How to fight inflation without subsidizing bankers at taxpayer expense

Central banks pay billions of dollars in interest to commercial banks through interest-bearing reserves, raising questions about the fairness and effectiveness of anti-inflation measures.

Photo: Frank Wagner/shutterstock.com

The major central banks pay interest on the reserve holdings of commercial banks. To combat inflation, these central banks began raising interest rates at the end of 2021. Let's take the example of the Eurosystem: the bank reserves of the credit institutions at the national central banks and the ECB exceeded 3.6 trillion euros in September 2023. Since April 2024, this has been more than 3.6 trillion euros. The value has fallen significantly, but remained at a respectable level of 3.15 trillion euros in August 2024 (see below). In September 2023, the interest rate on these reserves held by commercial banks was increased to 4% and subsequently reduced to 3.75% in June 2024. This means that the Eurosystem has paid out at least 126 billion euros in interest to credit institutions from September 2023 until August 2024. Other central banks, in particular the Federal Reserve and the Bank of England, follow the same practice of increasing the interest rate by increasing the interest rate on bank reserves .

To give you an idea of the size of these transfers in the Eurozone, consider this: with a transfer of 126 billion euros by the Eurosystem to banks in the Eurozone between September 2023 and August 2024, we are approaching the EU's total annual spending. That's 168 billion euros. This situation is all the more remarkable considering that the transfers from a European institution to banks are decided without political discussion and granted without conditions. In contrast, EU spending is the result of a complex political decision-making process and is usually associated with strict conditions.

Many economists and central bankers today assume that bank reserves earn interest. However, this compensation is a recent phenomenon. Before the start of the Eurozone in 1999, most European central banks did not remunerate banks' reserve balances. In the 1970s and 1980s, the Bundesbank used very high, unpaid minimum reserve requirements to divert large inflows of money into the country.

The ECB began charging interest on bank reserves in 1999. The Federal Reserve did not introduce interest on bank reserve balances until 2008. Therefore, before 2000, it was not common practice to pay interest on banks' reserve balances. That made perfect sense: commercial banks don't charge interest on their customers' sight deposits. These demand deposits serve the same function as bank reserves at the central bank: they provide liquidity to the non-bank sector. These are not remunerated. It's hard to justify why bankers should be paid when they have liquidity while everyone else has to accept that they won't get paid. In addition, the high interest rate on bank reserves leads to several problems.

First, when the central bank makes interest payments to commercial banks, it transfers part of its profits to the banking sector. Central banks make a profit (seigniorage) because they have been given a monopoly to create money by the state. The practice of paying interest to commercial banks amounts to transferring this monopoly profit to private institutions. This monopoly profit should be returned to the government that granted the monopoly rights. It should not be appropriated by the private sector, which has done nothing to generate this profit. In fact, it's worse. The transfers are now so high that not only are all of the central banks' profits being transferred to banks, but the central banks are also incurring significant losses that have to be borne by taxpayers. The current situation of paying interest on banks' reserve balances amounts to a subsidy to the banks, paid out by central banks at the expense of taxpayers.

Secondly, the problem of interest on bank reserves also becomes clear from the following. Banks “take out short-term loans and make long loans.” In other words, banks hold long-term assets (with fixed interest rates) and short-term liabilities. As a result, a rise in interest rates typically results in losses and reduces banks' profits because the interest costs of their liabilities rise quickly while interest income takes longer to rise. Banks are expected to hedge this interest rate risk. However, this is expensive, so they often shy away from taking out such insurance. By charging interest on bank reserves, central banks provided free interest rate hedging. Banks received immediate compensation from central banks when interest rates rose.

Paradoxically, as central banks fought inflation by raising interest rates, banks avoided the burdensome loss profile as they made significant profits during the period of interest rate increases in 2022 and 2023. This was possible because central banks took on this burden from commercial banks. It is difficult to understand the economic rationale for a system in which public authorities hedge banks' interest rate risks for free at taxpayer expense. It is also worth noting that central banks did not suffer losses when they raised interest rates to combat inflation in the 1970s and 1980s. Instead, they increased their profits. One of the main reasons for this was that they did not pay interest on bank reserves.

One could argue that while the large transfers to banks were unfair, these transfers were essential to effectively combating inflation. In fact, the opposite is true. The current system of interest-bearing bank reserves increases banks' profits and thereby strengthens their capital position when the central bank raises interest rates to combat inflation. As a result, this system provides banks with an incentive to increase the supply of bank loans. Thus, the current system has reduced the effectiveness of the transmission of monetary policy, which was focused on reducing inflation in the period 2021-2024.

Interest on bank reserves is not inevitable. There is an alternative. We propose the introduction of a tiered system. This is the definition of a level 1 made up of unremunerated reserves and a level 2 which is paid. Suppose a bank has 100 units of bank reserves. The central bank could specify that Tier1 consists of 50 units and Tier2 consists of 50 units. The Tier 2 portion can also be referred to as excess reserves and bears interest at the same deposit rate that the ECB has applied.

Such a tiered system allows for a significant reduction in the transfer of central bank profits to private actors and allows central banks to maintain their current operations. So when the central bank wants to increase the interest rate to combat inflation, it increases the deposit rate on Tier 2 reserves. This increase in the deposit rate has the same impact on the market interest rate as the current system, but results in fewer transfers to banks, making the system fairer while increasing the effectiveness of monetary policy.