In recent years the Bank of England has become a soft target for politicians. In 2022 Liz Truss, in the run-up to her very short premiership, suggested the Bank should shift from its 2% inflation target and be given an economic growth target instead. In the build-up to this general election Reform UK has floated the idea of ending the Bank of England’s practice of paying interest on deposits from commercial banks and reserves held in the course of quantitative easing.  In a rather odd coincidence, former Labour Prime Minister Gordon Brown has recently made an identical proposal. Present Shadow Chancellor, Rachel Reeves, appears much less keen to implement the idea if Labour is elected.

This article explores what such a system might entail for the Bank of England, its potential benefits and drawbacks, and draws comparisons with similar implementations by other central banks.

How would the Proposed Tiered Reserve System work?

Under the proposed tiered reserve system, the Bank of England would categorise bank reserves into different tiers with varying interest rates. A minimum required amount of reserves would earn no interest, while reserves beyond this threshold would earn interest. This system contrasts with the current uniform rate paid on all reserves at the moment.

One of the principal benefits of a tiered reserve system is cost savings for the government. By paying no interest on required reserves, the government can significantly reduce the total interest payments to banks, resulting in substantial cost savings for the Bank of England and increasing the size of the rebate the Bank pays to the UK Treasury.

In terms of monetary policy effectiveness, the interest rate on excess reserves can be adjusted to influence short-term market rates, providing the Bank of England with a more precise tool for implementing monetary policy. From a financial stability perspective, ensuring banks hold a minimum level of reserves promotes stability. Additionally, interest on excess reserves provides banks with an incentive to maintain adequate liquidity buffers, providing a buffer against financial shocks, and thereby reducing the risk of sudden bank failure.

Despite these benefits, there are potential drawbacks to consider. Implementing a tiered reserve system would require banks to adjust their reserve management strategies, which could entail costs and require significant time to adapt. While excess reserves earn interest, the required reserves do not; this might negatively impact the overall profitability of banks. Such a policy change might lead to unpredictable behavioural changes in banks, potentially concerning lending practices.

How do other Central Banks Manage Reserves?

The European Central Bank (ECB) has adopted a two-tier system for the remuneration of excess reserves. Under this system, a portion of bank reserves is exempt from the negative deposit facility rate, reducing the financial burden on banks while maintaining negative interest rates to encourage lending. This approach has mitigated the adverse effects on bank profitability and supported financial stability.

The Bank of Japan uses a similar approach which is more elaborate with a three-tier system: a positive interest rate for the Basic Balance, zero interest for the Macro Add-on Balance, and a negative rate for the Policy-Rate Balance. This system balances incentives for banks to hold necessary reserves while encouraging lending and investment to support economic growth.

The Swiss National Bank (SNB) exempts a certain quantity of reserves from negative rates, similar to the ECB. This system helps protect bank profitability and ensures sufficient liquidity, while the negative rate on excess reserves discourages unnecessary reserve accumulation. Denmark’s central bank, Danmarks Nationalbank, also exempts a portion of reserves from negative rates, aligning with the strategies of the ECB and SNB. This system supports the central bank’s monetary policy while minimising negative impacts on the banking sector.

Final Thoughts…

The proposed tiered reserve system for the Bank of England would be a major shift in monetary policy implementation and reducing costs for the central bank to allow it to pay a greater return to the treasury. By differentiating interest rates on types of reserves, the Bank of England can create for itself a dual ability to incentivise panel banks to hold deposits with the central bank but further balance this with motivation for panel banks to lend money to investors and support wider economic growth. Lessons from other central banks reveal the potential complexities and impacts on bank profitability must be carefully managed.