BoE: Lender of (not so) last resort

Last week, the Bank of England (BoE) published a speech by its Executive Director for Markets, Victoria Saporta, in which she laid out the central bank’s evolving role as a lender to the UK banking system. More specifically, the speech highlighted how the BoE expects to see UK banks having a greater reliance on its funding facilities going forward. We believe this represents an important transition, with the BoE’s role evolving from that of being “lender of last resort” to provider of funding and liquidity in the normal course of business. However, it is a transition that will have to be managed carefully to avoid re-introducing any stigma around banks accessing central bank facilities for non-emergency purposes.

Taking a step back, prior to the global financial crisis the BoE, the Federal Reserve and the European Central Bank operated a “scarce reserve” system; injecting enough reserves for settlement purposes and facilitating interbank markets. Bank reserves are like deposits that banks hold in their accounts with central banks. They are used to settle transactions between banks or between central banks and the banking sector. In response to the banking crisis, the three central banks embarked on quantitative easing (QE) programmes which saw large quantities of central banks reserves transferred into their respective banking systems – this was a move towards an “abundant reserve” system, where the role of the interbank market was diminished. The composition of banks’ liquid assets was changed away from government bonds and into remunerated central bank reserves, which were viewed as another form of liquid asset or investment. Central bank balance sheets obviously grew dramatically in this period as a result, with government and corporate bonds on the asset side and central bank reserves on the liabilities side.

Over time, central banks expanded their tools and introduced direct lending to banks, through programmes such as the ECB’s Targeted Long Term Refinancing Operation (TLTRO), the BoE’s Term Funding Scheme (TFS) and the Fed’s Bank Term Funding Program. These facilities enabled direct injection of funding and liquidity to banks, though they were time limited. Much like QE, they expanded the balance sheets of central banks and created an increasing volume of reserves.

In September 2019, with the Fed’s quantitative tightening (QT) ongoing, it became clear that under the current abundant reserve system, banks needed a higher level of reserves than they did under the previous regime, though the exact quantity required to settle transactions efficiently and comply with liquidity requirements remained uncertain. Central banks therefore had to revisit how to supply those reserves to the banking sector. In the US, the Fed is so far opting for a supply-driven system where it continues to hold a large balance sheet and a high volume of bonds, though the tools it may be using to supply these reserves are evolving. In Europe, the ECB is moving towards a mix of supply- and demand-driven system with the intention of reducing bond holdings further. In the UK, the BoE is looking to pursue a demand-driven supply system. This entails running down asset holdings to zero and instead supplying reserves based on demand from banks. This approach would reduce interest rate risk in the BoE’s holdings, which is an important political consideration as any gains or losses from QE in the UK (like those reported recently due to higher rates) are indemnified by the Treasury, and therefore contribute to public finances.

As the BoE moves towards this demand-driven reserve system (pursuing QT and TFS repayment), it expects the volume of reserves (and therefore the most liquid assets in the banking sector) to decrease. To address any disruption to short-term rates (with banks competing for reserves), the BoE in 2022 introduced the Short-Term Repo (STR) facility, which allows gilt dealers to swap their gilts for reserves for a period of seven days. This facility doesn’t inject new funding to the banking sector, but it does ensure access to central bank reserves in unlimited quantities (to the extent banks have the collateral is available). In addition to STR, the BoE is also running Indexed Long-Term Repo (ILTR) operations. In last week’s speech, Saporta emphasised that the BoE expects banks to increase their use of the ILTR facility in the normal course of business; reserves accessed through this facility are secured against a wider range of collateral than the STR and could act as a replacement for other funding sources. The regulator is already viewing both facilities as business as usual.

To be sure, the BoE is not the only central bank that sees merit in direct lending to the banking sector. Just last week, Democrat Senator Mark Warner of Virginia introduced legislation to overhaul the Fed's discount window, which is aimed at reducing the stigma around accessing that facility. As mentioned above, the ECB is also advocating a mix of tools. Still, the BoE remains in our view the most determined to pursue the demand-driven reserve system, and as a result, we see the greatest scope for higher central bank lending to the banking sector in the UK.

With that in mind, we believe that over the next 12 months or so, we will see increased use of both BoE facilities, as well as potential reform of the ILTR to make accessing this funding easier than it currently is. The BoE will likely continue its effort to improve the messaging around the availability of these facilities, though we believe that at least initially, banks will aim to restrict their usage and rely on other wholesale or retail funding sources.

Eventually, we believe the market will adjust to the concept of central banks providing funding directly to the banking sector in the normal course of business. For fixed income investors, we think the BoE’s transition to a demand-driven system is a positive development for the UK banking sector. Over time it should mean greater stability through reduced funding and liquidity risk, and perhaps even eliminate the stigma around banks using central bank facilities altogether.