Fig 3: Amount of money transferred to banks is a significant portion of debt costs and GDP

Transfer to banks per financial year where required reserves are not paid interest, in £bns, as a % of government borrowing costs and as a % of Gross Domestic Product.

Note: NEF analysis of Bank of England (2023) and Office for Budget Responsibility (2023) data. We assume £20bn/​year of active gilt sales. We model reserve requirements as a fixed portion of M4, where M4 is reduced by £0.8 for every £1 of reserve money withdrawn. Non-required reserves are modelled to not fall below £350bn. Interest is not paid on reserves up to the reserve requirement and after this July market expectations are used to calculate interest payments.

While raising interest rates the Bank is also unwinding QE;QE-bought bonds are maturing and not being replaced, and the Bank is making active sales at the same time. These active sales also cause losses for the Bank of England, as interest rates are higher than when QE was carried. The Bank is receiving less for the sale of bonds than it paid for them. This cost is covered by the Treasury and was estimated to cost £10bn a year in March 2023 by the OBR. With higher expected interest rates now this figure is likely even higher.

Some have speculated whether the unwinding of QE will also tighten monetary conditions. The Bank has said this is not part of its inflation targeting strategy and there is little evidence on what effects this might have. However, raising reserve requirements has often been used by the UK historically and central banks across the world to tighten monetary conditions. Such an approach in the UK could reverse the impact monetary tightening has on fiscal costs and bank transfers. Raising reserve requirements while tiering reserves would make government debt cheaper and stop billions going to the banking sector.

The counter arguments

Transitioning to a tiered reserves framework does have certain implications.. Most notably, moving towards a tiered reserves framework is criticized for being an implicit ​“tax on credit intermediation”, or a ​“withdrawal of a subsidy”. This is because, while the central bank reserves created to fund QE payments are an asset to the banking sector, the payments would have gone into deposit accounts of bank customers which are interest bearing liabilities.

Once the Bank ceases to pay interest on a specific fraction (or all) of the reserves, and market rates are above zero, commercial banks will find themselves with interest-incurring liabilities (customer deposits) but without interest-generating assets (like central bank reserves) to offset the interest due and the administrative expenses of such deposits, particularly those formed through QE. The interest paid to banks is required to subsidize the payments for banks interest bearing liabilities, the removal of this subsidy would either eat into banks’ profits or force banks to pass on the cost to their customers – or so the argument goes.

This objection is overstated. Firstly, of the interest paid to banks on their reserves, only 43% is being passed on to savers through interest rate rises on their savings accounts. The majority of interest payments — 57% — go in the banking sectors bottom line. Therefor more than £100bn by July 2028 would be transferred from the government directly to the banking sectors profits.

Secondly, as reserve requirements reduce the available liquidity to the banking sector, there will be intensified competition between banks to attract savers. They would aim to keep savers to maintain their market share and mitigate the risks of deposit flight, especially if they have a limited and concentrated client base. Therefore, this would potentially strengthen savers’ position. Regardless, to make a profit banks are more likely to pass higher interest rates onto borrowers rather than savers. In that case, raising the interest rate for borrowers encapsulates the very logic and primary intent behind increasing interest rates. As such, a tiered reserve system might function as an inherent stabilizer for ensuring price consistency. By enhancing the Bank’s intended tightening effect of rate rises, it becomes a deliberate design advantage, ​“a feature not a bug” as stated in an IMF working paper. Such a change would essentially make the monetary transmission mechanism stronger and the bank would have to weigh this up with every interest rate decision. To have the same effect a lower interest rate may be appropriate.

Another issue that warrants consideration is the implications the removal of a flow of income to banks may have on financial stability. This is an important concern, the materialization of risks would also reflect the implications of higher interest rates for financial stability more broadly and the capital adequacy of banks. However, net interest margins having risen sharply over the past year, helping to reduce the possibility of financial instability. If financial stability were still a concern, then we could introduce reserve requirements and the tiered reserve system conservatively and only gradually – whilst the Bank would also have to stand ready to lend out reserves if there appeared to be shortfall (signaling a partial return to the previous corridor interest rate system).

Conclusion
Fighting inflation and monetary tightening will entail a significant income transfer to the banking sector at the government’s and the British public’s expense. This does not have to happen. As the LSE professor Paul De Grauwe has shown, central banks made profits not losses when fighting inflation in the 1970s. The current monetary framework comes at an exorbitant cost and is historically unprecedented.

An alternative to our tiered reserves regime is to directly tax the banks. Positive Money have made such a proposal that merits consideration. Another option would be to implement certain financial regulations that force banks to pass a greater portion of the interest they receive to savers. A tiered reserve system is primarily different to these proposals as it aims to tackle the issue at it source. Our position is that all policy alternatives and reforms – including the status quo – should be considered to save the taxpayer billions.

The transfer of £34bn a year in 2024 – 2027 to the already significantly subsidized banking sector represents a substantial portion of public funds, equivalent to 2.8% of total government spending. Unlike traditional government expenses that undergo rigorous democratic oversight, debate, and often come with various conditions and reporting procedures, these income transfers now need to be met with similar scrutiny.

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