The Financial Conduct Authority put UK banks on notice last week to pass on interest rate rises to their savers, or else be ready to suffer the consequences:

Firms offering the lowest savings rates will be required to justify by the end of August how those rates offer fair value, according to the Consumer Duty*

FCA 2023

It’s a debate that’s playing out across the world, from Australia, to India, to America. Interest rates are rising, but savings rates are lagging behind. Banks are making money in the process with the rise in net interest margin (the difference between what banks pay on their liabilities – like deposits – and charge on their assets – like mortgages) one of the major drivers of increased profitability across the sector. UK banks are actually better than their global peers, according to S&P research, passing on a leading, but still less-than-stellar 43% of rises to consumers, while Ireland and Slovenia prop up the table with a paltry 7%. Politicians and regulators are responding, with Italian banks in for a nasty surprise yesterday with a 40% windfall tax on their profits, with their treatment of savings cited as one of the major reasons.

Pay me my money down

Why the needs for regulatory and political pressure? Shouldn’t market pressure alone cause banks to compete to offer the best rates? There are three reasons why this isn’t the case.

One is that the post-financial crisis regulatory regime has increased the barriers to entry for new entrants into the financial system. Additional capital requirements and heavier regulatory rulebooks serve the important purpose of protecting the economy from a repeat of 2008 and its aftermath, but at the cost of a more consolidated, less competitive banking sector.

A second is that banks are offering better rates, but only on term-deposit accounts that require customers to lock their money away for a defined period of time. In the UK, rates of just over six percent are available, but require a minimum term of a year. With the cost of living crisis biting, its easy to see why customers are reluctant to lose access to their funds in the meantime.

A third is the general ‘stickiness’ of deposits, with inertia driving many customers to the default savings accounts or current accounts that offer the lowest savings rates.

All this contrasts significantly with the money banks themselves hold with their central banks. In the UK alone, banks stand to make double-digit billions in interest from the Bank of England over the coming years, with their deposits held with the bank remunerated in full at the prevailing base-rate.

Livin’ in the future

As Andy Haldane notes in piece on the Financial Times last week, one of the CBDC topics that has not yet created much public debate is whether consumers ought to have the same benefit as banks from their money held with the central bank in the form of a CBDC: i.e., should your CBDC holdings be interest-bearing, just like banks’ are today. The general response of central banks to date has been an equivocal ‘no’, with the Bank of England hardening this view in their recent proposal for a digital pound stating that ‘no interest would be paid’.

This response is driven by a number of factors, namely that CBDC is meant to be a cash-like product, and like cash, it will continue to not pay interest; that CBDCs pose a threat to Commercial Banks’ business models, with interest payments exacerbate this threat; and that this effect could be particularly harmful during a time of crisis if consumers were to flee to the safety that CBDC offers as a direct liability of the central bank. I’d agree with Haldane that more debate is needed about this topic, which the arguments presented not necessarily aligning to a clear public-interest case, and mitigants such as daily limits on CBDC transfers seeming to have the potential to address many of the points raised.

In addition to his arguments, it’s also worth considering why central banks set interest rates in the first place. They do so as their main policy tool to try and influence the economy. Put crudely, when things are bad and they want to get the economy moving, they set rates low, like they did post-financial crisis. By making money ‘cheap’ to buy, they encourage more investment and spending. Conversely, during periods of inflation like we are currently experiencing, they raise rates, making new money more ‘expensive’ and deterring investment and spending in the present.

It stands to reason that a CBDC that paid interest at the bank rate would be a powerful lever of monetary policy transmission. Savers, from households through to businesses would have a reason to defer spending as they would know they would be getting the benefits of higher rates, helping to ease demand, and consequently, inflation.

Consumers and businesses are missing out on the rate rises that banks themselves are benefiting from, and that central banks want them to have as a tool of monetary policy transmission. We should think carefully about CBDC design and ensure that we don’t prematurely rule out what could be a an important public policy tool to both drive banking competition and benefit the public good.

*for the uninitiated the Consumer Duty is a new requirement on regulated institutions in the UK to “act to deliver good outcomes for retail customers”