Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Are Using Tiered Reserve Systems
Transcript
- Lucas: Let me start with a simple question that has a surprisingly complicated answer: how do central banks actually get banks to charge the interest rate they want them to charge? Luna: Right, because the policy rate — say the fed funds rate or the ECB's deposit rate — isn't a command. It's a target. Lucas: Exactly. And one of the most subtle tools in the central bank toolkit for hitting that target is something called a tiered reserve system. It's not a rate hike or a rate cut, but it can change how much banks want to lend, borrow, and park money at the central bank. Luna: So a tiered system means the central bank pays different interest rates on different chunks of a bank's reserves. Is that the core idea? Lucas: That's exactly it. You carve bank reserves into two or three tiers. The first tier — usually a small amount relative to the bank's size — gets paid a higher rate, or maybe it's exempt from a negative rate. The second tier, which covers everything above that threshold, gets a lower rate, or even a zero or negative rate. Luna: And the point is to encourage banks to do something with that excess money rather than just hoarding it at the central bank? Lucas: Yes, but it's more surgical than that. The European Central Bank introduced a two-tier system in 2019, right when it was pushing its deposit rate deeper into negative territory. The idea was: we want to penalize banks for holding massive excess reserves, but we don't want to crush their profitability so much that they stop lending to the real economy. Lucas: Exactly. And that meant a bank with two billion euros in excess reserves might have had, say, 500 million in the exempt tier earning zero, and the rest earning negative 0.5 percent. It softened the blow while keeping the headline policy rate negative. Luna: It's almost like a targeted tax break. You're not changing the rate for everyone, just for the marginal reserves. Lucas: Precisely. And the Bank of Japan has taken this even further. They've had a three-tier system since 2016. The first tier is the outstanding balance of reserves from before the negative rate announcement — basically a grandfather clause. That tier earns zero percent. The second tier covers required reserves and some macro prudential stuff — also zero. Then the third tier — any new reserves above those — gets the negative rate of minus 0.1 percent. Luna: So they're basically saying: we won't punish your legacy reserves, but any new money you park with us, we'll charge you for. Lucas: Right. And that creates a strong incentive for banks to lend out that marginal money or buy assets instead of just sitting on it. It's a way to push banks to take risk without having to slash the policy rate further, which might have unwanted side effects. Luna: But the Federal Reserve has never used a tiered system, has it? They just pay interest on all reserves — the same rate — since 2008. Lucas: That's right. The Fed pays interest on required reserves and excess reserves at the same rate, which is the interest on reserve balances rate, or IORB. That creates a floor under short-term rates: banks won't lend in the fed funds market at a rate lower than what they can get risk-free at the Fed. But there's no tiering. Luna: So why didn't the Fed need tiering? Because the US never went negative? That's part of it. Lucas: That's a big part. When rates are positive, paying the same IORB to everyone isn't a problem. The tiering debate in the US really flared up during the 2019 repo market turmoil. Remember September 2019, when overnight repo rates spiked to nearly 10 percent? Luna: Yeah, and the Fed had to step in with repo operations. Some people argued that a tiered system would have made reserves scarcer and more expensive for banks that didn't have enough, causing the spike. Lucas: Actually, the argument went the other way. Some economists said the Fed's flat IORB made reserves too abundant and too attractive for large banks. Smaller banks, which hold fewer reserves, were squeezed. A tiered system could have made the interbank market function better by giving smaller banks a better deal. Luna: Interesting. So tiering isn't just about negative rates. It's about shaping the distribution of reserves across the banking system. Lucas: Exactly. And that distribution matters because not all banks have the same access to funding. During quantitative tightening, the Fed is letting reserves drain out of the system. Some people worry that if reserves get too low for some banks, we could see another repo spike. A tiered system could be a safety valve. Luna: Let me step back for a second. You mentioned that tiering can act as a stealth rate cut without changing the headline rate. How does that work? Lucas: Say the ECB is paying minus 0.5 percent on the deposit facility, but they increase the exempt tier from six times minimum reserves to ten times. That means more reserves earn zero instead of minus 0.5. For banks, that's effectively a rate hike — or rather, a reduction in the penalty. Their funding costs go down, which can feed through to lower