There is concern that bank base rate increases will impact the cost of central bank reserve accounts which have effectively replaced around £800 billion of government debt. But that need not be a problem. In this video I explain how to address this issue, and solve it forever.
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I’ve watched this video and honestly, the idea you put forward is perhaps the most idiotic thing i’ve seen all year.
You start from the position of saying the the bank reserves held were “effectively gifted to them”. They weren’t – banks sold Gilts to the BoE for those reserves.
Then you miss the point of QE – which was to reduce long term rates and to increase reserves.
Why would any bank ever sell another bond through QE if all that will happen is that it gets swapped out for a much longer maturity bond with very low liquidity, and QE stops creating liquid bank reserves. It would essentially shut down banks ability to lend.
Then of course, by locking in the fixed rate of a perpetual bond at a very low rate, you are basically saying two things. The first is that you are aiming to penalize the banking system, by removing their ability to earn more on their reserves.
Secondly, you are implicitly building a case for interest rates being zero for perpetuity. Which in itself is a hugely myopic idea.
Did you just think this garbage up in 5 minutes this morning, or has it taken you a longer period of thought to come up with something where you clearly haven’t thought one iota about the consequences?
Giles
The money now in commercial banks was created by the BoE – and ended up on deposit on central bank reserve accounts. The BoE is adamant that this is the correct narrative. You can argue with the ordering of their presentation – they say the central reserves were created first and the gilts sold second, and that makes no sense, because the ordering is very clearly the other way round, but what is very clear is that the increase in these balances is heavily positively correlated with QE – and that, I think is indisputable. All QE did was an asset swap at the end of the day. Your second para is incomplete.
That has reduced interest rates for now. It has also increased reserves. If that was the aim (which it was not according to the BoE, but I think their claimed logic also open to question) it worked. But you have to note that you do not project the objective of QE correctly – the aim has been low rates but not increased reserves, per see, but always either objectives, as I have discussed elsewhere. Yor third para is wrong.
And this is base money – not commercial money. The BoE calls that base money ‘the ultimate means of settlement’. In 2008 there were around £20bn of such reserves., There are now £800bn or so. That guarantees banks should not fall over – just as the government desired: this is a buffer to help achieve that purpose created by the Bank of England, in effect.
The aim was never to boost lending capacity as no deposits are required for lending (as the BoE agreed in 2014) your claim that lending capacity would be restricted by what I suggest is simply wrong. That is also evidenced by the rapidly declining loan to deposit ratios. Your fourth para is, therefore wrong.
There is no penalty for the banking system in wart I propose then. And there is a market for very long term bonds, anyway.
And as for wanting to build in low interest rates for good – yes, why the heck not?
So no, doing another asset swap of a very particular and restricted sort to limit government exposure and achieve a low interest rate goal may be something you may not agree with, but it’s not what you are claiming it to be. And it would help if you got your facts right.
Richard
Now
It has massively changed the composition of lending bank balance sheets which very obviously have no use for the deposited funds
But there is a claimed risk to the government from the substitution of long term rates for what some claim will be short term volatile liabilities on these deposits
Richard,
The money in commercial banks was created by the BoE, but not given to the banks. It was traded in exchange for Gilts that the banks already owned. I quoted directly from your video when you say that the reserves they had were “effectively gifted to them”. They weren’t.
QE has a dual aim, according to the BoE. To reduce interest rates and to increase liquidity in the short term cash market. The combination of which should stimulate lending. Your plan would remove reserves, reducing liquidity and reduce demand for traditional Gilts – why buy them if there is a chance they get converted into perpetual Gilts at a near zero rate.
Base money supply is not £800bn. It is about £90bn at the moment. The reserves created by QE are in the broad money supply.
Extra bank reserves through QE don’t help bank stability in terms of capital adequacy or Basel 3. This is because Gilts and cash are treated almost identically for the purposes of both, and banks have sold Gilts via QE and received cash/reserves.
Deposits arent’y required for lending per se, but that entirely misses the point. Tier 1 assets are required, and lending is limited by legislation (again capital adequacy and Basel 3) which means you do need assets on your balance sheet before you can lend. Which in practice for retail banks means deposits.
