument that Government spending does not rack up debt for the next generation.
If CPI is not a good benchmark, it would be possible to use other comparators for Government debt
vs GDP – if the economy is growing it can accommodate more debt
vs Average or Median wages
vs Private debt
Apologies for the bizarre notion that, used correctly, high inflation might be good for grandchildren
Might you share the Twitter link?
I think I did this wrong last time
https://twitter.com/mhlg66/status/1594645105041874944
Looks ok
Fair point
My first concern is that what is an “opinion piece” is being published as “research”. I suspect that the “editors” who chose to publish it don’t really understand the issue and have looked at the author’s great experience and assumed what he asserts as “fact” is fact…. when it is not.
Beyond that, he raises issues that fall into two camps. (1) Danger to financial stability and (2) moral/legal obligation.
I think he is wrong on both of these and will explain……. but right now, other things need doing and it will have to wait.
Thanks
I will await
Thanks for the insights and contribution to the debate. Good to add to the reading.
FWIW the author worked for the Bank of England (monetary policy formation and financial market operations) and with BIS, IMF and EU Monetary Committee. He also worked at Brecon Howard who rarely hire fools!!
Many would say the BoE Governor is not a fool
I most certainly would
I would prefer to limit my responses to his (and others’) policies and comments rather to him as a person. But each to their own.
His career in public service suggests admirable…. but also suggests an unwillingness to explore unconventional solutions.
Alan Howard (of Brevan Howard) is, indeed, a smart chap and was (until we saw the the era of zero rates) a massive player in short rates futures and options and would certainly valued the insight that Mr. Allen’s years at official institutions would have brought. But that does not make Mr. Allen right on this topic.
I’m all ears Clive – I’ll just go and put the kettle on.
That is just a terrible article. It may have well been written by the banks themselves, I’d suspect a bank input there at some point. Who wouldn’t want free money.
Another issue here is that the BoE themselves are desiring to cut reserves in any case via QT, Has the NIESR complained that that could also reduce bank “liquidity”. Historically before the 2008 crash the central banks all tended to create reserves on demand from the banks it is not the other way round, so any liquidity problems were always catered for, that case is even more likely since 2008, so I cannot see a position anymore when the banks would run out of liquidity. Besides the banks do not hold much sovereign debt, or as I recall they hold as little as they can get away with, which as you point out here is a regulation set out by the Basel Agreements not the central bank.
Good point re QT
Stupid! I never thought of that! Good reason to treat the whole idea with suspicion.
https://twitter.com/mhlg66/status/1594645105041874944
Richard, you claim that banks were given central bank reserves for free.
This is manifestly not true, as they received these reserves in exchange for Gilts during QE.
If the above is true, which it clearly is, then how can you claim the banks are earning the sums you claim on sums “gifted” to them? If QE had not happened, they would likely be earning more money on bonds they would still be holding.
Given this claim of yours is false, does it not then follow that much of your following claims are then incorrect?
This is nonsense
Read my blog on how central bank reserves are created
You are deliberately viewing a microcosm of the whole process to present a false argument
I have done the double entry to prove it
You can check that too. Just google it
Meanwhile, I do not appreciate your tone when I am telling the truth
QE still gives me a lot of problems in working out how it works, Richard, despite your pretty clear explanations.
Problem is, that the BoE appears to say that these reserves aren’t ‘free’ money for the banks. This from the 2014 BoE quarterly bulletin article about money creation. The article has used an example of the BoE purchasing gilts from a pension fund as part of QE
“Why the extra reserves are not ‘free money’ for banks
While the central bank’s asset purchases involve — and affect
— commercial banks’ balance sheets, the primary role of those
banks is as an intermediary to facilitate the transaction
between the central bank and the pension fund. The
additional reserves shown in Figure 3 are simply a by-product
of this transaction. It is sometimes argued that, because they
are assets held by commercial banks that earn interest, these
reserves represent ‘free money’ for banks. While banks do
earn interest on the newly created reserves, QE also creates an
accompanying liability for the bank in the form of the pension
fund’s deposit, which the bank will itself typically have to pay
interest on. In other words, QE leaves banks with both a new
IOU from the central bank but also a new, equally sized IOU to
consumers (in this case, the pension fund), and the interest
rates on both of these depend on Bank Rate.”
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/quarterly-bulletin-2014-q1.pdf
I understand that the purpose of the bulletin’s is to explain BoE for, among others, the general public. Is this article being disingenuous/economical with the truth?
