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  • Writer's pictureWilliam Webster

Overnight Problems

Issue at Hand

A potential shift in the Bank of England's policy to stop paying interest on commercial bank deposits is becoming a live political debate. There is a growing sentiment that paying interest on reserve accounts is effectively a subsidy to the banking system. This increasing pressure could influence the Bank of England to change its policies, presenting significant challenges for financial institutions. It's important to note that this situation is not the same as a negative interest rate policy; there are viable alternatives available, although their returns will likely be lower than those you are accustomed to.

Over-reliance is Risky

Relying heavily on a single counterparty, such as the Bank of England, or one method of managing deposits makes you more susceptible to regime change. This is especially true for small banks, which find the simplicity of depositing with the central bank well-suited to their business model. They lack the resources to manage a more diversified portfolio of assets. Larger banks, however, have the resources and capabilities to diversify their asset base, thereby reducing their exposure to changes in central bank policy. Nonetheless, all banks must recognise that heavy reliance on one counterparty leaves them vulnerable to policy shifts

If the Bank of England stops paying interest, you will need to consider alternatives such as Treasury bills (T-bills) and repurchase agreements (repos). These options, while liquid, introduce more credit and operational risks and less certain liquidity. With this in mind, it is essential for banks to regularly test alternative strategies to ensure they are viable.

This means evaluating and trying out different asset allocations, understanding potential operational risks, and ensuring systems and processes are ready for a seamless transition.

For example, you might periodically invest in T-bills or repos to gauge their performance and integration with existing systems. Regular testing helps banks identify and address any operational issues, ensuring that they can quickly adapt to changes in the Bank of England’s policies without significant disruption. But this isn’t all.

You need to ask yourself how much of a problem this is. It’s all very well recognising that Net Interest Margin (NIM) will fall but by how much?

Readers of my blog will know I like to keep these things simple and here a delta will suffice. If you deposit £200m a year in the Reserve account for every 1% fall in interest there is a cost of £2m from your business.

Yes, a zero interest rate policy for reserves is so painful and it will force you to use alternatives. But they too can be affected.

Second-Order Effects

Changes of this type lead to unpredictable outcomes, for instance, if many banks suddenly shift their investments to T-bills, the increased demand could suppress returns, reducing their attractiveness.

Running some type of stress and using the delta approach to give you a feeling of what may happen is worthwhile. As I’ve previously discussed, using AI to give you some scenarios for the effect on both the wholesale and retail markets is worthwhile.

While stress testing can provide insights, there’s nothing like being prepared; it’s amazing how long it can take to get credit clearance, ensure your IT systems work and have proper legal documentation in place. Starting now could look fortuitous in the future.

In summary, these are the five questions you should be asking:

  1. How diversified is your asset portfolio? Are you overly reliant on deposits with the Bank of England, and what are the immediate steps you can take to diversify your assets to reduce fragility?

  2. What viable alternatives exist to replace Bank of England Deposits? What are the potential alternative assets, such as T-bills and repos, and how do their liquidity, risk, and return profiles compare to your current holdings?

  3. What would a regime change cost you? Are there some simple rules of thumb that help?

  4. How could second-order effects change things? How might increased demand for alternatives like T-bills affect their yields, and what would be the financial impact on your business if returns were to fall by 1% or 2%? Are these impacts significant for your overall profitability and stability?

  5. How prepared are your systems and processes for a transition? Have you tested your systems and processes to ensure they can handle a shift to alternative assets, and what are the costs and operational implications of such a transition?

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