Banks should be forced to pass on rate hikes to savers

The writer is UCL Professor of Economics and Finance and Director of the UCL Center for Finance.

Banks around the world are reporting record profit increases in 2022. In the UK, for example, Lloyds announced that profits had nearly doubled. One might wonder how bank profits can soar during a monetary tightening cycle.

After all, banks need to transform maturities: take short-term loans and lend long-term. When interest rates rise sharply, this implies a fall in net interest income and therefore a decrease in profits.

In fact, net interest income for banks has risen sharply in recent times and is the main reason for the surge in bank profits to date. According to recent McKinsey report.

Over the past five quarters, the base rate of the Bank of England has decreased from 0.1% to 4%. While the interest rate hike is quickly passed on to borrowers (as anyone with a mortgage is well aware), it is hardly passed on to savers.

As British readers are likely to know, deposit rates have risen only modestly since the start of the tightening cycle: standard rates offered by major UK major banks are still below 1% (they were practically zero a year ago). But banks can now earn a base rate of 4 percent by placing deposits with the central bank.

One would expect one of these banks to compete to attract deposits by raising rates to gain market share, say by offering 2 percent. Then another bank offered even more, say up to 2.5%, and so on. Ultimately, competition will bring the deposit rate closer to 4 percent.

The rate will not reach 4% as banks bear the costs of providing services, but such costs are likely to be in basis points rather than percentages. Some narrowing of the gap is to be expected in a competitive industry. That this is not happening is a clear sign of a lack of competition and a major reason for rising bank profits when central banks tighten monetary policy sharply.

The reason why competition does not work here is not obvious, since there are, in principle, enough banks to launch such mechanisms. However, it is also true that the market is dominated by a small number of large players. Given that deposits are notoriously sticky (savers don’t have a habit of looking for better rates), it could be that no major player has an incentive to deviate and offer higher rates while others don’t.

Lack of competition is generally a problem. While bargaining power generates additional profits for shareholders and greater rewards for managers, it worsens the situation of consumers. It also hurts the economy as a whole, as the losses to consumers outweigh the benefits to the firm. Besides this traditional argument, there are two other problems. Fortunately, there is also a simple remedy.

Concerns are connected with high inflation. First, high inflation causes the nominal rate to rise. But if the hike is only partially passed on to the real economy, higher nominal rates are likely to be needed to achieve the same tightening. In short, the lack of competition in the deposit sector weakens the transmission of monetary policy.

A line graph of the bank rate, in %, showing that the Bank of England is raising interest rates to curb inflation

Second, high inflation tends to disproportionately affect less financially sophisticated households. Such households are more likely to keep their savings in the form of deposits than, for example, invest them in bank equity. If the savings rate matched the rise in the nominal rate, this would alleviate the problem. Instead, the lack of competition in the deposit sector is exacerbating the cost-of-living crisis.

The solution is simple: condition the payment of interest on reserves by banks passing on higher rates to savers. For example, a central bank may set a maximum margin as a condition.

This is something he can and should do as it will improve the transmission of monetary policy, thus making it easier to fulfill his price stability mandate. It would also help ease the burden on consumers during This was stated by the head of the Bank of England Andrew Bailey. this week as a cost of living crisis for many people. At a time when the job of central banks is to make painful but necessary decisions, a simple reform aimed at making their task easier and helping society cannot be overlooked.

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