In a word, yes, in my opinion
That bulletin was a step forward, ending some of the previous denial, but was by no means an acceptance of the reality of what actually happens
William Allen argues that stability of the banking system would be put at risk if interest were not paid on reserves…. and so rubbishes the whole idea. Certainly, not paying interest on reserves does create some issues but I think they can be resolved. So, let’s look at what a resolution might look like.
First, Mr. Allen brings up the recent LDI/gilt market debacle. This is a complete red herring as he confuses the two uses of the word ‘liquidity’ in the world of finance. For the banking system ‘liquidity’ means cash (or near cash) assets and he is correct to raise the fact that if banks are required to hold more reserves then these reserves are not available for other purposes… hence, banks are less liquid…. which, could become a problem.
However, ‘liquidity’ for a gilt trader means ‘how big is the bid/offer spread?’ and ‘how much can I buy or sell without moving the market price?’. The disorderly market resulting from the Truss/Kwarteng mini-budget was due to three things – none of which has anything to do with the level of reserves held by a bank. First, the policy announcement was a surprise so nobody was positioned for it; second, the long end of the gilt market (and particularly the I/L gilt market is dominated by pension funds so tends to lead to everyone buying or selling at the same time. This market concentration has been exaggerated by QE and meant that when the pension funds needed to sell there was nobody willing to take the other side. Third, capital requirements in trading businesses are about 3 times what they were before 2008 so banks prefer to deploy their capital in other areas meaning that they can’t take the other side (in meaningful size) if the pension funds move – hence the outsized price movements.
Returning to the genuine question that Mr. Allen raises. “If a bank is required to hold more reserves, does the fact that these reserves are no longer available for other purposes mean they are less stable?”
My first point would be that holding reserves at a certain level is all about promoting stability. A certain level of reserves is essential to guarantee the smooth operation of the payments system and it is unclear what is the right number here…. but whatever the right number is then a good safety margin needs to be built in because it is a long time since we had anything other than lots of excess reserves slopping around. (The Fed got itself into a tangle a few years ago as they completely mis-judged the banking system’s desire to hold reserves over US Treasuries and was obliged to do a reverse ferret). In short, banks might want to hold more reserves (unremunerated or otherwise) than we think (or indeed, they say in public).
Second, the extra reserves that a bank might be required to hold are not completely useless for maintain stability. Indeed, they might become a decent “early warning” system. Banks could have a “jam jar” and a “piggy bank”. The BoE would mandate the level of money in the “piggy bank” and pay no interest. It would pay interest on money in the “jam jar”. If customers suddenly switched their money from bank A to bank B then bank A’s jam jar would become depleted and bank A would be obliged to borrow in the interbank market to make sure it did run out. Of course, if customers are switching away from Bank A due to fears for its safety then Bank A might be able to borrow in the interbank market and at that point it would have to break open the piggy bank to access those reserves. That act would trigger action from regulators to support (or otherwise) Bank A.
The template is the Capital requirement regime where there are three thresholds as a bank’s capital declines. (1) no dividends (2) the regulator comes in and starts to tell you haw to run your business (3) they shut you down. It might work in this case.
My point is there are technical solutions to ensure that financial stability is not endangered.
I will return later to “moral” arguments.
Thanks
Clive, you mention three thresholds as a bank’s capital declines: (1) no dividends, (2) the regulator takes a leading management role (presumably to stop further decline) & (3) shut-down of business. From this I deduce that at no point need there be a cessation of bankers’ bonuses (as evidenced by RBS continuing to pay bonuses across the duration of its melt-down crisis when dividends ceased abruptly and the UK Gov got thoroughly shafted when it paid £5.02 per share to bail RBS out. In the intervening 14 years these shares have never climbed above £3 and dividends, when they resumed again in 2018, have been unremarkable.
One wonders who funds NIESR. Surely not banks? Same question with respect to the author – whose background suggests that he should have known better.
At the risk of being inaccurate:
I provide a block of money to an entity.
The entity then complains that I don’t pay interest to that entity for them holding my money.
Sounds like mafia territory: you pay me protection money – whilst I protect your money (in a computer).
Also the BoE did that report back in 2014 on money and fractional reserve banking. The point being that banks reserves are leveraged – with Basel III defining the leveraged (I think). So not only do the banks leverage their reserves, they want the BoE to pay them interest on those reserves – just saw a rabbit, in a waist coat with watch, going down a burrow.
