UK central bank warns markets of change

Bold move: Bailey delivers a lecture at the London School of Economics. The BoE governor wants to make the transition to free the central bank from interest rate risk that has placed it under intense political scrutiny. — Bloomberg

LONDON: Bank of England (BoE) governor Andrew Bailey says markets should prepare for a big increase in securities repurchase operations as the UK central bank reduces the reserves it built up during the financial crisis and pandemic.

Signalling a radical shift in the way the BoE has worked with markets over the last 15 years, Bailey said he wants to replace the asset purchases done through quantitative easing (QE) with short-term loans (repos).

His speech set out in more detail the arrangements the BoE plans to have in place once it winds down its QE portfolio, which peaked at £895bil (US$1.1 trillion).

QE became the BoE’s main monetary tool to boost the economy, the benchmark interest rate was cut close to zero.

In recent months, commercial banks have been borrowing increasing amounts from the BoE’s short-term repo operations, which are designed to “pick up emerging scarcity in reserves supply at an early stage”.

The facility has broken previous records for usage in each of the last four weeks, with the most recent operation being tapped for £14.4bil.

The switch may start as soon as the second half of 2025, when the BoE shrinks its balance sheet, which is currently £760bil.

Bailey said he expects that to fall to a stable level of between £345bil to £490bil.

On current run down rates of about £100bil a year, including the unwind of a Covid funding programme for high street lenders, Bailey expects the level to be hit “as soon as the second half of next year”.

At that point, markets may hit some “bumps in the road”, Bailey warned.

“We would expect a significant increase in our repo operations as we look ahead to the future, and the market should continue to ready itself for this.”

The governor wants to make the transition to free the BoE from interest rate risk that has placed it under intense political scrutiny.

UK lawmakers have raised concerns about the cost to taxpayers of BoE losses on its asset sales, with some calling for changes to the programme.

QE has forced the Treasury to fund £50bil of losses since 2022 because the interest paid on reserves is less than what the BoE earns on the assets bought with those reserves.

Although QE made a profit of £124bil from 2009 to 2021, that money has been spent, and recent losses have had to be covered by the taxpayer.

Bailey said that in the future, the BoE wants to lend central bank reserves in exchange for collateral such as gilts provided by commercial banks.

That would replace the system in place during QE where the BoE created reserves, a form of central bank deposit, to buy assets.

Bailey admitted in a Q&A that there is a “a great worry about stigma in the sense of when banks come to the central bank for liquidity. Is it going to happen seamlessly and without giving rise to concerns about financial stability?”

Bailey dismissed concerns about market disruption during the US Federal Reserve’s (Fed) winding down of its balance sheet prior to the pandemic.

While the Fed was forced to halt quantitative tightening in 2019, Bailey said this wasn’t the US central bank hitting its minimum reserves level but was tied to “the distribution of reserves around the market”.

He said the BoE’s new repo operations are similar to action taken by the Fed to calm markets.

Because they’re loans, repos carry minimal interest rate risk. Moving to the new model would be a return to more traditional balance sheet operations, Bailey said in a speech at the London School of Economics.

“For much of the bank’s history we have lent on a secured basis, primarily against government securities and trade bills,” Bailey said.

“Perhaps it is time to return to such an approach. The absence of interest rate risk substantially mitigates the financial risk on the central bank balance sheet. So from this perspective, providing central bank reserves through repo-operations has much appeal.” — Bloomberg

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