EclectEcon

In an effort to add the appearance of stability to the UK banking system, the British Treasury will require banks that issue currency to leave matching funds on deposit with The Bank of England longer, thus forcing Scottish and Irish banks to forego as much as £100m per year in interest income [from news.Scotsman.com, courtesy of Brian Ferguson]:

The future of Scottish bank-notes could be in doubt following proposed new measures to protect customers from failing financial institutions, it was claimed last night.

Clydesdale Bank, one of three banks allowed to print Scottish banknotes, has admitted it would have to consider whether to continue issuing notes north of the Border if the Treasury proposals get the go-ahead.

Alex Salmond, the First Minister, has also voiced fears over the move, claiming the changes posed the "biggest threat" to Scottish notes in more than 160 years. Under current laws, Clydesdale Bank, Royal Bank of Scotland and Bank of Scotland have to lodge funds with the Bank of England to cover the value of their notes, but only for three days of the week – the other four days they can be invested elsewhere, gaining millions of pounds in interest.

However, the new proposals, announced last week by Alistair Darling, the Chancellor, would require funds to be lodged with the Bank of England for the entire week.

A spokesman for Clydesdale Bank said it was "very concerned" about the potential impact of the proposals and was seeking a meeting with the Treasury. He added: "If this were to go ahead, it would force us to consider whether issuing bank-notes would be viable in the future, a position we do not want to be forced into."

So, in an attempt to add the semblance of stability to the banking system, the Treasury considers putting in place a policy which reduces the amount of lending the banks can do. By itself, this policy would surely reduce the money supply in the UK and put upward pressure on short-term interest rates.

In expectation of this result, will interest rates start rising now? And even if they don't, will the Bank of England have to take off-setting measures, increasing banks' reserves and lowering overnight interest rates?