Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Tiered Reserve Systems
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- Lucas: Central banks have this quiet little tool that almost nobody talks about outside of monetary policy circles. It's called a tiered reserve system, and it's basically a way for a central bank to charge different interest rates on different slices of bank reserves. Luna: So like a progressive tax on bank deposits at the central bank — the first bucket gets one rate, anything above that gets a different, usually more punitive rate. Lucas: Exactly. And the reason central banks reach for this tool is usually to manage the side effects of negative interest rates. If you drop your policy rate below zero, banks that hold reserves at the central bank have to pay for the privilege. That eats into their net interest margin, and smaller banks with fewer lending alternatives really feel the pinch. Luna: Before we dive into the specifics, I want to mention something. This show is ad-free by design — we don't run commercials, no sponsored segments. If walking through the economy with us has made something click, and you want to support that independence, you can find us at buy me a coffee dot com slash fexingo. No pressure, just a way to keep this exactly as it is. Lucas: Appreciate that. And we mean it — listener support is what lets us pick these niche angles. So back to tiering: the classic example is the Bank of Japan in 2020. They had negative rates since 2016, but by 2020, the strain on regional banks was getting serious. So they introduced a three-tier system. Luna: Three tiers. That's more than most. What were the rates on each? Lucas: Tier one — the 'basic balance' — was the portion of reserves that banks had to hold anyway, roughly 6 percent of their reserve base. That got a positive 0.1 percent. Tier two was zero percent — no charge, no pay. Tier three was the rest, and that got the negative rate of minus 0.1 percent. So effectively, the BOJ exempted about 6 percent of total reserves from the negative rate. Luna: That makes a real difference for a small bank with a high deposit base and limited lending opportunities. Their marginal cost of holding reserves drops from negative to zero or positive on that first slice. Lucas: Right. And the European Central Bank did something similar in 2019. The ECB had cut its deposit facility to negative 0.5 percent, and banks were screaming that it was crushing profitability. So the ECB introduced a two-tier system: a multiplier of six on a bank's required reserves — so if you had to hold 100 million euros in minimum reserves, you'd get the zero percent rate on up to 600 million euros of excess reserves. Everything above that paid the negative rate. Luna: That's a pretty generous exemption. Did it actually help? Lucas: There's some evidence. A 2021 study from the Bank for International Settlements found that tiering did reduce the pass-through of negative rates to bank lending rates — meaning banks didn't have to raise loan rates as much to compensate for the negative deposit charge. On the flip side, it also meant that the negative rate didn't push banks to lend more aggressively, because a chunk of their reserves was shielded. So tiering buys financial stability but at the cost of policy transmission. Luna: So you end up with two effective policy rates — one for the banks, one for the real economy. That's a trade-off central banks are usually uncomfortable with, because they like a clean single-rate signal. Lucas: Exactly. And that's why the Fed has never used tiering. The Federal Reserve, post-2008, pays interest on reserves — IOR — at a single rate. When they raised rates in 2022 and 2023, banks earned that higher IOR, which actually helped their margins. No tiering needed because the rate was positive. But if the Fed ever went negative — which it hasn't, and most policymakers have ruled out — tiering would likely be part of the conversation. Luna: Has any central bank used tiering outside of a negative rate context? Or is it purely a damage-control tool? Lucas: For the most part, it's a negative-rate side effect. But there's a historical precedent: the Reserve Bank of India used a tiered reserve system in 2020 — not for negative rates, but to manage a massive liquidity glut. They set a 3.75 percent rate on reserves up to a certain threshold, and a lower 3.25 percent on anything excess. The goal was to discourage banks from just parking money at the central bank and instead lend it out. Luna: That's a different logic — using tiering to penalize hoarding rather than to protect small banks. A kind of carrot and stick approach. Lucas: Right. And it shows the flexibility of the tool. You can calibrate the tiers to any number, any spread. The BOJ had three tiers. The ECB had two. The RBI had two with a very narrow spread — just 50 basis points. But the core idea is always the same: create a preferential rate on a portion of reserves to incentivize or discourage certain bank behavior. Luna: One thing I've always wondered: does tiering create a stigma? If you're a bank that ends up paying the higher negative rate on a lot of your reserves, does that signal weakness? Lucas: That's a smart question. The answer is generally no, because the tiering thresholds are mechanical — they're based on a bank's reserve history, not its current condition. A bank with a large deposit base relative to its lending just naturally has more excess reserves. It's not a flag of distress. But there is a subtle issue: if the tiering multiplier is generous enough, it can encourage banks to inflate their reserve holdings to game the system. Luna: How would that work? Lucas: Let's say the exempt tier is 10 times your required reserves. A bank could borrow reserves overnight from another bank at a low rate, park them in the exempt tier, and earn the positive rate. That's a risk-free arbitrage. The central bank would then have to monitor that and possibly adjust the multiplier. The ECB anticipated this and set a cap on the exempt amount per bank. Luna: So tiering introduces complexity and monitoring costs. It's not a set-and-forget tool. Lucas: Not at all. And that's part of why central banks use it sparingly. The BIS study I mentioned earlier also noted that tiering can reduce the signaling power of the policy rate. If the rate on the exempt tier is zero and the rate on the top tier is negative, what's the 'policy rate'? Market participants have to figure out which rate matters for banks' marginal decisions. Luna: That must be especially tricky in a country with a large banking sector and a lot of cross-border flows. If foreign banks have access to the same tiering, it can get complicated quickly. Lucas: Yes. For instance, in the euro area, foreign banks with branches in the eurozone were eligible for the tiering, but only on their reserves held in the national central bank. That created asymmetries. A Japanese bank with a branch in Germany might have different treatment than a German bank. The ECB ended up harmonizing the rules in a 2021 reform to make it more uniform. Luna: So tiering is a pragmatic compromise — it protects bank profitability without completely abandoning negative rates. But it also muddies the waters. Is there a scenario where tiering becomes a permanent feature, rather than a temporary fix? Lucas: That's the open question. The BOJ kept its tiering in place even after it raised rates slightly in 2024. The ECB also maintained its two-tier system until it exited negative rates in 2022. So there's a pattern: once you introduce tiering, it's politically very hard to remove, because banks get used to the subsidy. Central banks have to be careful not to let it become a permanent crutch that dulls the transmission mechanism. Luna: Right. And if negative rates ever return — say, after a deep recession — tiering is likely to make a comeback. It's in the toolkit, just not on the front shelf. Lucas: Exactly. It's one of those tools that you hope you never need, but you're glad it's there. For now, the Fed, Bank of England, and others have positive rates, so tiering is mostly a historical and comparative curiosity. But for anyone watching Japan or Europe, it's a reminder that central banking is full of these clever, quiet workarounds. Luna: And sometimes the quiet workarounds tell you more about how policy actually lands on Main Street than the headline rate does. Thanks, Lucas. Lucas: Thanks, Luna. That's it for this episode of Monetary Policy Explained with Fexingo.