Forward guidance: A proposed U.K. bank tax would cause the Bank of England to lose control of monetary policy

From: Bill Nelson <Bill.Nelson@BPI.com>

Sent: Monday, September 8, 2025 6:46 AM

Subject: Forward guidance: A proposed U.K. bank tax would cause the Bank of England to lose control of monetary policy

The Institute for Public Policy Research – a U.K. think tank – has proposed a bank tax designed to claw back the interest the BoE pays to banks on reserve balances.  The proposal is based on the incorrect premise that interest on reserves is a windfall for commercial banks.  Reserves (deposits of commercial banks at the central bank) are just a loan to the government, and interest on reserves is no more a windfall than interest on T-bills paid to any investor in T-bills.  This email, however, is about a severe technical problem with the proposal.  The tax would cause the Bank of England to lose control of interest rates, driving money market rates down to 2 percent. 

The IPPR proposes (p. 14) that each large bank be taxed according to the following formula:

tax = max(Bank Rate - 2%, 0) * max(reserves - core liquidity allowance, 0)

“Bank Rate” is the interest rate the Bank of England pays on reserve balances.  It is currently 4 percent.  The Bank of England uses Bank Rate to guide overnight money market rates to a level consistent with achieving the Bank’s macroeconomic objectives, which are set by Parliament.  For example, SONIA (Sterling Overnight Index Average) was 3.97 percent on Friday. 

“Core liquidity allowance” is defined by the IPPR to be the amount of reserves each bank needs for clearing purposes.  The institute tentatively proposes that each bank’s allowance be 1 percent of the bank’s total sterling assets.  The quantity of reserve balances created by the BoE balance sheet – which must be absorbed by the U.K. banking system equals £667 billion.  Total sterling assets of large banks in the UK equal £3.3 trillion; 1 percent is £33 billion, which is only 5 percent of the total quantity of reserves.

As I wrote about last week (here), each bank can choose whatever level of reserves it wishes even though the total quantity of reserve balances is fixed by the central bank’s balance sheet.  Interest rates adjust to make banks in aggregate willing to hold the level of reserves provided.  Currently, with money market rates equal to Bank Rate, U.K. banks are content to hold the large quantity of reserves created by the Bank’s asset portfolio because the reserves provide the same interest rate as close substitutes (unsecured loans to other banks, reverse repos, T-bills). 

But suppose you are a bank subject to the tax that the IPPR proposes.  Your after-tax return on the reserves is Bank Rate – (Bank Rate – 2 percent) = 2 percent.  That is, after tax, you earn exactly 2 percent on your reserves regardless of the level of Bank Rate (for Bank Rate above 2 percent).  Consequently, for you to be willing to hold reserves in excess of your core liquidity allowance, money market rates would also have to be about 2 percent.  That would be true regardless of where the BoE sets Bank Rate. If the IPPR gets its way, the Bank of England would lose control of monetary policy. Money market rates would fall to 2 percent, a level that is far too stimulative, and inflation would rise and keep rising.

The consequences for monetary policy in the United Kingdom are similar to those I sketched out for the United States in my email from mid-July:  “Forward Guidance: What would happen if the IORB and ON RRP rates were zero?”

There are a lot of statements in the IPPR report that sound correct but indicate a lack of understanding of monetary policy implementation.  For example, “…what matters for monetary policy implementation is the interest rate on the marginal reserve.”  That’s true, but under their proposal, the interest rate on the marginal reserve is 2 percent. The marginal reserves are the reserves above the liquidity allowance.  Or: “Commercial banks can withdraw their reserves from the Bank of England, but only by ‘selling’ them to other commercial banks.”  As I wrote about at length last week, a bank can reduce its reserves by repaying a liability, buying a security, or making a loan to a business or household; it doesn’t need to make a loan to another commercial bank.

As noted, the proposal is based on an incorrect assertion that interest on reserves is a windfall for banks (for additional discussion see here).  Reserves are a loan to the government just like a T-bill, and interest on reserves is no more a windfall than is interest on T-bills.  As Milton Friedman said in A Program for Monetary Stability (1959):

The third justification for paying interest on reserves is on grounds of equity. It is not easy to see why the government should pay an annual fee for the resources it borrows from some individuals, namely, the holders of interest-bearing government securities, and nothing for the resources it borrows from other individuals, namely the holders of money…Reserve Banks should be required to pay interest on their deposit liabilities.

Please feel free to share this email with anyone who would be interested.  If anyone would like to be added to the distribution list for these free emails, they should just email me.  I’d be happy to add them.

Bill

Bill Nelson | Chief Economist and Head of Research | Bank Policy Institute | 1.703.340.4542