The Reserve Requirements Fad: A Solution in Search of a Problem

The Latest Epicycle in Interest Rate Mythology

Every so often, a new fad emerges to prop up the fantasy that interest rate targeting is some economic panacea. The latest contender? Reserve requirements.

The premise is simple: if we stop paying interest on massive excess reserve quantities held by banks, we won’t have to hand over vast sums to them. The stunning amount of intellectual effort required to come to this conclusion is why economists earn the big money. Predictably, it has been seized upon by those Right-Thinking Lefties who detest bank profits but remain wedded to the mystical notion of an all-controlling interest rate.

Misunderstanding Banking—Again

Since economists construct their banking theories on layers of myths, they inevitably arrive at the wrong conclusions. Yanis Varoufakis fell into precisely this trap when applying the reserve requirement argument to the UK.

So, let’s take a step back and examine reserve requirements in the context of UK banking—without the distortions of mainstream economic dogma.

Myth 1: The Bank of England’s ‘Losses’ on Gilt Sales

A common refrain is that the Bank of England loses money when it sells gilts from the Asset Purchase Facility (APF). It doesn’t. The actual economic burden on the state occurred when the Monetary Policy Committee (MPC) hiked interest rates—that being the point of raising rates.

Lowering interest rates and buying gilts (Quantitative Easing) removes free-money interest payments from the economy,  allegedly to encourage spending. Raising interest rates and selling gilts (Quantitative Tightening) does the reverse, injecting free-money interest payments back in, allegedly to promote saving. The Debt Management Office (DMO) has been selling gilts for decades based on the absurd belief that people won’t save unless you bribe them with interest payments.

If the Bank of England is ‘inflicting large losses upon itself’ by selling gilts, then so is the DMO every week. But, since both entities are effectively subsidiaries of HM Treasury, why is a ’large loss’ unacceptable when the Bank does it but fine when the DMO does?

Myth 2: Holding Gilts to Maturity is a Better Strategy

If the Bank of England doesn’t sell its APF gilts and instead holds them to maturity, it will still suffer the ’loss’—just in the form of ongoing interest on reserves payments instead of realised losses on gilt sales. The value of any gilt held to maturity is just the expected value of holding reserves at a floating rate. Mainstream theory itself concedes that these are equivalent in present value terms.

When the Bank sells APF gilts and draws down the Treasury indemnity, the Treasury issues more gilts to absorb the excess reserves. The result? It is the same position as if the Bank had written off the APF entirely and let the DMO handle all gilt sales directly. The difference from the time of purchase of QE assets to the time of sale is merely the change in the interest paid due to the increased Bank Rate—a political choice based on faith in an omnipotent interest rate acted upon by omniscient financiers.

The Bank’s Real Objective: Returning to Normality

The real reason the Bank of England wants to get rid of APF assets is simple: it wants to return to its historic role of running the UK banking system short. Banks are ordinarily net receivers of interest, and the current situation—where they are net payers—offends traditional banking sensibilities.

The introduction of the Short-Term Repo facility and discussions about a demand-led framework using time-boxed repos signal the end of the ‘interest on reserves’ era. It won’t be long before the Bank returns to discounting Bills—the system that served the UK banking sector perfectly well for 300 years.

The British Solution: Back to Discounting

Instead of mimicking the European Central Bank’s approach of paying zero interest on some reserves, the British solution is to eliminate those excess reserves. Banks don’t need them if the Bank of England stands ready to discount collateral as required.

The small evolution in Bank thinking—from open market operations to repos—is a step in the right direction. But they still haven’t made the final leap: the Bank holding a balancing deposit at the Bank Rate in all the regulated institutions, and relying on registered debentures rather than posted collateral.

The current practice—where the Bank demands extra collateral despite already approving a bank’s assets via its regulatory arm—is redundant. If the regulator believes an institution’s assets are sound, the Bank should be prepared to put its money where its mouth is.

Some skin in the game would help prevent the sort of regulatory failure we saw with Liability Driven Investments.

Conclusion: A Return to Sanity

The British banking system has lasted over 300 years for a reason. The obsession with reserves and interest rate control is a relatively recent experiment—and one that is rapidly unravelling. Instead of clinging to the latest economic fads, the UK is (slowly) rediscovering what it already had worked just fine. 

In the end, reserve requirements are just another distraction¹. The real solution is to eliminate excess reserves altogether and restore the pre-2005 framework, in which the Bank of England acted as a lender of last resort, not a permanent payer of subsidies to the banking sector.

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