Should the Bank of England introduce tiered remuneration?

Various commentators have suggested that the Bank of England introduce a tiered remuneration policy as a means of closing the fiscal 'black hole' identified by the new Labour Government.

This certainly has the potential to generate considerable net income. The Bank of England’s liabilities include nearly £750 billion of sight deposits by commercial banks – known as reserve accounts – which are remunerated at bank rate.

For every one percentage point reduction on £1 billion of reserves, the Bank would benefit by £10 million. And subject to the Bank meeting its own capital and reserves threshold, all its profits are passed to HM Treasury.

A four percentage point reduction on £550 billion would yield a whopping £22 billion boost to the UK fiscal position. That would be enough to close the aforementioned black hole.

A number of other central banks have tiered rates so that some portion of reserves are remunerated below the policy rate. For example, systems which have an element of required minimum reserves sometimes pay zero on that part - for example, the European Central Bank.

This is possible because the transmission of monetary policy works at the margin. In systems of excess liquidity, as long as all banks receive the policy rate on marginal changes in their reserves, that is enough to set a floor to inter-bank market lending rate.

The Bank does not have any required reserves component in its arrangements, but a similar scheme could be constructed.

The question is, would this be good public policy? The arguments are stacked heavily against it. One has to remember that commercial banks – and the Bank of England – have two sides to their balance sheets.

Central banks are inherently profitable in the medium-term through their issuance of bank notes at very little cost, while they usually have a positive return on their assets. 

In the UK such net seigniorage income is calculated explicitly and it all goes straight to HM Treasury.

For the commercial banks, their reserves accounts are assets with corresponding liabilities which are acquired and maintained at a significant cost.

The impact of tiered remuneration on central bank reserve accounts

Reserve account income is not ‘free money’. Reducing the interest income on their reserve accounts below market rates would create a transfer from commercial banks to the public sector, ie it is a tax.

Taxes on the banking system have consequences – if sufficiently large they might threaten financial stability. Tiered remuneration does not reflect an individual bank’s profitability – it could make some banks loss-making and hence unviable.

All banks would have to react by increasing income from their customers – higher loan rates, account charges and fees – such that the net effect was likely to be a severe tightening of credit conditions which could interfere with the desired monetary stance.

The public and politicians have scant sympathy for banks’ profitability, which is already subject to extra taxes. The bank levy was introduced on balance sheets in 2011 and the bank corporation tax surcharge was introduced on bank profits in 2016. In 2023/24 these two measures raised nearly £3 billion on top of standard corporate taxes.

If the UK Government wants to raise taxes on banks further, it should use fiscal measures directly rather than interfere with the Bank’s monetary policy arrangements.

Explicit taxes would be transparent and democratically based, can be designed to be efficient and fair, and the impact on the financial system can be assessed and controlled.

It’s not the banks’ choice that the aggregate level of reserves is so high, it’s a consequence of monetary policy and past quantitative easing in particular. The banks may try to shuffle reserves to each other, by increasing their lending if they can, but are constrained by regulatory requirements.

Forcing the commercial banks to hold large reserve accounts at off-market or even zero rates can be seen as akin to refusing to pay due interest on public sector debt.

Finally, there is no monetary policy rationale in having tiered remuneration solely for its fiscal consequences. It is widely accepted that central banks need to be independent from government in setting monetary policy.

The corollary is that they should not be making decisions on fiscal grounds, and should not be required to do so, otherwise their independence is clearly broken. 

So, while the Bank could feasibly set a tiered rate of remuneration on reserves, and that might be part of the armoury under some future monetary policy configuration, it would be bad public policy to use such tiering purely to raise taxes from the banking system.

Further reading:

Why would central banks what to issue digital currencies?

How big should the central bank balance sheet be?

Is ring-fencing UK banks really necessary?

Why central banks need to understand behavioural finance

Paul Fisher is an Honorary Professor at Warwick Business School and a former member of the Bank of England's Monetary Policy Committee. He teaches on the Global Central Banking and Financial Regulation qualifications.

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