Friday, 28 September 2012

Why do commercial banks react to changes in central bank base rates?

Darned if I know.
The amount of reserves that commercial banks need to hold as a proportion of their total assets or liabilities varies from country to country. In some countries (e.g. Canada) there is no minimum reserve requirement. In the latter sort of countries, commercial banks’ only reason for holding reserves is to enable them to settle up amongst themselves.
As to what reserves are relative to M4 or commercial bank lending, this has varied over the last five years from a ratio of about 1:10 to about 1:20 in the UK.
Now if a commercial bank needs £1 of reserves for every £20 lent, the fact of it having to pay an extra percent or two to obtain those reserves will have a negligible effect on the rate it charges for lending the £20.
So why do changes in central bank base rates have any effect on commercial bank lending?
Anyone know?


  1. Base rates increase the amount paid on reserves you hold (either directly or via old fashioned reserve drain paper swaps).

    Therefore there is an arbitrage.

    If base rates are 4% and the corridor is 1% then central bank deposits attract 3.5% and borrowing is at 4.5%.

    Therefore if bank A is looking for 1.5% turn, then it could lend at 2% creating a deposit paying 0.5%

    However Bank B can attract that deposit by offering 1% and get 3.5% from the central bank. This drains reserves from bank A which it has to to top up at 4.5%. Instant profit for bank B and loss for Bank A.

    So the market shifts to an equilibrium point. Bank A pays 3.5% and charges 5% for the loan - getting the 1.5% turn it requires. There is no longer much point Bank B attracting the deposit as there is no longer much money in it.

    1. Thanks. You’ve put me right there. Except that I’d put your point differently, as follows.

      Central banks can attract depositors away from commercial banks. Of course private sector non-bank entities cannot actually deposit money at the central bank, but they can buy government debt. And if a depositor writes out a cheque for some of that debt, the commercial bank on which the cheque is drawn then has to pay the central bank with CB money, i.e. monetary base / reserves. So in order to avoid losing reserves, commercial banks have to pay depositors a rate that competes with the base rate.

      But there is an irony that follows from that. As Warren Mosler pointed out, if a CB just prints the money needed to pay extra interest, the net effect could be the opposite of the intended effect: the extra money is stimulatory. So to deal with that one could get the extra money by raising taxes. But just raising taxes and “unprinting” the money collected would on its own have a deflationary effect. So why bother raising the base rate???

      That rather confirms the claim made (I think) by most advocates of Modern Monetary Theory, namely that the best way of effecting stimulus is simply to create new money and spend it into the economy (or raise taxes and unprint money if deflation is needed). The latter policy is also advocated by Positive Money, the New Economics Foundation and Richard Werner.

  2. Possibly in response to expectations from the public. An increase in the base rate allows banks to justify charging more interest. Conversely if it goes down the public expect to pay less.
    However I'm not sure that unsecured lending rates have actually changed that much in line with the base rate. Credit card rates have kept going up

    1. Re credit cards, there is actually another study which found no relationship between base rates and credit card rates:

      Which shows that the relationship between base rates and other rates is tenous.

      Re expectations, that’s another good point. This Bank of England publication puts stress on expectations. See Col.1, p.3 here:


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