MNI INTERVIEW: BOE To Opt For Bespoke Negative Rate Tiering

The Bank of England could announce its intention to shield banks' household deposit accounts from the effects of any future cuts in official rates to negative levels when it unveils a detailed framework later this year for how it could take rates below zero, former senior Bank of England official David Aikman told MNI.

Differences in financial system regulation mean that the BOE cannot simply copy tiering systems used by other central banks to limit the impact of negative rates on banks, Aikman, former technical head of division in the Bank's Financial Stability Strategy and Risk Directorate, said in an interview. European Central Bank tiering used in conjunction with its negative deposit rate, for example, is based on eurozone banks' minimum reserves, which are not required of British lenders.

"The Bank's framework doesn't have a minimum requirement … I think there may be merit in basing the exemption amount on the size of each banks' small household deposit accounts, i.e. allowing banks to shield small household deposits from negative rates," Aikman said.

EFFECTIVE LOWER BOUND

The BOE said in February that banks had until August to get ready for negative rates and staff were told to design a tiered system to continue to remunerate a tranche of financial system deposits, reducing the impact of such a policy on net interest margins. Financial market expectations of rate cuts have since receded as the economy recovers from its pandemic slump, but the review is meant to establish negative rates as a credible tool should they be required in future.

The BOE will have to consider the issue of how negative Bank Rate can be taken within a tiered system, said Aikman, now a professor at King's Business School.

External MPC member Silvana Tenreyro said in January that the effective lower bound was at least minus 75 basis points, but the Bank has not publicly re-evaluated old estimates, which do not take tiering into account and which indicate rates could not usefully be cut from about the current 0.1%.

"Another issue for the Bank to think through is what level of Bank Rate can be supported through such mechanisms, i.e. where is the effective lower bound?" said Aikman, noting that that number is likely to differ across countries and depend on the impact of negative rates on local banks' profitability.

The Bank has also left unanswered the question of what will happen to its term funding scheme (TFSME), which provides banks with cheap funding linked to Bank Rate, in the event the benchmark goes negative.

Aikman noted that while setting tiering exemption balances would be a matter for the Bank executive extending the TFSME is an MPC matter and members may not want to pre-announce it.

"They might be nervous about signalling this to the market in advance of the decision actually being taken on negative rates. It's also not obvious to me that the benefits of advanced communication would be large in this case," he said.

GROWING BALANCE SHEET

Even as the Bank works on a negative rates framework, attention in official circles is already turning to the opposite scenario, when recovery might prompt increases in official rates. The quantitative easing programme with which the BOE has supported the Covid surge in government borrowing will soon have left about a third of the UK's public debt on the central bank's balance sheet, all funded at Bank Rate, a rise in which would have painful consequences for public finances.

This has led some prominent economists to suggest the government is likely to push the Bank to exempt reserves used to buy government bonds from interest payments, but this would be met by stiff BOE opposition. Such a move could fuel inflation, Aikman said.

"In such a scenario, we could presumably see a very large reduction in reserves demanded and a large increase in broad money and credit (a return of the "money multiplier" to more normal levels). If this was left unchecked, this could have significant inflationary consequences," he said. "The Bank would need some other mechanism to maintain monetary control. We could, for instance, see bank liquidity requirements tightened, forcing banks to maintain large reserve holdings for regulatory purposes – this was pretty much the regime in place in the post-war period. Alternatively, it could be that the leverage ratio requirement then acts as the marginal constraint on money supply.

"I think neither case is desirable, but it is not inconceivable that such a situation could arise," Aikman added.