Beyond the 'Bonanza': Unseen Dimensions of the De Grauwe/Ji Reserve Policies

In their article “The new operating procedures of the Bank of England: A bonanza for the banks,”, Paul De Grauwe and Yuemei Ji propose a two-tier system of reserve requirements to mitigate large transfers from the Bank of England to commercial banks. While their analysis highlights significant fiscal implications, it overlooks critical aspects of the UK’s financial framework, particularly the Debt Management Office’s (DMO) role and the mechanics of government cash management.¹

The Role of the Debt Management Office

The DMO is an executive agency of HM Treasury responsible for carrying out the government’s debt and cash management policies. Its goals include minimising financing costs over the long term and managing the government’s cash needs. The DMO achieves this by issuing government securities, such as Treasury bills and gilts, to finance public borrowing requirements. These instruments are sold to financial institutions, including commercial banks, which earn interest on their holdings.

Interest Payments: A Broader Perspective

De Grauwe and Ji express concern that paying interest on bank reserves leads to substantial transfers to banks, potentially reducing the effectiveness of monetary policy. However, this perspective does not fully consider that the government routinely pays interest to banks through various channels, not solely via central bank reserves. For instance, when the DMO issues daily repos and weekly Treasury bills, it incurs interest obligations to the purchasers, most of whom are commercial banks. This practice is a standard aspect of government cash management and is not typically viewed as problematic.

The Ways and Means Account: An Alternative?

The authors do not address the possibility of altering the DMO’s cash management strategy, such as eliminating the issuance of Treasury bills and instead utilising HM Treasury’s Ways and Means account held at the Bank of England. The Ways and Means account serves as the government’s overdraft facility with the central bank, allowing for short-term financing needs. Relying on this account would eliminate interest payments to commercial banks, as the Bank of England would account for the relevant credits at a zero rate.

If, as De Grauwe and Ji argue, zero-rated reserve tiers do not distort monetary operations, then using the Ways and Means account should be just as unproblematic. The logic underpinning their position—and that of the European Central Bank—implies that reserves held at zero interest do not create distortions. Therefore, if such an approach is acceptable, there can be no operational reason for the Ways and Means account to cause issues. The argument must be internally consistent: De Grauwe and Ji (and the ECB) are wrong about the effect of zero-rated reserve tiers, or the conventional fears over using the Ways and Means account have no logical basis.

Money Creation and Fiscal Implications

It’s important to clarify that the Bank of England does not create money when crediting interest on reserves. Instead, it utilises income from its assets, such as government bonds held in the Asset Purchase Facility and indemnities received from HM Treasury. Therefore, interest payments on reserves are ultimately a fiscal expense borne by the government, as with interest payments on Treasury bills and repos issued by the DMO.

Consistency in Fiscal Policy

The critique raises a fundamental question: Why is paying interest to banks via the DMO’s operations considered acceptable, while similar payments through the Bank of England’s reserve remuneration are viewed as problematic? In the UK, the Bank of England and the DMO operate under the umbrella of HM Treasury. Consequently, transfers to the banking sector, whether through debt issuance or reserve remuneration, have comparable fiscal impacts. If zero-rated reserves are deemed non-disruptive, then logically, the same must hold for the Ways and Means account. A comprehensive assessment of these practices should consider the overall coherence of fiscal and monetary policy rather than isolating specific mechanisms.

Conclusion

While De Grauwe and Ji’s proposal for a two-tier reserve requirement system aims to reduce transfers to banks and enhance monetary policy effectiveness, it does not fully account for the integrated nature of the UK’s fiscal and monetary operations. Furthermore, their position is internally inconsistent: if zero-rated reserves do not interfere with monetary policy, the Ways and Means account should not be considered problematic either. A holistic approach that considers the roles of the Bank of England and the DMO and the various channels through which the government interacts with the banking sector is essential for formulating effective and consistent policy recommendations.

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