What I know is this:
The private bankers – who are known to be greedy, criminal and short sighted and therefore a source of instability in the financial system – get a nice big fat safety net to catch them if they are greedy, criminal and short sighted. A safety net that comes with ‘cash back’ in the form of interest too.
Now – what is that everyone else gets from the government in this shit house of country, when they get into financial trouble?
Part 2
Another part of his argument involves HMT, the BoE and the APF. Frankly, I don’t follow his argument but given that the BoE, HMT and APF are all part of the same entity – the UK State – there can’t be any problem here. Why would ceasing to pay interest on reserves affect the loan arrangement with the APF?
He also suggests that this would a be a tax on banks. Errr – yes. In some sense it is and that is the whole point. He fears that this would lead to business migrating to the shadow banking system. There is a general point that if you regulate or tax any activity too harshly then the activity migrates into the shadows…. and money is no different. However, in this case I would argue if non-banks start to take on the roles of banks in any serious way then they ARE banks and should be regulated as such (look out, Fintech – I mean you). Also, reserves can’t disappear except through tax or gilt sales so if banks don’t get interest on reserves then they will merely price that into their arrangements with their clients.
It is possible that problems would emerge in a bank’s swap book as this Asset/Liability management process would have been undertaken on the presumption that reserves would be remunerated… but a gradual, phased in approach would allow banks to manage this risk.
In conclusion, through a gradual policy combination of increasing the requirement to hold “special reserves” and slowly reducing the interest paid on “special reserves” to zero one could achieve the policy aim – not giving free, undeserved money to banks – without risking stability or causing major disruption to the banking system.
Agreed
This needs further thinking though – I suspect it is central to future economic policy
Yes – more thinking needed.
Thanks Clive for your two contributions on reserves; clear, concise and illuminating. Very interested in your two tier jam jar/piggy bank proposal, because what alarmed me since 2007 was all the soft soap about the built in stringency of the tougher new regulatory mechanisms; but Ihave always been uneasy about how well increases in reserves, for example would of itself trigger ‘early warning’ when matters were going wrong in the modern complexities of matching assets and liabilities across the spectrum. Is the empty jam jar, the point when the red light flashes at the central bank?
I recognise the different framework, but I found it unnerving how quickly the LDI pension fund crisis developed so quickly, to the point the intervention of the BoE required to be so sudden. I appreciate that is a different issue from bank reserves, but It seems to me in a modern, very fast moving digital monetary environment regulations have to be a great deal better. I am not sure, however how far reaching you think your jam jar/piggy bank idea could be extended or developed here?
On your second contribution I remain perplexed by the argument about ‘shadow banking’, because it seems to me you are right; if you are doing banking you should be treated (regulated) as a bank. Wasn’t that one of the major issues in 2007-8, the uninvestigated rise of shadow banking? I am not sure there is a rigorous, non-porous definition definition of banking; at least one that is usable? What is a bank? Sometines, it seems to me, as money has developed its way of working the intricacies of the time value of money, especially in our current age; sometimes banking, hedging, insurance look as if they are virtually the same thing; depending, relatively only where you are observing the specific activity you are undertaking. Merely pointing in the direction of shadow banking as a risk here seems to me an easy attack line; but the question perhaps should be, why is the boundary between the two not being heavily patrolled by the regulator – already?
One small point. I lost the thread slightly on the Bank A example; “to make sure it did run out”; “didn’t”? Or am I being obtuse.
On your last point – sorry, a typo.
I share your concern and surprise at how quickly the LDI debacle developed….. and I am not sure what you do about it. Investors need to realise that what they think is liquid (ie. easily sellable without moving the price) ain’t necessarily so. And the only way investors learn this lesson is through bitter experience repeated on a regular (but rare) basis. There are various reasons why the markets these days are more susceptible to these gyrations the two main ones being (1) increased capital requirements meaning that dealer risk taking capacity in low margin/low profit businesses (like gilt trading) is much reduced. (2) Algorithmic/automated trading means thing develop in the blink of an eye – too fast for a human to go “that’s crazy, stop the machine!”. However, this is totally unconnected with the level of Central Bank reserves held – it is all about Capital Requirements.
The “jam jar” for day to day use and the “piggy bank” to be broken in case of emergency is, I think quite a useful idea. In terms of Bank capital there is a specified amount of “buffer capital”. If you eat into that buffer then your business is “constrained” by the regulators but you are only shut down if you blast through the buffer and go below the legal minimum capital levels.