You would expect the loan to deposit ratio to go UP if you didn’t need deposits to lend.
There is a huge penalty for the banking system in what you propose.
1. You fix the coupon at 0.1% in perpetuity, instead of receiving floating in perpetuity.
2. You increase the duration of the bank holdings – dramatically increasing interest rate risk.
3. You take liquid cash assets away from the bank and give them less liquid “reserve” Gilts instead. if they can be sold into the market you have immediately reversed QE, and there would be £800bn of Gilt supply which will force rates up. If they can’t be sold, they will be almost totally illiquid and therefore not worth as much as cash.
Either way you are giving banks a massive penalty. Tell you what. You loan me £100k cash, and I’ll pay you back 0.1% of that fixed in perpetuity. I assume you wouldn’t be willing to do that deal, so what should a bank be either?
Low interest rates are fine, but you can’t force them to be low just because you like them there. By saying you will fix rates at zero forever, you lose the ability to manage inflation. Unless of course you are assuming that inflation will be zero forever, and saying rates will be zero forever has no effect on inflation expectations. Surely though nobody is that stupid?
What you are proposing would reverse QE. Clearly you haven’t realised that. You would remove liquid bank reserves and replace them with illiquid long term Gilts if they can’t be sold to market, or if they can you would flood the market with highly illiquid long term Gilts which would force rates higher again.
It rely defies logic that you can’t see what likely effects there would be from doing. It is literally insane. Which is I suppose why nobody else has ever ventured such an idea.
This is kind of tedious….
a) The BoE created the money. The banks got it. There was a trade, but they were conduits. It ended on their balance sheets nonetheless: that’s what happens when the BoE creates new money.
b) The funds are specifically stated time and against to be reserves used for inter-bank settlement by the BoE. They are base money – which you wholly incorrectly define as notes and coins – and which the BoE specifically say (Quaterly Review 2014, Volume 1, page 16) are base money
c) The binds I define would only be available to banks_ they would be an assets swap. They could be used for inter-bank settlement – and yes, I did forget to say that in the video. They would be available fo the identical use that is made now of these balances – which are QE created and are not broad money
d) They still count for Tier 1 – all your arguments on lending fall away
e) I merely suggest a fixed interest rate – that is literally it. Nothing more, or less.
f) Where is the penalty in that for a bank that never wanted these assets in the first place – but ended up with them, and as they’re base money can’t get rid of them?
g) And no you don’t lose the ability to control inflation by having fiex low interest – which is a fact (whatever you say, and the inevitable long term trend – which suggests negatri8ve rates are very firmly next, as I note the OBR agrees)
h) No this would not reverse QE: the assets purchased by QE are already in effect cancelled and they are not being resold again. I am defining a new asset group to fix the rate on reserves held for inter-bank settlement
i) Sure this is insane to you – but then you can’t even define base money correctly
And please don’t try a third time – you have got so much wrong I will not be posting anther comment from you
Here we can clearly see a good reason for my not volunteering (to general relief, I imagine) to be part of the QT50. If people like Giles are in it, and they doubtless will be, I can see show after show made pointless while parties argue over basic definitions. People would have to have some accurate understanding of economics to make the premise worthwhile and how would Beeb producers be able to judge that? They’d be more likely to pick anyone they thought had telegenic qualities. It’ll be entertainment, not education. I can sense a circus coming on.
Hi Richard, I must admit to being surprised that the BoE pays 0.1% interest on the QE bonds it has repurchased from financial institutions – I don’t see the logic here at all – surely those bonds have been removed from ownership of that private sector? Have I totally misunderstood what is going on? Thanks
Bank deposits remain – held by the banks with the BoE – being the net consequence of money paid for those bonds, in effect
I see, it is the deposit with the BoE rather than the actual bonds – But in that case surely these deposits are being used to purchase more bonds , in this case the £394 billion that Sunak has now borrowed ? Thanks
The deposit is in effect the payment for the bonds
There are in effect no bonds on sale right now – the issues are covered by continuing QE at present
No. I don’t think this makes any sense at all.
