This article first appeared in Forum, The Edge Malaysia Weekly on March 6, 2023 - March 12, 2023

In an effort to tackle inflation woes, major central banks have been raising interest rates aggressively. But a byproduct of the recent rate hikes is higher interest payments on central-bank deposits held by commercial banks — in effect, a transfer of public-sector money to private banks.

The Eurosystem — comprising the eurozone’s 20 national central banks and the European Central Bank — will pay €107 billion (RM510 billion) in interest (on €4.3 trillion of deposits) to financial institutions during 2023.That number will increase to €129 billion when ECB raises its deposit rate to 3% in March, as it has promised to do.

In the US, the Federal Reserve recently voted to raise the interest rate paid on reserve balances to 4.65%. That means it will owe US$140 billion in interest payments on roughly US$3 trillion of bank reserves this year. The Bank of England is also on the hook for similarly massive handouts to commercial banks.

The latest monetary-tightening cycle implies profits for commercial banks and financial losses for central banks, raising anew the question of whether commercial banks should be remunerated for holding reserves at the central bank. Is paying interest on reserves necessary to conduct monetary policy? Or can central banks raise interest rates without giving massive handouts to commercial banks?

While many economists take it for granted that bank reserves earn interest, the practice is a rather recent phenomenon. ECB introduced interest payments on excess reserves when it started its operations in 1999, and the US Congress authorised the Fed to do so in 2008. Prior to 2000, the general practice was not to pay interest on banks’ deposits.

In fact, commercial banks do not pay interest on demand deposits, even though these deposits, too, provide liquidity for the real (non-financial) economy. Why should bankers be paid for holding liquidity while everybody else should accept not being remunerated?

The lack of a genuine economic basis for paying interest on reserves becomes even more apparent when one considers how central banks make their profits: by obtaining a monopoly from the state to create money. The practice of paying interest to commercial banks amounts to transferring monopoly profit to private institutions. But that profit is essentially taxpayers’ money, and it should be returned to the government that has granted the monopoly rights, rather than funnelled to commercial banks.

Still, many economists believe that remunerating bank reserves is indeed necessary to conduct monetary policy nowadays. After all, major central banks face an overabundance of reserves, owing to years of quantitative easing. Because of this oversupply, the interest rate is stuck at 0% and the central bank cannot raise the market interest rate (which it needs to do to fight inflation).

According to conventional wisdom, the only way central banks can push up rates in such an environment is by paying interest on the ocean of reserves held by credit institutions. Since commercial banks will not lend in the interbank market at an interest rate below the risk-free deposit rate, the latter acts as a floor for the market interest rate. Higher deposit rates then feed through to the entire structure of interest rates.

But there are other ways for a central bank to drive market interest rates higher without transferring its profits to commercial banks. For example, it could sell government bonds, a form of quantitative tightening that major central banks are already implementing.

The problem is that shrinking a central bank’s balance sheet is a very slow process. It could take more than a decade for the volume of bank reserves to reach pre-2008 financial crisis levels. That is why bond sales should be supplemented by a temporary increase in minimum reserve requirements.

ECB has chosen not to use this instrument to date, maintaining the current reserve requirement at 1%, while the Fed has abolished the requirement entirely. But policymakers should reconsider the issue. As central banks gradually pared back their holdings of government bonds, minimum reserve requirements could likewise be steadily reduced.

By transforming the excess reserves held by commercial lenders into required reserves, on which no interest is paid, central banks could recreate the system that existed prior to the financial crisis. At that point, the scarcity of reserves would mean that small manipulations in the supply of reserves could change the money market rate, without the need for central banks to pay interest on deposits.

Some object to the use of minimum reserve requirements on the grounds that it amounts to a tax on banks and could result in economic distortions. But all taxes introduce distortions; the real question is whether the gains outweigh the costs.

The advantages of minimum reserve requirements are twofold. First, the authorities can eliminate the distortion created by providing massive subsidies to banks. Second, policymakers gain an exceptional policy tool designed to take a big bite out of a central bank’s balance sheet while still maintaining financial stability.

Central banks can increase interest rates without massively subsidising banks. Their profits should once again be transferred to governments. Taxpayers, not banks, should benefit from public-sector money. — ­Project Syndicate

Paul De Grauwe is chair of European political economy for the European Institute at the London School of Economics. Yuemei Ji is associate professor of economics at University College London.

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