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Shadow Chancellor Rachel Reeves warned of the “dangers” of overhauling how the Bank of England pays interest to commercial lenders on their deposits, pouring cold water on an idea that some economists said could help the Labor government find savings.
Reeves said on Tuesday that Labor had no plans to “layer” the interest paid on reserves held by commercial banks at the BoE, which currently stand at around £770bn.
Such a move, which would have to be enacted by the central bank, could potentially save the public sector billions of pounds a year, but Reeves indicated at a press conference that she was not interested in making changes.
When asked about the idea, Reeves said, “We don’t have any plans. And actually paying interest on reserves is part of the transmission mechanism of monetary policy, it is one of the ways that higher interest rates filter into the real economy.
“I do not think so [changing the current system] she would be out of danger.”
But the idea of changing the way the BoE pays interest has hit the political stage because of the huge amount of reserves in circulation.
Reserves are deposits with a central bank that are used by commercial creditors to settle payments among themselves.
During subsequent waves of its quantitative easing program during the global financial crisis and the Covid pandemic, the BoE financed purchases of hundreds of billions of pounds of government bonds and other paper held by the private sector – by issuing central bank reserves.
Currently, the BoE pays its benchmark interest rate of 5.25 percent on all reserves as it transmits monetary policy to the economy.
The interest earned by Britain’s biggest banks on their reserves at the BoE rose by 135 percent year-on-year in 2023, according to figures published by a House of Commons committee in May.
NatWest, Barclays, Lloyds and Santander received a combined £9.23bn in interest from the BoE last year, the committee said.
Economists have suggested that the BoE could switch to a system where commercial banks are required to hold a fixed amount of money without securing interest, while the central bank only pays its official rate from a portion of reserves.
Michael Saunders, an economist at Oxford Economics, a consultancy, said the savings from such a reform could be between £4bn and £5bn a year, depending on where reserve requirements were set.
That would still allow the BoE to set money market rates at whatever level its Monetary Policy Committee wishes, he said, adding: “It is certainly technically feasible. And it’s similar to a bank tax, of course.”
However, BoE Governor Andrew Bailey was lukewarm on the idea. He said last month that the fact that the central bank’s reserves bore interest at the official rate made them “a necessary anchor for the conduct of monetary policy”.
The BoE would have to be “very careful how we implemented something like this,” Bailey added. “That’s a pretty substantial change and not one I’d advocate at this time.”
The BoE’s benchmark rate sets a floor for the market because if commercial rates fell well below it, banks would borrow money from the market and deposit it with the central bank to earn risk-free profits, Bailey added.
“This ‘floor’ system has been successful in keeping money market rates very close to this level [BoE] bank rates,” he said.
Nigel Farage, leader of the right-wing Reform UK party, said on Monday that the government could raise £40bn a year to prevent the BoE from paying interest on commercial lenders’ reserves.
UK Finance, the trade body, warned after the arch-Brexiter’s comments that a change in approach could lead to higher banking costs for consumers and businesses.
Reeves is under pressure to clarify whether a Labor government would introduce taxes or adopt Tory spending plans that see cuts in many Whitehall departments after the general election.
On Tuesday she repeated her pledge not to increase income tax, value added tax or national insurance.
But Labor has not ruled out raising capital gains tax, prompting warnings that such a reform could put off UK investors.