First, it’s circular (at a “big picture” level). QE is all about buying bonds (adding reserves); why would you want to issue (drain resrves)? Just stop QE and you get the same result….. which I suspect is NOT what you want.
Second, you talk as if the reserves were “given” to the banks as a gift. No, they are result of the BoE buying gilts from investors/gilt dealers who will then be credited with cash in their account at a UK bank….. who in turn deposit it at the BoE because there is nowhere else to lend profitably. On the bank’s balance sheet it will have an asset and liability that match in maturity. If you start getting banks to buy these perpetual bonds they will have to hedge the interest rate risk (by paying in the swap market) which would offset the downward pressure in rates that QE is delivering and eat up bank capital.
Third, what problem are you trying to solve? If you are worried about paying higher interest rates on reserves then don’t! there is no requirement to do this – just say to the banks “put your money elsewhere if you don’t like it” – and they can’t because there is no credit demand in the economy.
Finally, if eventually rates rise this is a GOOD thing. It means that the economy is recovering an credit demand needs to be restrained….. a high quality problem to have from where we are sitting now.
Clive
Good points – but the reality is that what has happened is that deposit to loan rate of banks has doubled as a result of this
What is the maturity issue then?
And what is the issue? Simply avoiding having to avoid paying increased rates on this sum if rates increase – which I would prefer that they did not for many macroeconomic reasons, but which they could
Third, these reserve balances are virtually impossible for the banks to reallocate these balances as you suggest – they are base money
But if you wanted the problem would be solved by saying base rate does not apply to base money – but I think that is harder
So how else to hedge that risk. Your suggestion?
Richard
The short answer is that there is no hedge. Looking at it in a narrow sense of the BoE balance sheet the have long dated fixed assets (gilts) and short dated floating rate liabilities (reserves). If the rate paid on reserves goes up it is going to cost. Any effort to hedge this risk defeats the purpose of QE.
Do I care? No.
The first question why would interest rates rise? Peston and others seem to think that interest rates are like the weather — beyond our control. They are not. The BoE sets rates. At the short end the MPC picks the “right” policy rate and the BoE operates to guide market rates to this level and paying interest on reserves is one tool that they use. At the long end they use QE.
Do note that paying interest rates is a relatively new idea (2006 in the US, not sure about the UK). In the past, banks have struggled to keep reserves at the required minimum level because in a “normal” growing economy there is always a need for more reserves in the same way that a bigger machine need more oil to lubricate the moving parts. Consequently, all the “action” in open market operations was adding reserves through repo or a coupon pass (the US term for outright purchases of US Treasuries by the Fed before QE was even thought of). Without addition of reserves interest rates would have spiked higher to the detriment of the real economy.
The world has changed — for all sorts of reasons. QE delivered a huge boost to reserves in the hope that it would promote investment in the real economy (it didn’t). With no growth and no inflation there is now no longer such a strong natural demand for more reserves so now all the “action” in open market operations is paying interest on reserves to prevent market rates falling too low.
So, if the BoE wishes to raise the level of rates paid by the wider economy (for some reason) then I do accept it has to raise the rate that it pays on reserves.
But back to the original question “why raise rates?”. Presumably because the economy is over heating and credit demand is strong and inflationary pressures emerge (we will leave the issue of balance between monetary and fiscal policies to control inflation for another day and assume that rising inflation does need an interest rate response). In which case increased tax revenues will dwarf the rising interest costs.
Who gets to receive this interest? Deposit account holders (as banks for competitive reasons will have to raise rates paid to depositors). If that is a problem then it could best be sorted out through the tax system.
I do fear that the low level of interest rates is creating asset bubbles and problems for the future but we need to get away from the idea that everything is controlled by a single thing — the policy interest rate. How about credit controls? Differential rates for different activities? Bank capital requirements based on “usefulness” not just risk. Etc.
I suspect that QE might be better operated by rate targeting rather than quantity (although it would not be QE then!). Rather than pushing long term gilt yields to absurdly low levels with an arbitrary volume of buying, the BoE should be saying that we will prevent yields rising above a certain level — whatever the government chooses to issue. In this way, the real economy is protected against the risk of rising rates, savers are not pushed into excessive risk taking and speculators can’t borrow for free.
