Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Tiered Reserve Remuneration
Transcript
- Lucas: So the Bank of England raised rates fourteen times in a row between December 2021 and August 2023. That's a pretty aggressive tightening cycle by any historical standard. But what's less known is that alongside those hikes, the Bank quietly changed how it paid interest on the reserves that commercial banks hold with it. Luna: You're talking about tiered reserve remuneration, right? The system where central banks pay different rates on different portions of banks' reserves. Lucas: Exactly. And it matters because when a central bank raises rates, it also raises the interest it pays on reserves. That's normally a good thing for banks — it's basically risk-free income. But when reserves are huge, as they've been since quantitative easing, the cost to the central bank of paying interest on all those reserves becomes enormous, and it creates what's called a 'carry cost' for the banking system. Luna: Wait, a carry cost for banks? I thought paying interest on reserves was pure profit for lenders. Lucas: It would be, if banks didn't have to fund those reserves somewhere. The thing is, reserves are liabilities on banks' balance sheets, funded largely by deposits. When the Bank of England raises its policy rate, the interest it pays on reserves goes up, but the cost of deposits also goes up — banks have to pay depositors more to keep them from leaving. So the net effect isn't automatically positive. Luna: And that's where tiering comes in. By paying a lower rate on a portion of reserves, the central bank effectively reduces the subsidy to banks and allows rate hikes to bite more on bank profits. Lucas: Right. But in the UK, the Bank of England actually did the opposite. In August 2022, it introduced a 'tiered' system where the first chunk of each bank's reserves — the 'allowance' — would continue to earn Bank Rate, but any reserves above that threshold would earn a lower rate, specifically Bank Rate minus 15 basis points. Luna: So they actually reduced the rate on excess reserves, not increased it. That seems counterintuitive for a tightening cycle. Lucas: It does, until you understand the logic. The Bank was worried that if it kept paying full Bank Rate on all reserves, banks would have an incentive to hoard reserves rather than lend them out. By lowering the rate on excess reserves, the penalty for holding extra liquidity increases, and banks are nudged to use those reserves for lending or other productive uses. Luna: So it's a way to make the transmission of monetary policy more effective — to ensure that rate hikes actually feed through to lending conditions, not just to bank profits. Lucas: Exactly. The European Central Bank rolled out a similar system in 2019, though with a different structure. They introduced a two-tier system where a portion of excess reserves — calculated as six times the bank's minimum reserve requirement — would earn the main refinancing rate, and anything above that would earn the deposit facility rate, which was negative at the time. Luna: And that was really about protecting bank profitability during a period of negative rates, because banks were paying to hold reserves and couldn't fully pass on negative rates to depositors. Lucas: Precisely. So the ECB's tiering was a shield for banks, while the Bank of England's was a sword — it was designed to penalize excess reserves and encourage lending. Two different policy contexts, same tool, opposite objectives. Luna: That's fascinating. And I remember that when the Bank of England announced its tiering in August 2022, the market reaction was quite muted. But actually, it had a real impact on the banking sector's net interest margins. Lucas: We can put some numbers on it. The Bank of England estimated that the tiering reduced the average rate paid on total reserves by about 10 basis points. That might not sound like much, but when you're talking about reserves of roughly £500 billion at the time, that's about £500 million per year in foregone interest for the banking system. Luna: Half a billion pounds that banks would have earned if not for tiering. That's real money. And presumably it affected their lending decisions. Lucas: It did. A 2023 study from the Bank of England's own staff found that banks subject to higher excess reserve penalties reduced their lending more than banks with smaller excess reserves. The effect was modest — around a 1.5 percent relative decline in lending for a typical bank — but it shows the channel works. Luna: So tiering is a tool that can sharpen or dull monetary policy transmission, depending on how you set it. Why don't we hear more about it? Lucas: Because it's technical and it's a second-order concern for most people. But for central bankers, it's a live issue, especially as quantitative tightening reduces reserve balances. The Bank of England actually ended its tiering in September 2023, when reserves had fallen enough that the penalty was no longer needed. Luna: So it's a temporary tool, not a permanent feature of the monetary policy framework. Lucas: Exactly. It's deployed when reserve levels are 'abnormal' — post qe — and withdrawn once reserves normalize. The question now is: will we see it again? If central banks ever expand their balance sheets significantly, they'll face the same choices. Luna: And if walking through the economy with us has made something click, we should mention that listener support is what keeps this show ad-free. People who care can buy us a coffee at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small way to help us keep digging into these wonky but important topics. And it genuinely makes a difference. Luna: So back to the tiering question — there's actually a related concept called 'reserve averaging' that some central banks use, where banks have to hold a certain amount of reserves on average over a maintenance period, but they can run short on some days. Lucas: Right, reserve averaging is about smoothing short-term interest rates, not about affecting the transmission of rate hikes. But it's another example of how central banks design the plumbing of the banking system to achieve policy goals. Luna: Let's go back to the ECB for a second. When the ECB moved to positive rates in 2022, did they keep their tiering system? Lucas: They did, but they adjusted it. Starting in September 2022, the ECB increased the multiplier from six to nine, meaning a larger portion of excess reserves earned the higher rate. That was actually an expansion of the subsidy to banks, which strikes me as odd for a tightening cycle. Luna: Why would they do that? Lucas: To avoid a credit crunch. The ECB was worried that raising rates quickly while banks were still adjusting from negative to positive rates could cause banks to pull back on lending. So they used tiering as a buffer to keep bank profits stable, even as policy tightened. Luna: So the same tool, but used in opposite ways by two different central banks. That's a great example of how monetary policy is as much art as science. Lucas: It really is. And it underscores why investors and economists need to look beyond the headline rate decision. The details of reserve remuneration can tell you a lot about what a central bank is actually trying to achieve. Luna: I think there's a broader lesson here about the complexity of modern monetary transmission. A decade ago, most people thought of central bank policy simply as 'rates up or down.' But now we have tiering, we have the yield curve control that the Bank of Japan used, we have quantitative tightening and its interaction with reserves. Lucas: Absolutely. And the tiering experience demonstrates that central banks are having to micro-manage the banking system's balance sheets in ways they didn't anticipate. The sheer size of reserves post qe created new frictions that required new tools. Luna: So what should listeners take away from this episode? Lucas: I'd say two things. One: when a central bank raises rates, don't just look at the rate decision — look at how it's paying interest on reserves. That's where the real transmission happens. Two: tiering shows that central banks are willing to adjust the plumbing to achieve their goals, which means the policy framework is more adaptable than it seems. Luna: And maybe three: the next time reserves balloon — if there's another QE episode — tiering will almost certainly be back on the table. Lucas: Exactly. It's not a relic of the 2020s. It's a tool that will be used again, and now you know how it works.