Rachel Reeves warns Bank of England against changing the way it pays interest on reserve funds

Rachel Reeves, the shadow chancellor of England, has warned of “the dangers” of changing the way the Bank of England pays commercial lenders interest on their deposits. She has thrown cold water on a proposal that some economists had said could be a good idea to help a Labour-led government save money.

Reeves stated on Tuesday that Labour has no plans to “tier”, the interest that is paid on reserves held by commercial banks at the BoE. These total around £770bn.

Reeves said at a recent press conference that she wasn’t interested in any changes.

Reeves responded: “We don’t have any plans to do this.” In fact, the payment of interest on reserves forms part of the transmission mechanisms for monetary policies. It’s one way that higher interest rates are transmitted to the real economy.

I don’t believe that changing the current system would be without dangers.

The BoE has been under pressure to change the way it pays interest due to the large amount of reserves that are in circulation.

Reserves are the deposits made at the central banks by commercial lenders for settlements between themselves.

During successive waves in its quantitative easing program during the global financial crises and Covid pandemics, the BoE funded the purchase of hundreds of millions of pounds worth of government bonds and paper held by private sector by issuing reserves from the central bank.

The BoE currently pays an interest rate benchmark of 5,25 percent on all reserves as it implements its monetary policy in the economy.

According to the House of Commons Treasury Committee, the interest earned by UK’s biggest high street banks from their BoE reserves will increase by 135 percent annually in 2023.

The committee reported that NatWest, Barclays and Santander received collectively £9.23bn interest from the BoE last year.

Economists suggest that the BoE may switch to a system where commercial banks hold a certain amount of money, but without receiving interest. The central bank would then pay its official rate only on a portion.

Michael Saunders of Oxford Economics, an economist, says that the savings could be between £4bn to £5bn per year depending on how the reserve requirements are set.

He said that this would still allow BoE to set rates for money markets at any level desired by its Monetary Policy Committee. “It’s certainly possible in terms of technical feasibility.” It’s like a tax, obviously.

Andrew Bailey, the BoE governor, has been lukewarm on this idea. He stated last month the central bank reserves are “essential anchors for the implementation of the monetary policy” because they are remunerated according to the official rate.

Bailey said that the BoE must be “very cautious” in implementing anything similar. “That’s a substantial change, and one I wouldn’t currently recommend.”

Bailey said that the BoE’s benchmark rates set a floor on the market, because if the commercial rate fell below the BoE’s benchmark, the banks would borrow from the market to deposit at the central bank in order to earn risk-free profits.

He said that the “floor” system had been very successful in keeping the money market rates close to the [BoE] Bank Rate.

Nigel Farage of the right-wing Reform UK Party claimed on Monday that by stopping the BoE paying interest on reserves held by commercial lenders, the government could save £40bn per year.

UK Finance, an industry trade group, warned that the arch-Brexiter’s comments could result in higher banking costs for businesses and consumers.

Reeves has been pressed to say whether or not a Labour-led government would increase taxes or accept Conservative plans for spending, which include cuts to Whitehall departments.

She reiterated her pledge on Tuesday not to raise income taxes, value-added tax or national insurance.

Labour hasn’t ruled out a rise in capital gains taxes, despite warnings that such a reform might deter investors.