Sorry for the long rambling reply. Weather is wet and I have nothing better to do!
I have had another go at https://www.taxresearch.org.uk/Blog/2020/12/04/the-bank-of-england-balance-shgeet/
“Finally, if eventually rates rise this is a GOOD thing. It means that the economy is recovering an credit demand needs to be restrained….. a high quality problem to have from where we are sitting now.”
I have a simple question. Some Government ‘borrowing’ is borrowing (setting aside the esoteric journal entries that transfer money as value between the mystical and metaphysical as discussed in this thread above – I do not wish to go there, and do not have a practitioner’s subtle appreciation of the nuances). That aside, as interest rates rise the cost of servicing the debt also rises; this is probably sufficently far off to be almost a theoretical matter in policy planning terms, neverthless it is an issue essentially of substance for governments to contemplate (like long-term pandemic planning), is it not?
May I develop that thought, albeit tangentially?
1) On the issue of mandatory commercial bank reserves, the BofE policy, reformed 18th May, 2006 is quoted here: “The introduction of reserve accounts, held by commercial banks at the Bank, on which the official Bank rate is paid. The reserves scheme is voluntary and members undertake to hold a particular target balance not every day but on average over a monthly ‘maintenance period’.”
Presumably both the decision to make them voluntary and to pay interest is itself voluntary, a decision which was presumably made by the BofE?
2) Does the discussion above not ignore the issue of just how reliant investors are on ‘safe assets’, and on interest-bearing gilts, or presumably TBs? Here I am thinking of the major Pension Funds that rely (in part at least) on Gilts in order to pay pensioners? I understand that there have been occasions when BofE reverse auctions have not been successful, even when offering a very good market rate, to induce pension funds to give up long dated gilts, because they prefer both the safe asset, and the interest?
Why do we need to pay any interest on reserves held by the BoE? Surely the creation of all these new reserves is in itself helping bank liquidity sufficiently ,without having to pay interest to the banks to hold it on top, which as you say is yet another govt subsidy to the banks. Banks are supposed to be in the business of lending money not sitting back and saving it.
Paying interest on reserves like this only started to happen post 2008 when the govt sought to help the banks sort out the liquidity mess they had created. Prior to that no interest was paid to banks for reserves held at the BoE.
I am seeking to mitigate this
You will see that there are those who strongly disagree with the objective
I admit I cannot see why a further and very particular asset swap is such a big deal – effectively ensuring that these assets are retained for the purposes of settlement and on reserve for that purpose at this rate in perpetuity
Others diasgree
In the scheme of things it isn’t a big deal I agree, this is a bit of a side issue.
But when people see an EXTRA £800 million a year(on top of interest we pay for previous QE and existing reserves) going to a sector that scarcely deserves another state handout, people quite rightly get a bit hot under the collar. We have mandatory capital reserves for banks and there are now plenty available reserves sitting idle because of QE, so the banks will have little problem settling aside capital buffers or with settling daily with each other, that in itself is doing a job(one that is admittedly secondary to the purpose) so why pay any interest if it is achieving that goal anyway?
It is a big deal. If gilt yields rise to 2% (ie a real yield of zero – a reasonable working assumption for the long run rate) the the price of a 0.1% perp would fall to 5% of face value! If you did this on GBP800bn it would be a loss of GBP720bn. Market capitalisation of Lloyds and Barclays are each about GBP 33bn so I think you have to agree that this IS a big deal.
Which is why rates may not rise – because they literally cannit
Remember mark to market crushes vast numbers of balance sheets come what may on this basis
It also made vast numbers – including that if the BoE which under IFRS is recognising considerable gains
Actually, doesn’t this imply that constructing a Byzantine system of risk-protecting supposedly independent commercial banks is, in essence, an oxymoron; in fact a sham? Underneath all this labyrinthine transactional complexity the commerical banks cannot really stand on their own feet. Does ‘Too big to fail’ the mantra of bank rescue post-crash not simply disguise the fact that the independent commercial banks cannot in reality be independent?
