In last week’s Autumn Statement the Chancellor announced a £55 billion in tax rises and spending cuts that will take taxes to record highs as well as putting intense pressure on creaking public services. A key reason for this deterioration in the state of the public finances is the rising cost of servicing government debt, which has been exacerbated by the aftereffects of Quantitative Easing (QE) – the extraordinary monetary policy deployed since the financial crisis to help kick-start the economy.
On Tuesday the Bank of England announced that it had been transferred £828 million by the Treasury to the tune of £828m in October to cover higher interest payments it has had to make to banks, the first tranche of an expected £133 billion bill to be paid over the next five years. Should the Treasury take action to cut the interest bill and thereby avoid a large chunk of the planned public spending cuts?
The cost of QE
Quantitative Easing involved the BoE purchasing government debt through a special vehicle called the Asset Purchase Facility (APF). Banks selling bonds to the BoE during QE received payment through additional reserves in their accounts with the BoE. There was thus an excess of reserves in the system above the level banks would have typically wanted to have. To ensure that interbank lending rates remained close to bank rate, the BoE paid interest at bank rate on reserves, thereby putting a floor on interest rates. This has effectively shifted a large fraction of UK government debt from fixed-rate to floating-rate borrowing. While the bank rate remained low in recent years (and below gilt rates), the cost of paying interest on reserves was small and far less than the income from coupons on the gilts held in the Asset Purchase Facility. The APF was therefore very profitable: the BoE has so far transferred £124 billion to HM Treasury.
Since the Bank rate has started increasing, however, this fiscal tailwind has become a headwind, with interest payments now beginning to exceed the savings on coupon payments. And as bank rate increases further, so will the cost of paying interest on reserves. Even with recent reductions in expectations for the bank rate, these costs are expected to run into the tens of billions annually: the OBR expects them to peak at £37.2 billion in 2023–24. At a moment when the public finances are under intense pressure, attention has fallen on whether anything should be done to address these costs. There are three reasons to consider taking action.
First, this transfer to banks is not justified by their own activities or an outcome of their business decisions, but merely a lucky revenue windfall as a by-product of extraordinary monetary policy. This implies a strong case for the government to recover the payments somehow.
Second, these payments mostly end up as profits for banks since the banking sector is less than fully competitive, deposits are ‘sticky’ as depositors fail to shop around for the best rates and banks may be content to see their share of deposits fall. This means it is unlikely that interest paid on banks’ reserves will be passed on to depositors in full.
Third, it’s important to set the right policy framework for the future. Since it is likely that QE will be repeated in future periods when interest rates hit the zero lower bound (which is likely to happen more frequently in a low real interest rate world), and that these periods will also be followed by periods of increasing bank rate when remuneration of reserves will be costly for the taxpayer, it makes sense to create a coherent policy framework to deal with this situation.
Why pay interest on reserves?
There is no a priori reason why reserves should be remunerated. Reserves are money, more akin to notes and coins than government debt. They do not have to be repaid at any time (indeed, it is not clear what they would be ‘repaid’ with), there is no credit risk, the interest rate is set purely by fiat and there is no way that the banking system collectively can reduce its holdings. Consequently, arguments that failing to pay interest on reserves would constitute a ‘default’ on government debt seem inappropriate. Traditionally, the BoE and most other central banks around the world did not pay interest on reserves and the BoE has only done so since 2005–06.
But failing to renumerate reserves would break the transmission mechanism of monetary policy by decoupling interbank interest rates from bank rate. In an era of excess reserves created by the QE programme, simply moving back to a system where reserves are not renumerated is not an option.
Could tiered reserves be a solution?
One alternative recently proposed by the New Economics Foundation is to only pay interest on each bank’s reserves above a certain level at its policy rate (‘marginal reserves’), whilst the remainder would be not be remunerated, or only remunerated at a lower rate. This would leave the interest rate on reserves unaffected at the margin, allowing monetary policy to continue to function properly. A key attribute of such a policy is that there is significant flexibility in designing its features, both in terms of the size of each tier as well as the degree to which each tier will be renumerated, allowing the BoE to minimise financial stability risks. However, there are two main problems with tiering, relating to economic credibility and financial stability. First, since the treatment of reserves is the Bank’s decision, government intervention to push the Bank to change its policy in a way that would clearly benefit the Exchequer risks undermining Bank independence. This is a particular concern at a time when the public finances are under strain and is risky in the context of a government seeking to regain economic credibility.
Secondly, from a financial stability perspective, a system of tiered reserves would reduce the amount of liquidity in the system. With banks forced to maintain a certain level of reserves, they would cease to be a liquid asset they could draw upon if necessary. Banks might then in turn extend less liquidity to the market, potentially causing wider financial instability.
Would a windfall tax be better?
A better alternative to tiering that achieves the same economic goal could be to impose a tax on banks broadly equivalent to some fraction of the additional income they receive from reserve remuneration. This would avoid the two main concerns associated with tiering.
A tax could be designed such that each bank would be faced with a levy based on its reserve levels at some point before the tax was announced and the current level of the bank rate. Being imposed directly by the government, a tax would avoid infringing BoE independence and pose no threat to financial stability.
Paying interest on reserves represents a significant increase in banks’ income that does not result from any improvement in the services they are offering their clients or investment choices they are making. It is, in other words, a subsidy to banks that lacks any clear justification. Taxing that subsidy away appears to be the best option for removing the windfall from banks.
Given the significant sums that could be raised, which may render a significant chunk of the chancellor’s planned spending cuts unnecessary, this is an option that would be worth the Treasury investigating further ahead of next year's Budget.