Government could save £55bn over next five years by limiting Bank of England’s interest payments to commercial banks

The government could save £55bn over the next five years if it limits the amount of money the Bank of England pays interest on to commercial banks, according to new analysis from the New Economics Foundation. The Treasury will pay out over £150bn to the Bank of England to fund its payments to the banking sector by 2028, this on top of the £30bn already paid out in 2023. This is a result of the Bank of England paying interest on all central bank reserves, including the £875bn created through quantitative easing (QE).

Instead, the analysis finds that the Bank of England could pay interest on a smaller portion of reserves by requiring commercial banks to hold 10% of their liquid assets in reserves that pay no interest. This would save the government £55bn over the next five years, enough to repair crumbling schools and hospitals and fund installation for 7 million homes.

This 10% ​‘reserve requirement’ is lower than requirements used by central banks in China and Brazil in recent years and the UK in the 1970s. The European Central Bank has recently announced a policy to stop paying interest on these reserves, and the application in the UK has been discussed by former deputy governor of the Bank of England, Sir Paul Tucker.

The Bank of England holds money for commercial banks in reserves and currently pays interest on all of this. The level of interest is set by the Bank’s own interest rates. The Treasury is responsible for funding any gap between the interest the Bank of England receives on bonds bought via quantitative easing and the interest it pays out, along with any losses the Bank makes from active sales.

The analysis shows that how the government could save billions by implementing a tiered reserves policy which would reduce the proportion of central bank reserves that the Bank of England pays interest to the banking sector on. The analysis finds that, over the next five years:

• A 1% reserve requirement, equal to the policy implemented at the European Central Bank would save the government £1.3bn a year.
• A 2.5% reserve requirement would save the government £3.3bn a year, enough to fund a mass insulation programme for 7m homes over five years. Such reserve requirements are common place in Switzerland.
• A 5% reserve requirement would save the government £6.6bn a year, enough to fund repairs for crumbling schools and hospitals over the next five years. Such reserve requirements are lower than those used by China this summer.
• A 10% reserve requirement would save the government £11.5bn a year, enough to implement all the above policies. Such reserve requirements would be lower than in the UK in the 1970s.

Dominic Caddick, economist at the New Economics Foundation (NEF), said:

“At a time when millions are struggling with rising mortgage and debt costs, the Treasury are set to pay out billions in public money to fund transfers to commercial banks. The policy of the Bank of England paying interest on reserves was introduced in response to the financial crisis, but now we’re 15 years on and in a different economic context, the government needs to change its approach. Public money should be spent supporting people through the cost of living crisis, not giving banks a huge bonus.”

Notes
The New Economics Foundation is a charitable think tank who are wholly independent of political parties and committed to being transparent about how it is funded.

We use Bank of England estimates for projected annual cash flow from unwinding 80bn per year as the cost of interest rate rises to the Treasury which can be found at: https://​www​.bankofeng​land​.co​.uk/​a​s​s​e​t​-​p​u​r​c​h​a​s​e​-​f​a​c​i​l​i​t​y​/​2​0​2​3​/​2​0​23-q3

School repair costs are estimated at £11.4bn and NHS costs are £10.2bn, NEF has estimated a Great Homes Upgrade would cost £11.7bn.

We model reserve requirements as a fixed portion of money supply measure M4, where M4 in future periods is stable but reduced by £0.8 for every £1 of reserve money withdrawn. Non-required reserves are modelled to not fall below £350bn as this is a measure of the minimum amount of reserves banks demand. Interest is not paid on reserves up to the reserve requirement and after this September market expectations are used to calculate interest payments on non-required reserves.