INTEREST ON RESERVES -- FALLACY AND FACT / MACLEOD FINANCE

Interest on reserves —fallacy and fact

The UK’s Reform Party says that the Bank of England should not pay interest on reserves, potentially saving £30 billion a year. The BoE resists it. Which is right?

ALASDAIR MACLEOD

Richard Tice, Reform’s Deputy Leader accused the Bank of England of enriching City institutions to the tune of billions of pounds at the taxpayers’ expense. 

But this is typical political-speak, designed to appeal to the masses with a simple argument. 

Naturally perhaps, The Bank of England has rejected Tice’s proposal.

This was not an issue until the BoE, under pressure from the government of the day and the actions of its central bank group-thinking peers, started to buy up its government’s bonds in the market — otherwise known as quantitative easing (QE).

The objective was to stimulate the economy by creating extra credit. 

The way QE worked was that pension funds and insurance companies holding gilts would be offered attractive bids for their holdings to encourage them to sell. 

Those which sold would then reinvest the proceeds, created out of nothing, into other bonds or equities to offer them a better return over the whole transaction.

Because these non-bank institutions do not have accounts with the BoE, the transactions are handled through their commercial banks. 

Therefore, payment for the QE bonds is credited to the selling institution’s bank. 

And the selling institution’s bank account is credited to match.

The key to understanding the transaction is that the BoE operates in the same way as any commercial bank. 

In return for delivery of the QE bonds, the BoE enters into a credit obligation in favour of the pension fund’s banker, on which interest is paid just as if it was a transaction between two commercial banks.

What would happen if the BoE didn’t pay the prevailing rate of interest, as Tice demanded?

Remember that the correct definition of a bank is that it is a dealer in credit, creating credit under loan contract for a higher interest rate than it pays to its depositors. 

That is the core reason for any bank’s existence, the rest being just bells and whistles.

If a central bank refused to pay interest, commercial banks would be reluctant to act for clients selling bonds to the central bank because it is not in their interest to do so. 

A possible remedy is that a central bank could force commercial banks to hold an increased portion of their assets in required reserves. 

But this is turning the clock back to pre-Basel 3 days, when credit creation was regulated by managing the level of required reserves instead of the Basel 3 risk-based approach.

Furthermore, there is a wider operational consideration. 

When management of required reserves was in the monetary toolbox, if it became known that a bank was obtaining extra credits from its central bank it was suspected to have liquidity issues. 

Consequently, banks avoided what was known as the discount window, which was the source of this additional credit and the same thing as a short-term deposit. 

Basel 3 changed that by listing deposits at a central bank as Level 1 zero-weighted high quality loan assets.[i]

The change in emphasis meant that the Bank of England could operate freely in money markets without creating stigmas for their counterparties. 

It was then able to influence wholesale rates directly, preventing rate spikes in times of stress. 

It has been the principal reason behind money market rate stability in recent years. 

All this is permitted because the BoE pays interest on its liabilities to commercial banks: in other words, their reserve accounts.

Clearly, political populist commentary over interest payments on bank reserves, “enriching City institutions to the tune of billions of pounds at the taxpayers’ expense” is based on ignorance of the way things actually work. 

There is much else to blame the BoE for, but paying interest on reserves is not one of them.