This is already part of the liquidity rules in the sense that (subject to certain assumptions about depositor behaviour) a bank can operate for 30 days without access to borrowing in the interbank market. However, I don’t see any reason why an additional measure like a buffer of unremunerated reserves could not be added to the safeguards already in place…. (other than the fact that the banks will squeal). One issue is how much should a particular bank hold in the excess unremunerated reserves? How could that change as banks change….. and here I am open to suggestions.
I share your concerns about “shadow banking”. In any industry, excessive regulation/lack of access/high prices will prompt illegal alternatives (unlicensed taxis, loan sharking etc.) We deal with them by calling the police. The issue here are peripheral players who, because they are not “systemically important”, are less closely regulated. There is a delicate balance between allowing small players to innovate without undue burdens, not permitting “unfair competition” with established players and preserving the safety of the system without entirely underwriting all financial risk. Not sure what the answer to this one is.
Clive,
“I share your concern and surprise at how quickly the LDI debacle developed….. and I am not sure what you do about it.”
The problem here? “Algorithmic/automated trading means thing develop in the blink of an eye – too fast for a human to go that’s crazy, stop the machine!’. This, unfortunately is not a paasing accident; but our actual direction of travel. Bankers and, I suspect dealers focus on price spreads and matching the timing of assets and liabilities (how old fashioned); but that is not what drives the change.
Schumpeter called it “creative destruction” (the contradiction is not avoidable, the creation brings the destruction). Today we call this “permissionless innovation” (see Adam Thierer, Shoshanna Zuboff); and permissionless innovation was precisely the concept Big Tech conceived from Schumpeter and developed in California to come to dominance in the 21st century. The seduction of digital innovation has carried off the capacity of banks or dealers to control what they are unleashing, in order to exercise their faith in their own fragile and limited knowledge of the market processes they think they understand, for their advantage; and Governments are left to carry the can for the consequences of the illusion. The can Governments are bailing with however, is too small, arrives too late, and has no bottom. And we haven’t even scratched the surface of applying AI to these fast moving technical applications.
The lethality is found in the LDI crisis, surely; nobody ever thought it might first happen – to pension funds. Pension funds – what are they DOING there? It is all already out of control. All you can do is provide ruthless regulation that forbids the use of these methods in pension funds; but I suspect it is already far too late to do much at all, but wait …. for the next disaster. Bring your own lifebelt.
Lots of interesting points but the BOE looks clear on what it is going to do
https://www.bankofengland.co.uk/markets/market-notices/2022/august/explanatory-note-on-operational-implications-of-apf-unwind
People can be clear about the mistakes they intend to make
Technically, from the bunker in Threadneedle Street, the BoE plans look great. However, as they emerge blinking into the sunlight they might not enjoy the encounter with sans-cullottes carrying pitchforks. The key ingredient they are missing is “politics”. Soon or later, the interest paid on reserves (and banking profits) will be compared with cuts to public services and the voters will ask “why was the Bank squandering our money?”… and neat explanations on their website will just not cut it.
The Bank would be well advised to engage on this issue before it explodes.
Precisely
Politics and every thing else!
I find that I’m seeing the same sort of thing at a local authority level housing development. At the moment, the threats to cut back public spending has really spooked my local authority.
So now (forgive me Richard) the accountants are to the fore – they are insisting on closing down the investment avenues we have through our Housing Revenue Account.
We’ve already failed this year due to all sorts of well known factors to spend £20 million of this year’s investment before end of March. We have just whisked away £4 million for NEXT year’s investment to some other year.
Now, the accountants have decided to up the rate of return on HRA development loans to 4.50% from 2.56% – it’s ours at the moment to set. So now a lot of new schemes are nonviable. They’ve done this to capture the ‘cost of living’ rise and also because we’ve been told rent rises (income) is going to be capped at 5% when in fact we need 11% next year to recover costs of Covid etc.
But as Clive alludes, it’s all very well banging on on about the accounting side of it – what’s the collateral damage? And what about ‘leadership’ and a steady hand at the tiller?
Well, with us I’ve challenged their assumptions:
What is happening to the year on year under-spending we’ve been doing since 2014?
Do your business case models take into account that we are in recession now and it will only get worse? There maybe opportunities -cheaper labour and supply chains that we might be able to exploit for the social good.
How do you feel helping your LA to contribute to the recession in the City you run?
How are you going to explain to your stakeholders (Councillors, service providers and voters) that they will lose their Right to Buy receipts to government because you are not going to investment them; that houses in multiple occupation and over crowding are going to get worse and housing lists will grow longer?
