Beware Farage’s £40bn raid on banks – there is no such thing as a free lunch

It never seemed likely that the arcane subject of the payment of interest on commercial banks’ deposits at the Bank of England would come to be a topic of conversation down the Dog and Duck. But this is apparently what has happened after Nigel Farage discussed the policy of not paying such interest on the Laura Kuenssberg TV programme last week.

I have written on this topic before, but now that it is figuring in the election campaign – it is a key Reform policy – it deserves another look. Does this offer an attractive option for a cash-strapped government? (Be warned: this is not a subject for the economically faint-hearted.)

At issue is the Bank of England’s practice of paying the base rate of interest on any deposits held by commercial lenders at Threadneedle Street. The cost of this arrangement has risen because of quantitative easing (QE) and, because of the way the system was set up, taxpayers are footing a significant portion of the bill.

The Bank of England’s balance sheet was inflated hugely by the QE programme. In 2006 to 2007, commercial banks’ reserves at the Bank were on average only about £20bn. By contrast, they currently stand at over £700bn.

Much of this money printing was done at a time when interest rates were at historic lows. With the base rate currently at 5.25pc, paying interest on banks’ reserves costs the Exchequer about £40bn.

Some critics argue that stopping the Bank paying interest would be impractical and/or extremely dangerous. Yet the Bank only started the practice in 2006. Moreover, in many other countries today, the central bank does not pay such interest or does so only on a portion of the commercial banks’ reserves.

The precise amount of the potential saving from not paying interest is the subject of some confusion. Some people argue that the net saving would be only about half this sum because the Bank earns interest – admittedly at a lower rate – on the bonds that it holds, financed by the commercial banks’ reserves, which contribute to the interest payments to banks.

This confuses two things. Ceasing to pay interest on bank reserves does not imply any reduction in the Bank’s bond holdings.

Nevertheless, it is true that the amount of interest saved is expected to fall over time. As rates are reduced, then the cost of paying full interest on banks’ reserves will fall. Moreover, as the Bank’s holding of bonds gradually runs down, or is forced down by the policy of quantitative tightening (QT), then reserves will also fall back.

Some critics have argued that if the commercial banks did not receive interest on their reserves, market interest rates would drop to zero as the banks tried to rid themselves of their surplus money by buying assets, lending money and reducing their deposit rates. In these circumstances, the Bank would effectively lose control of monetary policy.

Yet the policy of not paying interest on bank reserves has been endorsed by two former deputy governors of the Bank, Sir Paul Tucker and Sir Charles Bean, one nearly governor, Lord Adair Turner, one special adviser to the Bank, Charles Goodhart, and the former chancellor and prime minister, Gordon Brown.

They all recognise that there is a simple way to avoid interest rates being forced to zero – namely, to impose minimum reserve requirements on the banks, or to levy special deposits to be held at the Bank.

The Bank would have to leave a margin of reserves in the system over and above the required minimum in order to facilitate commercial banks’ transactions and cover precautionary needs.

Admittedly, it would be difficult for the authorities to judge the appropriate level of these spare reserves, potentially leading to volatility in overnight interest rates. When bank reserves did not earn interest before the 2005 shift, overnight interest rates were indeed extremely volatile.

Believe it or not, early in my career I had direct experience of this volatility and may even have contributed to it. I briefly worked as a dealer in the sterling money markets. I was responsible for lending out surplus deposits at the Bank and/or getting them in by the end of the day to leave my bank’s reserves at the Bank as close to zero as possible.

I was often hauled over the coals for getting it wrong.

The way to minimise such volatility is surely to pay interest on operational deposits above the required minimum. This is known as tiering. It is the system operated by the ECB for the euro markets. Of course, to the extent that this practice is adopted, the savings to the Exchequer would be smaller than the sum of £40bn referred to above because some interest would still be paid. Even so, what’s not to like?

Many years ago, the economist Milton Friedman pronounced: “There is no such thing as a free lunch”.

The savings to the Exchequer must come from somebody. In the first instance, that somebody is the banking sector. But the banks wouldn’t sit idly by and just accept this hit to their profits. They would surely respond by widening the spread between their lending and deposit rates, thereby passing at least some, and possibly all, of the burden onto their customers.

This isn’t necessarily a very desirable outcome. It would tend to divert financial flows away from the banks and towards other financial channels that are much less transparent and less regulated, or not regulated at all. And it might tend to reduce aggregate demand.

In truth, though, all ways of raising revenue have potential disadvantages. Any responsible government should assess the relative costs of different sorts of taxes and weigh these against the benefits of public spending. In practice, though, they are usually driven by political factors.

This measure undoubtedly has some political advantages. Those people and businesses who would suffer as a result of higher lending rates and lower deposit rates would not easily associate their loss with the policy change. Moreover, the measure would not increase the tax burden. Rather, it would reduce government expenditure.

Is everything clear now? I did warn you. You may feel just as confused as before – but hopefully at a higher level.

Roger Bootle is senior independent adviser to Capital Economics.