Tilt Mechanism

Central banks move to fix the game as losses appear.

In pinball, a tilt is an error condition in the game when you move the table too much in order to direct the ball – it’s an anti-cheat thing. Depending on what type of pinball machine you are playing on a tilt can either cause you to lose the ball or the entire game. In state finance, a tilt could be used to describe the actions authorities take to regain the ball they think they’ve lost. See the difference? In finance, the tilt is the way the authorities cheat. The years of ad hoc policy distortions mean a ‘tilt’ may make an appearance in central bank policy. Actually, it already has.

In July this year, the IMF estimated ‘after roughly breaking even in 2022, the Euro System is projected to incur large losses in 2023−24… of about €55 billion over the two years, worth 0.5 percent of euro area GDP...’

Also in July, and probably not coincidentally, the ECB removed remuneration of Minimum Required Reserves (MRR). The move was either a/ a small step toward stemming these losses or b/ a bank levy and so a further intrusion into fiscal policy by the European monetary authority. It may be both. The ECB claimed the decision would ‘reduce the overall amount of interest paid on reserves. Such reassurance involved some sleight of hand; the simultaneous decision at the same meeting to raise interest rates by 25bps on a much larger stock of excess reserves meant ‘overall’ the amount of interest paid on reserves increased that day. Indeed, the decision on MMR remuneration may imply the ECB sees a need for even higher policy rates, leading to larger losses. My estimates suggest the move to remunerate MRR at 0% may save the Euro System EUR6 billion at current rates over a full year. That’s not really going to move the dial on the expected losses. But it takes some of the sting out of policy making and allows policy makers to tell their political leaders they ‘are doing something’. For, no doubt, the losses, coming on top of an inflationary episode widely blamed on central banks, is a political-economy challenge.  

If a little bit of help from MRR is possible, why not repeat the exercise? Subsequently, economist, Paul De Grauwe, suggested remuneration should be removed from a much larger percentage of central bank reserves, thereby reducing losses in a much more meaningful way.

But hold on, higher interest rates are designed to hurt those who fund assets with short-term funding. The fact that QE has made central banks the largest holders of assets, funded by short-term rates, is not a mistake; it is the result of prior policy conducted after careful deliberation. These losses were part of prior policy calculations.

To get around this inconvenient truth, language deployed by the professor is confused. He suggests the remuneration of reserves causes a ‘massive transfer of central bank profits to commercial banks.’ That is an odd use of the word ‘profit’. Profit accrues when income exceeds outlays. Central banks decided to buy lots of bonds above par, financed by issuing reserves whose interest rate was linked to their policy rate. There is no more profit because they increased rates.

No-one likes losses. Especially if losses can be clearly attributed to past decisions. Central banks are no exception. Central banks are different in that they have ways to mitigate their losses. The move to remunerate Minimum Required Reserves at 0% shows how they can tilt the game. And once you’ve tilted a table once, it is hard not to tilt again. Especially if they can justify a change of rules in attractive terms, such as a tax-saving measure, or a move against rapacious self-interest, or both.  Professor De Grauwe looked theatrically shocked explaining the current system means commercial banks ‘make fantastic profits, and what do they do with it? They buy back their own shares and transfer the profits that you have made possible… so all the money that should go to the taxpayer is channelled through the banks to the shareholders…’ Well, that is not quite an accurate depiction of how we got here.

Photo by James Lee on Unsplash

Most are aware that many past policy choices of the ECB had met with scepticism from the German central bank. Ironic then, that the Bundesbank is now lumbered with the largest loss of all European central banks. Probably sensing a ready audience, Professor De Grauwe offered a siren appeal: ‘if we raise the minimum reserve requirement it will save these transfers. The banks won’t like you but if the rest of the public like you, you shouldn’t worry.’ A little later professor De Grauwe says:’ ‘If you go to 15% (MRR) you can more-or-less eliminate this problem’. How could the Bundesbank resist?

A few correctives are needed here.

Recognition of how we got here is the first part of a proper diagnosis of future action. Hats off, then, to the president of the Bundesbank, Joachim Nagel, who responded ‘yes, there might be future losses… All that we are doing in the Governing Council (of the ECB) is about monetary policy. It is not about profit and losses of commercial banks… Banks are getting this large remuneration as… the result of what we had to do when we were in a disinflationary scenario… All that we had to do… is coming with a certain price.’  In a few short sentences, sanity was restored.

There certainly is a policy problem posed by remuneration of reserves. Interest rate rises normally curtail profitable lending opportunities for banks. Under current conditions banks are forced to lend at high interest rates to central banks. But higher rates also still transfer to borrowers in the wider economy. The central bank designed this framework, not the commercial banks.  

Moreover, not all central banks are equal in the Eurozone. The Bundesbank, sponsor of professor De Grauwe’s public discussion, may post the largest losses in the Euro System, according to the IMF paper. Others may be more fortunate. The Banca d’Italia may even avoid a loss altogether, according to the paper.

IMF: Raising Rates with a Large Balance Sheet: The Eurosystem’s Net Income and its Fiscal Implications, July 2023

Of course, a major reason for large losses at the Bundesbank is the investor preference for a ‘core’ jurisdiction in which to deposit money. There is much lower ‘excess liquidity’ in the Italian or Spanish banking systems, and therefore lower remuneration of reserves and lower losses.

Unfortunately, the lower cost of remuneration of reserves in Italy and Spain comes with an unpleasant side-effect; the Minimum Reserve Requirement takes up a much higher proportion of available liquidity in these banking systems. At 1% the MRR uses 4% of total German liquidity while it consumes 9% of Italian banking system liquidity. If MRR is raised to 5%, as some have suggested, MRR will consume 18% of German bank liquidity, but 44% of Italian available liquidity. Above 11% MRR, the Italian banking system will need to borrow liquidity at great cost simply to meet its minimum reserve requirements. The 15% target suggested by De Grauwe is a non-starter, at least for Italy. Perhaps that part of the the solution was not deemed relevant.

Then there is the issue of how reserves are treated by international bank rules. The latest Basel regulations include central bank reserves in Level 1 HQLA assets ‘to the extent that the central bank policies allow them to be drawn down in times of stress’. The Euro system ‘considers only the part of the daily account holdings that exceeds the average daily required reserves as withdrawable in times of stress and thus eligible for inclusion in HQLA.’ That means any increase in MRR in the Eurozone will force banks to acquire more HQLA.

There is an unfortunate logic here. Losses to central banks (or ‘excess profits’ for commercial banks) can be mitigated by adjustments to MRR. And any increase in MRR may lead to higher demand for Level 1 assets which ‘include cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks, among others.’ Banks don’t want cash and don’t need more reserves, which leaves HQLA to be satisfied by ‘marketable securities backed by sovereigns’. This is an obvious convergence of interest between central banks facing losses and fiscally constrained governments looking to expand their investor base.

Increased demand for HQLA will do nicely. Expect the Minimum Reserve Requirement to move higher. The tilt sensor will be reactivated again soon.