Why have you done no evaluation about savings in the round to council budgets such as the General Fund and Social Care budgets from HRA investment? Developing housing gets rid of crappy sites around the the city that can cost thousands of pounds a year to maintain and keep clear of dumping; the disabled bungalows we develop can save LA social care budget care costs. But these are viewed at ‘externalities’ and are invalid even though we’ve done some work to testify to these realities. I thought accountants were here to account for things but it seems that they are only interested in simple costs and savings.
It’s a queer way of looking at investment if you ask me. It reeks of ‘orthodoxy’ and has nothing to do with ‘invest to save’ which we decided to do in 2010 (and as I said before, we failed to do as well – I mean what we don’t spend accrues – the money is the LAs, we no longer have to send surpluses back to central Government).
At the rate we are going we’ll end up being like Kensington and Chelsea where Grenfell happened – we’ll have huge reserves whilst people who rely on interventions suffer and have to put up with well below par services and help.
The politics of fear – pure fascism from Hunt and Sunak – is what is driving this if you ask me.
Karl Whelan had some interesting points on the Fiscal Black Hole. Especially the interest on reserves… ECB and Japan pays interest on marginal reserves. The reserves that actually are working within the ECB and BOJ,,
https://karlwhelan.com/blog/?p=2132
The slight of hand is incredible imo!
Very well argued
I’ve been here since the Cappuccino Economy. I’m non partisan to party or economic pretext and I thank you.
Thank you for this Patrick.
One of the key statements in this is this:
‘So that’s the black hole. It is not in any way a pressing matter in which the UK is on the brink of “running out of money”. It is a consequence of an arbitrary rule the government has imposed upon itself with its specific form having been set just over a year ago. Had the UK government set a longer time horizon for the net debt ratio to be falling or used a different definition of the net debt ratio, the black hole would be smaller or perhaps non-existent.’
So the Government has shot the country in the foot with an artificial concept of a ‘disaster’ – a threat – to justify its actions.
Fascism, fascism, fascism again folks.
Mr Houlden,
This is an excellent, trenchant piece of work by Karl Whelan. It contains a forensic dismantling of the ‘fiscal rules’ (a key factor in the elusively protean Black Hole); not merely their inherent instability (they are changed at will), but even in the inconsistent outcomes in the OBR’s own interpretation of their application.
For those who have not had time to read it (or read it all), here I wanted to refer to two points that summarise Whelan’s conclusions on the payment of interest on reserves by the BoE to commercial banks, because they reflect on the discussion on reserves in this thread, the ‘tiering’ of interest payments on reserves, and even on the Bank of Japan: “The government doesn’t need to compensate all the reserves a bank holds. It just requires that the marginal pound of reserves that a bank holds would receive this compensation. This “tiering” approach has been used by both the Bank of Japan and the ECB, albeit in the context of negative interest rates, so that only some of the reserves that banks held with them were subject to the negative rates. But the logic that it was the marginal reserves that mattered for market rates worked perfectly.
…. there is no monetary policy rationale for compensating all reserves. In other words, deciding to pay interest on all reserves is the Bank of England stepping into fiscal policy, rather than sticking to its monetary policy mandate.”
It is interesting that Whelan should refer to the BoE straying into fiscal policy, because there has been a tension between BoE independence (over interest rates) and Government economic policy; a serious iddue distorted and misdirected, perhaps too easily by the Truss-Kwarteng bungled budget. We are now invited to see the Sunak Government as simply protecting BoE independence in pursuit of ‘stability’; which of course pleases the markets, even if they have no strong convictions, or even support, for austerity. But I wonder whether in fact this very subtle, discreetly unobtrusive subservience of government rather signals a deeper (if fragile) shift in the delicate balance of economic power between them, from Government to Central Bank (at least as representing the sanctified Priesthood who can alone interpret the sacred text of the markets); which by happenstance allows, even unconsciously the BoE to extend its influence more widely over economic policy.
It has always been assumed that central bank independence would not ever impede the independence of sovereign Government economic choices. Can we really say that now?
Excellent points
This discussion reminds me of Richard Werner’s ‘Princes of the Yen’ (2003) – and the film – and how an independent central bank under the cloak of supposed ‘objectivity’ can act politically.
In that case and this, the banks seem to be responding to the needs of an outside influence – an element of ‘capture’ is present.
I think as Richard pointed out in a past post, some sort of power struggle was taking place between Bailey and Truss simply because the latter decided to ignore expert advice or just work unilaterally.
