Reform UK — a populist party and successor to the Brexit Party headed by former commodities trader Nigel Farage — has proposed a radical reform to how the Bank of England remunerates commercial bank deposits.
In its manifesto, or “contract” with the British people, launched on Monday, the right-wing party has suggested that if it were elected it would force the Bank of England to cease paying interest on quantitative easing reserves within 100 days of the election, so October 12 at the latest.
Quantitative easing introduced £895bn of new money into the system, of which £700bn remains outstanding, flooding commercial bank reserves with cash. The Bank of England remunerates banks for these holdings at the current Bank Rate, 5.25%.
The amount paid out by the central bank to UK commercial lenders rose 135% in 2023 compared to the previous year, thanks to the Old Lady’s steady stream of rates increases, data from the Treasury Committee show.
Between them, NatWest, Barclays, Lloyds and Santander UK received more than £9bn combined from the central bank’s coffers. The costs of paying out UK lenders now exceeds the revenue the central bank receives from its Gilts portfolio, with the UK Treasury stepping in to fill the gap.
This current regime is set to cost the Bank of England — and the UK taxpayer — £120bn over the next five years, according to research from think tank the New Economics Foundation.
Time for tiering
Of course, the Bank of England does not need to pay out for every penny of central bank reserves. It could, if it chose to do so, tier its remuneration like many other central banks already do.
Tiering central bank reserves is nothing new. The European Central Bank, for instance, has operated a two-tier system since September 2019.
Under the ECB’s two-tier system — introduced when the central bank’s deposit rate sat at minus 50bp — a portion of eurozone banks’ excess holdings is remunerated at an annual rate of zero.
Of course, when this was first introduced by Mario Draghi five years ago, it was done so with the aim of avoiding commercial banks paying through the nose for their ECB deposits, acting as an effective subsidiary for commercial banks. But now, the picture is different, and the two tier system works the other way, with the central bank benefiting from not having to pay out.
This sort of tiering system has its advocates in the UK: former prime minister Gordon Brown said earlier this year that implementing a reserve requirement like what’s found in Europe could save £1.3bn-£3.3bn.
However, that is not what Reform UK is proposing. Farage and co want to take the radical approach to zeroing the remuneration on all central bank reserves — effectively ending any payout from Threadneedle Street to commercial banks.
Reform UK believes that this could raise around £35bn a year — more than 10 times what former chancellor Gordon Brown believes would be possible with a European style tiering system.
Paul Johnson, director of the Institute for Fiscal Studies, has pointed out that such a change would not even raise half of what Reform UK expects. In fact, the amount raised would be fluid, moving in line with Bank of England base rate.
And doing so could have drastic consequences for the transmission of monetary policy in the UK. Remunerating central bank deposits allows the Bank of England to impact directly the real economy — removing this mechanism could prove costly in the long run.
Of course, Reform UK is a long way from forming a government — and so its ideas an equally long way from implementation. But the allure of tiering central bank reserves with an ECB-like model might prove too hard for the next chancellor to resist.
After nearly 15 years of austerity, the UK state has had much of the flesh stripped from the bone — and the tax burden is at an all time high. With parties across the political spectrum promising either massive tax cuts or sharp increases in funding, the Treasury will have to find the extra cash from somewhere.
And as Liz Truss showed in September 2022, you can’t just expect to borrow at will to fund your wild plans. But tiering the Bank of England’s reserves could alleviate the pressure to cut or borrow elsewhere.