Some unintended side-effects of current monetary policy

Alexander Demarco is Deputy Governor of the Central Bank of Malta

It is the season where domestic banks report their earnings for the first half of the year. This year domestic banks have overall reported strong increases in profits, largely driven by higher net interest income. This should be welcome news because profitable banks are usually a signal of financial soundness of the sector, unless profits arise from excessive risk taking.

The increase in this year’s profits was most certainly not driven by excessive risk taking. It was to a very significant extent a result of a combination of strong and rapid tightening of monetary policy, with key interest rates of major central banks rising rapidly to very high levels, and past quantitative easing that generated excess reserves which will take time to reverse.

Until mid-2022, when monetary policy was still ultra loose, the Deposit Facility Rate (DFR) was still negative at -0.5%. This meant that credit institutions had to pay central banks for placing a deposit with them. With the reversal of monetary policy in the second half of 2022, credit institutions are paid interest on overnight deposits with central banks, currently at 3.75%, a peak since the inception of the ECB, seen only one other time following a hike in October 2000. For the first half of 2023 the DFR averaged at around 2.8%.

It is therefore no surprise that banks witnessed a surge in interest income this year with such a turnaround in remuneration and rise in bond yields. The second half of 2023 should show a similar trend given that interest rates are very unlikely to fall and excess reserves are likely to remain high. According to the June 2023 balance sheet, published by the Central Bank of Malta (CBM), total liabilities related to monetary policy operations, which are essentially reserves and overnight deposits of local credit institutions with the CBM, amounted to €6.4bn or around 15% of total assets of the domestic banking sector.

This indicates that the increase in profits by domestic banks has been largely driven by monetary policy action on interest rates and a significant excess of risk-free deposits of domestic banks held with the CBM, as the minimum required reserves in June amounted to just around 4.7% of their overall holdings with the CBM.      

While the increase in banking sector profits should be good news for their shareholders, however, it is of concern that the transmission of monetary policy in Malta has been very weak, both with respect to lending rates, but especially on deposits, also when compared to the euro area average.

Such weak transmission implies that depositors (savers) subsidise borrowers as lending rates remain lower than what they ought to be with a stronger pass-through. This distortion in the price signal for money continues to support growth in bank credit, thus undermining efforts to lower inflation back to 2%. While Malta may benefit from a stronger transmission of monetary policy elsewhere in the euro area, through the effect of lowering imported inflation, the domestic element of inflation could remain higher than the euro area average because of the weak interest rate pass-through in the domestic banking sector which helps sustain local demand. This is especially the case for real estate given the high concentration of lending by domestic banks in this activity.   

Current monetary policy and its operational framework is also giving rise to a redistribution of public funds to shareholders of credit institutions. One could argue that when interest rates were negative bank shareholders were effectively taxed on excess reserves held with central banks. However, the interest income received by the domestic banking sector on deposits with the CBM between September 2022 and June has already exceeded the interest payments that the banks had made to the CBM between June 2014 and July of 2022 when the DFR was negative. This excess is expected to grow further by the end of this year.

Some euro area member states such as Spain and Lithuania, have addressed this re-distribution by introducing a special tax on banks. An alternative that would be aligned to the current monetary policy stance could be that of increasing the minimum required reserves, which had been reduced to 1% in January 2012 and remained unchanged since then.

Banknotes in circulation have historically never earned interest and will continue to do so, and as indicated by the European Commission’s legislative proposal on the establishment of the digital euro, published on 28 June, a central bank digital currency would likewise also earn zero interest. Following a decision by the Governing Council in its meeting of 27 July, minimum required reserves are now also unremunerated.

Banks’ excess reserves/overnight deposits are practically the only liabilities of a central bank that are remunerated. Globally, the general practice among central banks before the year 2000 was not to remunerate banks’ excess reserves/overnight deposits. Indeed, it is difficult to communicate why central banks should remunerate excess reserves/overnight deposits, especially at such high rates, when banks do not usually pay their customers interest on demand deposits. It is difficult to justify that the seigniorage that central banks earn from the public on legal tender is being transferred to private shareholders of banks through interest payments rather than channeled to public coffers through dividend distribution. A review of the monetary policy operational framework would therefore need to also consider how best to limit such unintended side-effect.

The opinions expressed in this article do not necessarily reflect those of the Central Bank of Malta

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