But it also shows us just how poorly the whole situation was managed by the Tory government under Truss. I mean – who rules really?
Is it impossible to sack the governor of the state-owned bank – cod independence or not?
And we have a central bank that is hurting people, apparently without any accountability at all! They act as though they are innocent and above it all. Far from it.
You mention that the Treasury covers the BoE for losses from QE and in return takes the profits from them. This came up last week and I have not seen you write about it but maybe I missed it – part of the details around the budget were that according to the OBR the Treasury is expected to have to pay the BoE a total of £133bn up to 2028 to cover the QE losses and according to the coverage of this the reason is because of George Osborne deciding to implement what is described as a clever accounting trick that has backfired, where in 2012 he decided that the government should get the profits from QE in return for covering any losses, and after getting £120bn in profits they are now starting to make a loss. This appears to me to not match up to what you are saying when you say ” the terms of the indemnity are absolutely clear and have been known ever since QE began” and that “it has also always taken the profit from them as well (albeit with a delay in early years).” Also, I know you were calculating something that was related but slightly different but this £133bn is similar to the £136bn you calculated for the excess interest payout for the reserves.
I understand that this profit/loss is based on the difference between the interest the Bank gets on its gilt holdings and what it pays out in interest on commercial bank reserves, and now that interest rates have risen above gilt returns the Bank is going to start making a loss on its holdings, but I am still a little confused by this. According to the coverage, before Osborne’s change the income that the Bank got from its gilts were kept by the Bank in an isolated holding and were not accessible to the Treasury. I don’t fully understand what this means – what was going to happen to this money and what was its purpose, was it just going to sit there indefinitely not doing anything or was the Bank going to spend it on something? The coverage suggests that Osborne got greedy and wanted this profit to reduce the deficit but now this has backfired and the Treasury has to cover the losses, but if the change hadn’t been made and the Bank would be liable for the losses I don’t understand how the Bank would be supposed to cover these losses – I know the government has an account with the Bank through which the Bank funds the government, but if the Bank was liable to cover the losses and not the Treasury then I do not understand how the Bank could cover its own losses in a way that would be different to how it now covers the Treasury’s losses by funding the Treasury.
Another thing I am not sure about: the Bank holds gilts, which get returns, and when these yield a profit that goes to the Treasury, but maybe I am missing something but I thought it was the Treasury that was paying the returns on those gilts, so the Treasury was making a profit by paying the return on gilts and then collecting that return back? Am I missing something here?
This is all being used as a reason for why QE was wrong and a justification for why it’s important to reverse QE as it is portrayed as a short-term gain with a bigger long-term cost to the government and now that cost is due and so QE is a bad idea as overall the costs outweigh the benefits.
Bloomberg has covered this including an article just before the budget where they went over the background details
https://www.bloomberg.com/news/articles/2022-11-11/uk-s-fiscal-hole-deepens-on-osborne-s-decade-old-accounting-ploy
and then another article after the budget where they gave the update of the OBR’s figure of £133bn
https://www.bloomberg.com/news/articles/2022-11-17/uk-faces-133-billion-bill-from-boe-qe-wiping-decade-of-income
I think this actually increases the importance of the argument you are making. You are saying we are paying £27bn a year to banks that could go somewhere much better such as the NHS, but it’s also important to make the case for reducing the payout for reserves on the basis that this payment is being used to criticise the overall use of QE, which you have long championed as a valuable tool. Alongside the classic of QE is bad because you can’t just print money or you’ll end up like Zimbabwe/Weimar, we now have QE is bad because it’s costing the Treasury and therefore taxpayers £26bn a year (and it will be more if as expected the Bank increase interest rates), and so therefore QE was a big mistake and we have to reverse it. It doesn’t matter if this isn’t an accurate representation of the truth, if the right-wing media push this narrative then enough people might believe it. It’s therefore important that you make the case that we don’t have to pay such a large amount of interest on those reserves as this takes away the argument that QE’s costs are bigger than its benefits and so it should be reversed and not used again.
Simon
I have intended to answer this for days and have felt too tired to do so
In essence the stories are total nonsense
There is a) no reason to sell bonds at a supposed loss b) there is no loss because this is a purely internal transaction to government c) the loss was because the BoE has deliberately inflated interest rates. So the loss was planned and desired
I hope that will do
Richard
Richard,
Huge thanks for such a thorough article, especially given how you are feeling. Now listen to your body – you are needed fit and well. There’s no danger of there being a lack of issues to discuss when you are better.