You are, in effect right
I think the facility created (and only the BoE can create it) is a form of capital in all but name
I am spending the afternoon reading about this – when I should be doing other things
I would add,this will slightly help bank capital only if the banks use the interest payments as retained profits which go towards increasing the their capital buffers.
These new reserves are indeed designed to help fund the govt but a repercussion is that we also now see huge reserves sitting idle at the banks own reserve accounts at the BoE. The main benefit for the banks is just the sheer volume of new reserves created as this allows them to settle daily short falls without having to borrow at high rates, taking a great pressure of all the banks. The banks used to only hold the bare minimum of reserves prior to 2008,which proved fatal when the interbank market froze so actually this issue directly led to the 2008 crisis. The BoE introduced the payment of interest on reserves held to encourage banks to hold onto reserves for stability reasons, they also claimed it helped impose interest rate targets but I think that of limited use and it was just another direct subsidy given out rather quietly by the BoE looking after their mates in the City. The BoE could just as easily imposed reserve ratios(which were entirely scrapped years ago), Of course the banks had stopped lending in any case, cutting down on their need to seek spare reserves so this was a questionable policy from day one
In addition QE was never meant to last for long, not only has this not been the case we have now gone on and doubled it! The banks do not really need all these reserves but they have them by default. I still see no reason for them to be paid interest on something they neither asked for nor need. Maybe paying interest on a required reserve level would be acceptable and any excess reserves held get no interest,(what else can they do with them?) which was a policy of the Fed in the past.
https://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves/
I think you have got the whole point of what I am trying to do
We need to ask ‘what is this balance sheet structure for?’
“I think the facility created (and only the BoE can create it) is a form of capital in all but name”
The relevant balances in the central bank must appear in the commercial bank balance sheets. The transactional complexity of the relationship between central bank, commercial banks and government begin to look rather like smoke and mirrors; blurring or disguising a potential unresolvable underlying dependency. Neoloberalism certainly could not afford candour on such a matter; too grievous to the ideology.
Read a set of commercial bank accounts; brimming full of references to “stress” tests. Is the reality simply one of implicit dependency?
I think it is….
Mr Richardson makes the interesting and reflective point that: “The BoE introduced the payment of interest on reserves held to encourage banks to hold onto reserves for stability reasons, they also claimed it helped impose interest rate targets but I think that of limited use and it was just another direct subsidy given out rather quietly by the BoE looking after their mates in the City. The BoE could just as easily imposed reserve ratios(which were entirely scrapped years ago), Of course the banks had stopped lending in any case, cutting down on their need to seek spare reserves so this was a questionable policy from day one”.
Should we rather be looking at the geometry of clearing bank clearing. Just how much has the process changed? Just how deep is the dependency of the ‘independent’ banks? Can we tease out what is actually going on?
I am aiming to do more on this today … time permitting …. there is a lot else to do as well
John,
My view is the commercial banks are not “independent” at all, what we have is “crony” free enterprise set up whereby the banks pretend they are independent commercial businesses, with boards , shareholders and accounts that give it the appearance of a normal commercial operation. They are in fact quasi commercial institutions ,part commercial and part government run. Martin Wolf actually makes this point well by claiming that bankers are just civil servants implementing govt monetary policy…and should be remunerated as such.
I am not for nationalising banks ,but what we have is as Mervyn King once said ,a banking system that is the worst of all kinds.
Richard,
You need a research grant that would allow you to direct a team of smart post-docs to do the burrowing, perhaps with some background connection to the Levy Institute, New York or Missouri-Kansas; or perhaps a Minsky enthusiast or clever young MMT-accountant!
But such grants are nigh on impossible to get
Academia does not ask hard questions
Still unconvinced (to put it mildly).
Totally happy if reserves carry no interest. Totally content that rates will stay low (and reserves, therefore, not receiving interest) for a long time. But “perpetuity” is longer! …. and whatever you propose has to be robust in all weathers.
When I pointed out the market risk to banks owning these perpetual bonds you seemed to suggest that this would be a reason that rates would not rise. Well, I would hate to be in a situation where interest rate policy is continually restrained by worries about bank solvency. The numbers are very big.
