The Bank of England is costing us billions

With rumours circulating that the government seeks to cut £3bn from disability payments, it seems surprising the Treasury appears willing to hand over £26bn a year to the Bank of England without any fuss. One would be forgiven for wondering: why does a central bank, which can create money, need such large transfers? And how does this align with central bank independence? The answer is complex but the reason it matters is simple. These costs reflect large transfers of public money to the financial sector which limit the Chancellor’s ability to meet her self-imposed fiscal rules. To reverse austerity in public services and invest in vital public infrastructure, changing our approach is vital. Fortunately, international examples show how better management of the central bank balance sheets could unlock over £130bn by 2030, enough for the government to build over half a million new social homes.

Currently, central banks across the world are making losses as their costs outstrip their income. This is primarily an after-effect of quantitative easing (QE), where central banks bought government bonds, at very low interest rates, to stimulate the economy. These bonds were bought with newly-created reserves – the digital money private banks hold and are paid interest on at the central bank, to implement monetary policy. Today, as the interest rate the central bank sets is higher than the interest received on the bonds it bought, central banks are incurring a loss.

In the UK, these losses have been increased further from active quantitative tightening (QT), where the Bank sells bonds back to the market rather than letting them mature. As bond prices fall as interest rates rise, the bonds are worth much less than they were originally bought for. Recent sales have bonds sold for as little as 28% the original price, contributing to even larger losses.

In the UK, an indemnity agreement between the Treasury and the Bank means these losses directly put pressure on tax and borrowing levels. This indemnity was agreed by George Osbourne back in 2012 when QE was profitable allowing the Treasury to receive just under £125bn from the Bank of England between 2012 – 2022. However, the majority of this has been reversed in the past two years with over £70bn worth of losses charged to the Treasury. As new stats published by the Bank of England last week show, by 2027, the Treasury is expected to be a net loser from this agreement with lifetime costs over £150bn by the early 2030s. Fortunately, these costs are not inevitable. Reforms such as tiering reserves, slowing QT and changing the indemnity could reduce the costs, and are already implemented in other countries.

“To reverse austerity in public services and invest in vital public infrastructure, changing our approach is vital.”

Tiered reserves would reduce interest paid by central bank to private banks. This is achieved by requiring the private banks to hold a portion of reserves that pay no interest. By paying interest above this ​“reserve requirement” tier it ensures the central bank can still transmit its interest rate policy. The European Central Bank (ECB) adopted this system in 2023, saving €5bn annually. NEF previously calculated the UK would save £1.3bn a year if it followed suit. Furthermore, higher reserve requirements, used internationally and historically, could save up to £11.3bn a year. Some worry the negative impact on bank revenues could tighten monetary conditions as banks pass on costs to borrowers, but this could be tackled with lower interest rates and a more cautious approach. Furthermore, some argue a tax on bank profits could be more effective, while this could certainly help recoup the massive windfall banks have already received, tiering reserves acts as a first guard to stop bank profitability being tied to central bank transfers.

Furthermore, the active QT sales the Bank makes are a large contribution to overall losses. At NEF, we calculated slowing QT active sales to the pace they were in 2022 – 2023 could save £4.4bn a year, while halting active sales would save up to £13.5bn. This would align the UK with the eurozone and US, where active sales are avoided. The bank justifies its QT speed citing the interest rate losses from holding long-term bonds, but these losses stem directly from its own decision to hike interest rates. Slowing down sales and looking at other ways to reduce interest rate risk, like tiering reserves and rethinking its interest setting strategy, could be much more effective.

“Continuing to burden the Treasury will only keep the Bank in the political spotlight, threatening its independence.”

Instead of an indemnity, the UK could adopt a deferred asset system, as used by the US Federal Reserve and the ECB. This system records losses on the central bank’s balance sheet, to be paid down by future profits. While this is essentially an accounting trick it avoids immediate fiscal strain on taxation and borrowing. As noted by Chris Giles at the FT, ​“monetary financing would look the same on central banks’ balance sheets” but the deferred asset makes sure this is temporary. 

Moving to a deferred asset system could free up to £26bn a year for the Treasury. While these savings would ultimately disappear in the form of forgone profits in future the scale of profits per year has seemingly been much lower than potential losses – helping smooth the cost over time. Ultimately, a deferred asset is not the only way costs can be smoothed and financial agreements between treasuries and central banks are often updated and revised. Given the pressure the Bank is exerting on fiscal rules, now would be a good time to rethink and restructure these costs.

Overall, while fiscal rules are the ultimate culprit for imposing false constraints on public spending, the fiscal strain the Bank is putting on the Treasury is clearly unhelpful. As the Fed notes, its losses ​“do not affect [its] ability to conduct monetary policy or meet its financial obligations.” Therefore, the UK should question why the Bank cannot absorb more of these costs. Continuing to burden the Treasury will only keep the Bank in the political spotlight, threatening its independence. Reforming the system now could unlock billions of public spending, avoid needless austerity while creating a fairer monetary system.

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