The Bank of England (BoE) will soon stop paying interest on commercial bank deposits in a move that could save the UK taxpayer billions of pounds but hammer profits among high street lenders, a leading analyst says.
Jonathan Pierce, UK banks analyst at Numis Securities, has argued that further interest rate rises will make it politically difficult to continue with the current BoE practice of paying “interest on reserves.” Doing so will amount to a payment from UK taxpayers to the banks.
Most bank analysts assume that the industry’s profitability will rise automatically with interest rates because UK banks have close to half a trillion pounds on deposit at the BoE. Those reserves are paid at the prevailing interest rate, currently 1.25%. High street lenders are not passing on BoE rate rises to customers who have deposits. Instant access savings earnings less than 0.25%, BoE data shows.
Pierce said the risk of a policy shift that could hit bank profits is being underestimated in the sector.
In his valuation models, he assumes the Treasury will intervene to make the BoE stop paying interest on as much as half of its almost £1tn of reserves.
The issue arises because BoE reserves exploded by £450bn during the pandemic. Under quantitative easing, reserves are created to buy government bonds. The new money is then placed on account with commercial banks at the BoE. Those reserves are paid the interest rate.
The arrangement effectively swaps government bonds, on which the Treasury pays a fixed interest rate, for overnight deposits. Roughly speaking, as long as interest rates are below 2%, the Treasury makes money. Above 2%, it has to make transfers that end up at high street banks.
At a time when the government is under pressure to find funds to support voters through a cost-of living crisis and deliver promised tax cuts, the prospect of a back-door raid on high street lenders’ profits may be tempting.
In a letter to the Financial Times last week, Tim Young, a former portfolio manager responsible for foreign exchange reserves at the BoE, warned that “the interest rate exposure involved in QE … is the 500-pound gorilla in the room.”
“As public awareness of the epic scale of this fiscal impact grows, I expect it to provoke a major international story,” he said.
Analysis by both Bloomberg and the Office for Budget Responsibility has shown that the government will start making transfers from next year. If interest rates hit 3% by the end of this year, as markets now expect, the transfers will be even greater than expected. Pierce’s thoughts, which are long held, were given fresh impetus by a report from the New Economics Foundation last week that showed the government could save as much as £15bn a year by paying zero on reserves.
In a note, Pierce said the politics of making large transfers to banks could persuade the authorities to change reserves remuneration, which would have a “significant” impact on bank profits.
He has taken a conservative approach to reflect his view that the “risk-reward is finely balanced.”
The Treasury and the BoE have repeatedly said they have no intention to change the BoE reserves remuneration policy. Pierce pointed out doing so could have an impact on the City of London’s international competitiveness but he was sceptical about official arguments it would affect the monetary policy transmission mechanism.
LEAVE A COMMENT Your email address will not be published. Required fields are marked*
US consumer spending cools in sign of economy on a weaker footing
Egypt set to receive $500mn from World Bank to boost food security
GCC plastic industry advances on circular economy amid challenges: GPCA
Gulf funds’ profit booking drags QSE below 12,200 points
HSBC recognised in nine of The Banker’s ‘Deals of the Year 2022' in Middle East
Qatari fintech platform KARTY gets pre-seed QR4.3mn funding
Qafco wins 'Crystal Award' for Qatarisation support in energy sector
Qatar's PPI surges in May: PSA
MoCI holds preparatory meeting for 2023 strategic planning forum