You also hinted that these assets/ liabilities should not be marked to market but this creates huge problems. If I transfer £1 from my clearer to another person who banks with a different clearer – what will be the movement of reserves? £1 of “proper” reserves, £1 face of perpetual bonds? £1 market value of perpetual bonds? If you start messing with reserve money you open a can of worms.
As I see it, your objections to paying interest on reserves are (A) it is an undeserved reward for doing nothing and (B) that if/when rates rise that the cost to the government will get too big.
If so, how about demanding that banks pay interest to depositors at a rate linked the rate they get on reserves? That would take away the free lunch.
As an MMT-er I would argue that interest paid on reserves is just adding money to the economy…. which can be drained though fiscal policy. You could re-jig the whole tax system away from the current state that taxes capital at a lower rate than labour or you could just apply withholding tax on interest payments.
Finally, I think the problem goes away in 10 or so years after the economy starts to grow again at a rate that might warrant substantially higher rates (if ever it does). If we draw a trend continuation from 2007 of M1 versus the actual number then the current level of reserves will be about right in about 10 years time (VERY roughly).
Richard, you have lots of good ideas that I agree with, a few good ideas that I don’t agree with……. but this is, I am afraid, a bad idea looking to solve a problem that has other possible solutions…… if, indeed, it is a problem at all.
I have had another go at https://www.taxresearch.org.uk/Blog/2020/12/04/the-bank-of-england-balance-shgeet/
Mr Parry,
Thanks for this. I really like this: “how about demanding that banks pay interest to depositors at a rate linked the rate they get on reserves? “. My question is – on what grounds was that not a condition of granting the interest?
I like this, not just because it fairly reward depositors (it is their money, that is the ‘raison d’être’ of the banks after all), but I would hope, this would reduce the non-independent ‘independent’ commercial banks to their core public banking function – the only one that produces economic utility; not simply serving the exploitative, bonus-seeking, rent-seeking conglomerate financial investment vehicles they have become.
You worry me, however with your underlying stoic acceptance of the implications of this: “If you start messing with reserve money you open a can of worms”; but you did not surprise me. If there is a ‘can of worms’, post-crash was the time to clean it up. A lot of people suffered penal austerity in the expectation all the putrid cans of worms would be dealth with, once and for all.
The difficulty is that this assumes that there is a link between the two
There is not, of course
That said it ha an equitable appeal
Yes, that articulates my underlying concern. It is like tax, for example; every time a change is made to stop a clever tax accountant or lawyer inventing a scheme to avoid a tax; the change is outmanoeuvred by the tax consultants inventing a new scheme to counter it. All the most expensive, cleverest advice is loaded towards avoidance, because the financial gains from avoidance are vast. Effectively the tax system is paying for the tax consultants to be richly rewarded for developing methods to avoid the tax system’s best efforts, through ever more complex devices.
In banking the central bank is paying banks to do more than provide basic, free banking facilities to the widest community (not forgetting the elderly who are not internet proficient), and providing essential and conventional banking services to the whole community; very basic stuff. What the central bank regime seems to do is provide the conglomerate financial institution with a safe environment to pursue the expoitation of rent-seeking through ever more ingenious derivatives, far from the needs of the real community and economy.
It is noteworthy that neoliberals do not recognise the economic significance of money, per se; but preside over the financialisation of everything. MMT recognises the economic significance of money, but wish to tackle the problems of the non-financial, real economic community. How ironic.
A massive part of all this is the incomprehension most have about money
I have pretty compelling evidence on this – coming soon – the draft paper is being reviewed now
Richard, I may be being thick but if the Bank of England Asset Purchase Facility buys a gilt from a Pension Fund – or anyone else other than a bank, how does it always end up as a Bank Reserve?
Does it mean that the only way Pension Funds can sell these gilts is by asking banks to do it on their behalf?
This reflects the fact that the payment has to go to a clearing bank – like it or not – and however that payment is used the only way to provide that payment to those clearing banks is via a reserve account. If I get time I will do the double entry
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