Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Tiered Reserve Remuneration
Transcript
- Lucas: When a central bank sets interest rates, the basic story is simple: one rate, one target. But in practice, especially when rates go negative, central banks get creative. They start carving out exceptions. Luna: You're talking about tiered reserve remuneration—where banks get a better rate on the first chunk of their reserves and a worse rate on anything above that. Lucas: Exactly. The European Central Bank introduced a tiering system in September 2019, when its deposit rate was at negative 0.4 percent. Banks were effectively paying to park excess reserves, and that was squeezing their margins. So the ECB exempted a portion of those reserves from the negative rate. Luna: I remember that. The exemption was calculated as six times each bank's minimum reserve requirement. So if a bank had to hold 100 million euros in required reserves, it could park up to 600 million euros at zero percent instead of negative 0.4 percent. Lucas: Right. And the ECB estimated that would save the banking sector roughly 4 billion euros a year in interest payments. It was a targeted relief valve—meant to protect bank profitability without loosening the overall policy stance. Luna: And if today was actually useful to you, the way these stay ad-free is listener support. Buy me a coffee dot com slash fexingo. Just a mention for people who want to keep this going. Lucas: Yeah, exactly. It really helps. So the tiering system—how did the ECB decide that six-times multiplier? It wasn't random. They looked at the distribution of excess reserves across the banking system and wanted to keep the marginal cost of holding reserves unchanged for the average bank. Luna: So they calibrated it so that the average bank wouldn't see its total reserve remuneration change if it didn't change its behaviour. But banks with more excess reserves—bigger than six times their requirement—would still pay the negative rate on the excess. Lucas: That's the key design feature. Tiering doesn't change the marginal rate on new reserves—the rate that should influence a bank's decision to lend versus hold reserves. The first tier gets a subsidy, but the second tier still faces the negative rate. So in theory, the policy transmission is preserved. Luna: But in practice, did it work? Did European banks actually lend more after tiering? Lucas: It's hard to isolate the effect. Credit growth in the euro area was already subdued, and tiering came alongside a broader package of policy measures, including a new round of targeted longer-term refinancing operations. Most studies suggest tiering had a modest positive effect on bank lending, mainly by reducing the drag from negative rates on bank capital. Luna: So it's more about preventing damage than stimulating new lending. The Bank of Japan did something similar in 2016, right? Lucas: Yes. The Bank of Japan introduced a three-tier system. The first tier, about 10 trillion yen, pays positive interest of 0.1 percent. That covers required reserves. The second tier, which includes the stock of reserves accumulated before the policy change, pays zero. And the third tier—new incremental reserves—pays negative 0.1 percent. Luna: So they basically grandfather the existing reserves at zero and only penalize new reserves. That's a clever way to encourage banks to deploy excess reserves without causing a shock to the system. Lucas: Exactly. The Bank of Japan's tiering is more complicated than the ECB's, but both share the same logic: protect bank profitability on legacy holdings while maintaining a negative marginal rate to push banks to lend or invest. Luna: Has the Federal Reserve ever used tiering? They've never gone negative, but they've discussed it. Lucas: The Fed has never implemented tiering for excess reserves. In 2019, when repo markets spiked, there was some talk about tiering the interest on reserve balances to encourage smaller banks to lend in the repo market, but it never materialized. The Fed's approach to negative rates has been a firm 'no,' so tiering remains a hypothetical for the U.S. Luna: But if the Fed ever did go negative, they'd almost certainly need tiering. Otherwise, money market funds and banks would face massive disintermediation. Lucas: Right. The European experience showed that negative rates without tiering can crush net interest margins, especially for banks with large deposit bases. Tiering became a political and practical necessity. In fact, the ECB expanded its tiering multiplier in 2020 — from six to nine times the minimum reserve requirement — as the deposit rate was cut further to negative 0.5 percent. Luna: So they increased the subsidy as rates went more negative. That makes sense — the more painful the negative rate, the bigger the exemption needed. Lucas: Exactly. And this gets to the core debate about tiering: is it a legitimate tool to improve monetary transmission, or is it a hidden subsidy that delays necessary restructuring in the banking sector? Luna: I lean toward the subsidy critique. If a bank is unprofitable because it can't pass on negative rates to depositors, maybe that bank should fail or merge, not get a free pass. Lucas: That's the argument. But central banks counter that bank failures during a period of already weak growth would be counterproductive. Tiering is meant to be temporary, a bridge until rates can normalize. The problem is that 'temporary' can last a decade. Luna: Let's talk about the mechanics more. How does a central bank actually implement tiering? Is it a programming change in their reserve management system? Lucas: Essentially, yes. The central bank already tracks each bank's reserve account. It simply sets a threshold — say, six times the required reserves — and then applies a different interest rate to balances above and below that threshold. The computation is straightforward, though it requires clear communication so banks know how much reserve space they have. Luna: And does the tiering threshold change over time? Because required reserves might change if a bank grows or shrinks. Lucas: Great point. The ECB recalculates each bank's allowance every maintenance period based on its latest reserve requirement. So the threshold moves with the bank's balance sheet. That's important because it means the exemption is automatically proportional. Luna: So a bank that takes in more deposits and thus has higher required reserves automatically gets a bigger exemption. That seems fair. Lucas: It does. And it aligns the exemption with the size of the bank's deposit base, which is exactly where the negative rate pressure is most acute. Deposits that can't be re-priced get a buffer. Luna: Are there any other central banks using tiering? The Swiss National Bank? Lucas: The SNB has negative rates but no tiering. They do have a traditional exemption — a certain amount of reserves are exempted from negative rates, but it's not a tiered system with multiple rates. It's more of a lump-sum exemption. And in 2022, the Reserve Bank of New Zealand considered tiering as part of its review of tools for a low-rate environment, but since rates have risen, it's been shelved. Luna: So tiering is really a tool for when rates are stuck at the lower bound. If rates normalize, it goes away. Lucas: Exactly. And that's why it's a fascinating part of the central bank toolkit. It's a sign that policymakers are trying to have it both ways — keep a negative marginal rate to stimulate the economy, but shield the banking system from the full cost. Luna: It's a bit like having your cake and eating it too. But whether that works in the long run is an open question. Lucas: It is. And as we see more central banks around the world contemplating negative rates, tiering is likely to become a standard part of the conversation. The ECB and Bank of Japan have provided the playbook. Luna: Thanks for breaking it down, Lucas. For listeners, if this kind of policy detail is useful, you know how to support the show.