Don’t Stop Paying Interest on Banks’ Reserve Balances

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.[1]

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.

A further financial stability concern is that locking up bank assets in non-interest-bearing required reserves would aggravate 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.

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.

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).

If the Treasury wanted interest payments on reserve balances to stop, it would have to stop paying interest on the loan from the Bank of England to the Asset Purchase Facility. That would amount to a default on the indemnity that the Treasury provided to the Bank of England. The Asset Purchase Facility would become insolvent, because its solvency depends on the indemnity, and the Bank of England’s loan to the Asset Purchase Facility would be seriously impaired. The loan amounts to a very large multiple of the Bank of England’s capital and reserves, which are £5.8 billion, so that if there were to be a default, the solvency of the Bank of England, too, would be threatened. It may be argued that other central banks continue to function with negative net worth, but the Bank of England and the Treasury an accord in 2018 on a dividend formula which embodied an agreement about the purposes of the Bank of England’s own capital, which would not be served if the capital was negative.[3]

The government’s legal advisers might find a way of changing or interpreting the law so that the termination of interest payments to the APF was not deemed to be a default[4]. But whether or not it counted as a default in law, forcing the banks to accept massive interest bearing balances in settlement of payments for securities purchased by their customers, and then announcing later that interest was no longer going to be paid, would have exactly the same effects as a legal default.  If it walks like a duck, swims like a duck, and quacks like a duck, it’s a duck. The Treasury agreed to the enormous amount of quantitative easing that the Bank of England has done. 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.

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.

[1] Gerard Lyons, ‘Ministers must reassure the markets about their growth plan’, Financial Times, 7^th October 2022.

[2] In addition to the cash ratio deposits, currently 0.412% of eligible liabilities, levied on banks to provide income for the Bank of England.

[3] H.M. Treasury, ‘The financial relationship between the Treasury and the Bank of England; Memorandum of understanding’, June 2018.

[4] The terms of the indemnity have not been published.

Click here to read our blog – Should the Bank of England Lose it’s Independence?