lending rates for customers. The market might even interpret it as a de facto rate cut. Luna: But the ECB would never say they cut rates. They'd say they adjusted the tiering multiplier. Lucas: Exactly. That's the beauty of it. It's a way to ease financial conditions without the political or signaling baggage of a formal rate cut. The Swiss National Bank has done this too. In 2015, when they introduced negative rates, they exempted a large chunk of reserves — up to 20 times the minimum reserve requirement — from the negative rate. That was huge. Luna: So tiering is a way to make negative rates politically palatable for banks and for the public, because banks don't pass on the full cost. Lucas: That's the theory. And it worked, at least for a while. But tiering isn't without critics. Some argue it creates complexity and distortion. If you're a small bank with few reserves, your effective rate is different from a large bank with huge reserves. That can create arbitrage opportunities and make monetary policy transmission uneven. Luna: And it's not a permanent tool, right? The ECB actually ended its two-tier system in 2022 when it started raising rates out of negative territory. Lucas: Right, they phased it out once the deposit rate turned positive again. Once you're paying banks 0.5 percent or 1 percent on reserves, tiering becomes unnecessary. So it's very much a crisis tool — a way to deal with the side effects of ultra-low or negative rates. Luna: But with the Bank of Japan still in negative territory until very recently — they raised rates in March 2024 — and with other central banks potentially facing low-rate environments again in the future, could tiering become a permanent fixture? Lucas: Some economists argue it should be. They say tiering gives central banks a more nuanced tool than just one rate for everyone. In a world where reserves are abundant because of quantitative easing, tiering can help the central bank steer the money market without draining reserves, which is hard to do. Luna: It's funny — we think of central banks as having these big blunt instruments like the policy rate. But tiering shows they can be surprisingly surgical when they want to be. Lucas: And that's a recurring theme in this show. The policy rate is just the headline. The real work happens in the plumbing — in the way reserves are priced, the way standing facilities work, the way tiering shapes incentives. And speaking of the plumbing, I think a lot of what we do on this show is about helping people understand that machinery. Luna: Yeah, and that's why we keep the show ad-free. We want the explanation to be clear and independent, without a sponsor trying to sell you a mortgage or a trading app. Lucas: Exactly. And if walking through the economy with us has made something click, one way to support that choice is at buy me a coffee dot com slash fexingo. No pressure, just an option if you find value in what we do. Luna: And it genuinely helps keep the lights on and lets us spend time researching episodes like this one on tiering. Lucas: So, back to tiering. Let's talk about another scenario where tiering could matter: what if a central bank wants to tighten policy without raising rates? Could tiering work in reverse? Luna: You mean like reducing the exempt tier to effectively increase the penalty on reserves, acting as a stealth rate hike? Lucas: Exactly. Theoretically, if a central bank wanted to tighten financial conditions but didn't want to formally raise rates — maybe because of political pressure or exchange rate concerns — they could shrink the tier that gets the higher rate. That would effectively raise the average cost of reserves for banks, pushing them to lend less or borrow more. Luna: But that's never been done, has it? Central banks usually just change the policy rate. Lucas: Not explicitly as a tightening move, no. But consider the Bank of England. They don't have a tiered system per se, but they do have a 'reserves averaging' scheme where banks can meet their reserve requirements on average over a maintenance period. That's a form of tiering in spirit, because it gives banks flexibility in how they hold reserves. Luna: So tiering is really about giving banks options — and that flexibility can make policy transmission smoother. Lucas: Exactly. And it's one of those topics that seems arcane until you realise it's been used by the ECB, the Bank of Japan, the Swiss National Bank, and even the Swedish Riksbank. It's part of the modern central banking toolkit, even if it's not as famous as quantitative easing or forward guidance. Luna: So if I'm a listener trying to remember one thing from this episode, what should it be? Lucas: That a central bank can change the effective cost of reserves for banks without changing its headline rate — by adjusting how many reserves get the preferential rate. That's tiering. And it's a reminder that the most interesting monetary policy is often happening below the surface. Luna: I think that's a good note to end on. Thanks for drilling into the plumbing with us. Lucas: Thanks for listening. And if you want to support more of this kind of deep dive, you know where to find us.