It never seemed likely that the arcane subject of the payment of interest on commercial banks’ deposits with the Bank of England would become a topic of conversation along the Dog and Duck. But this is apparently what happened after Nigel Farage last week discussed the policy of not paying such interest on the TV show Laura Kuenssberg.
I have written about this subject before, but now that it is playing a role in the election campaign – it is an important reform policy – it deserves further attention. Does this offer an attractive option for a cash-strapped government? (Be warned: this is not a topic for the economically disadvantaged.)
At issue is the Bank of England’s practice of paying base rates on deposits from commercial lenders on Threadneedle Street. The cost of this scheme has increased due to quantitative easing (QE) and because of the way the system is set up, taxpayers are footing a significant portion of the bill.
The Bank of England’s balance sheet was massively bloated by the QE programme. During 2006-2007, commercial bank reserves at the Bank averaged only around £20 billion. In contrast, they currently stand at well over £700 billion.
Much of this money printing took place at a time when interest rates were at historically low levels. With the base rate currently at 5.25%, paying interest on banks’ reserves costs the exchequer around £40 billion.
Some critics argue that stopping the Bank’s interest payments would be impractical and/or extremely dangerous. Yet the Bank only started this practice in 2006. Moreover, in many other countries today the central bank does not pay such interest, or only on part of the reserves of the commercial banks.
There is some confusion about the exact amount of potential savings from not paying interest. Some argue that the net savings would be only about half this amount because the Bank earns interest – albeit at a lower rate – on the bonds it holds, financed from the reserves of the commercial banks, which contribute to the interest payments to the banks.
This confuses two things. Ceasing interest payments on bank reserves does not imply a reduction in the Bank’s bond investments.
Nevertheless, it is true that the amount of interest saved is expected to decrease over time. As interest rates are reduced, the cost of paying full interest on banks’ reserves will fall. Moreover, reserves will also decline as the amount of bonds the Bank holds gradually decreases, or is forced by the policy of quantitative tightening (QT).
Some critics have argued that if commercial banks did not receive interest on their reserves, market interest rates would fall to zero as banks would try to rid themselves of their excess cash by buying assets, lending money and lowering their deposit rates . Under these circumstances, the Bank would effectively lose control of monetary policy.
Yet the policy of not paying interest on the bank’s reserves has been endorsed by two former deputy governors of the Bank, Sir Paul Tucker and Sir Charles Bean, an almost-governor, Lord Adair Turner, a special adviser to the Bank, Charles Goodhart, and former chancellor and prime minister Gordon Brown.
They all recognize that there is a simple way to prevent interest rates from being forced to zero – namely by imposing minimum reserve requirements on the banks, or by imposing special deposit fees that must be held with the Bank.
The Bank should leave a reserve margin in the system over and above the minimum required to facilitate the transactions of commercial banks and cover precautionary needs.
Admittedly, it would be difficult for authorities to assess the appropriate level of these reserves, potentially leading to volatility in overnight interest rates. When bank reserves were not earning interest before the 2005 shift, overnight interest rates were indeed extremely volatile.
Believe it or not, early in my career I had direct experience with this volatility and may even have contributed to it. I worked briefly as a dealer in the real money markets. I was responsible for lending out excess deposits at the Bank and/or collecting them at the end of the day so that my bank’s reserves at the Bank remained as close to zero as possible.
I was often blamed because I had done it wrong.
The way to minimize this volatility is undoubtedly to pay interest on operational deposits above the required minimum. This is known as layering. It is the system operated by the ECB for the euro markets. To the extent that this practice is applied, the savings to the Treasury would obviously be less than the sum of £40 billion mentioned above, because some interest would still be paid. But still, what’s not to like?
Many years ago, economist Milton Friedman said, “There is no such thing as a free lunch.”
The savings for the treasury have to come from someone. Initially this is the banking sector. But the banks would not stand idly by and accept this attack on their profits. They would certainly respond by widening the difference between their lending and deposit rates, thereby shifting at least some, and possibly all, of the burden to their customers.
This is not necessarily a very desirable outcome. It would tend to divert financial flows away from banks and towards other financial channels that are much less transparent and less regulated, or not regulated at all. And it could cause aggregate demand to decline.
But in reality, all monetization methods have potential downsides. Any responsible government should assess the relative costs of different types of taxes and weigh them against the benefits of government spending. In practice, however, they are usually driven by political factors.
This measure undoubtedly has some political advantages. The people and businesses that would suffer from the higher lending rates and lower deposit rates would not easily associate their losses with the policy change. Moreover, the measure would not increase the tax burden. On the contrary, it would reduce government spending.
Is everything clear now? I have warned you. You may feel just as confused as before, but hopefully on a higher level.
Roger Bootle is a senior independent advisor to Capital Economics.