**Bank of England Set to Review Leverage Rules for Government Bonds**
The Bank of England (BoE) is poised to announce a review of its leverage rules concerning government bonds, potentially providing a significant boost to the UK’s bond market and reducing public borrowing costs by over £1 billion ($1.3 billion) annually. This announcement is expected in the upcoming half-yearly Financial Stability Report, scheduled for release at 0930 GMT on Tuesday.
The review comes in response to calls from banks, which argue that current leverage rules discourage them from holding public debt. The BoE had previously relaxed its main capital requirements in December, prompting discussions about how leverage rules operate. The central bank's examination of these regulations follows similar relaxations in the United States, which have intensified competitive pressures on British lenders and raised concerns about financial stability nearly two decades after the global financial crisis.
Barclays, one of the UK's largest banks with over 20 million customers, has advocated for the BoE to exempt holdings of British government bonds, known as gilts, from the leverage ratio. This ratio mandates that banks maintain capital worth slightly over 3.25% of their assets to cover potential losses. A change in this area could encourage British banks to increase their holdings of gilts by as much as £150 billion, leading to a reduction in average yields by a fifth of a percentage point. According to Barclays, this adjustment could save the government £2.5 billion annually in debt interest, a significant relief amid strained public finances.
Lloyds Bank has also expressed support for changes to the leverage rules, suggesting that even a modest increase in gilt demand could result in at least a £1 billion reduction in government interest payments. This reduction could help address funding shortfalls in recently announced defense plans. Analysts at Lloyds noted that enhancing demand for gilt issuance is a primary concern for the Treasury, making regulatory changes that boost bank demand for gilts politically appealing.
Currently, the UK government relies heavily on foreign investors, including hedge funds, to finance its borrowing, which has contributed to rising yields. In comparison, British banks hold only half as much domestic bank debt as their eurozone counterparts.
Despite the potential benefits, some former regulators have cautioned against altering the leverage rules. Sam Woods, the former BoE deputy governor for prudential regulation, warned that exempting all gilts from leverage requirements could be a "profound — and highly risky — change." His successor, Katharine Braddick, previously a senior executive at Barclays, will now oversee these discussions.
David Aikman, who was involved in establishing the original leverage rules at the BoE, expressed skepticism about the effectiveness of exempting gilts from the leverage ratio. He argued that the leverage ratio should not be the primary constraint on banks' lending capabilities. Aikman suggested that the focus should instead be on reassessing the risk weights assigned to various lending activities, particularly concerning hedge funds and other non-bank financial institutions.
Aikman emphasized that gilts are not risk-free and can still lose value, referencing the eurozone debt crisis of the early 2010s as a cautionary tale about the dangers of intertwining the health of banks with government finances. He indicated that the BoE might consider eliminating a unique cyclical component of the leverage ratio rather than exempting gilts entirely.
In addition to the review of leverage rules, the BoE is also examining risks associated with private markets, conducting its first stress test of the sector's resilience to significant geopolitical shocks. Furthermore, the central bank is scrutinizing the gilt repo market, which had £74 billion in aggregate net borrowing as of March. In September, the BoE proposed minimum risk margins, or "haircuts," for gilt repo transactions that are not centrally cleared, with a comprehensive update on this matter expected by early 2027.
Deputy Governor Sarah Breeden has previously stated that "doing nothing is not an option," highlighting the importance of addressing the liquidity dynamics within the gilt repo market. While this market plays a crucial role in enhancing liquidity for British government debt, the BoE has raised concerns about its concentration among a small number of hedge funds employing similar strategies, which could pose trading challenges during a crisis.
As the BoE prepares to unveil its findings, the implications of these potential regulatory changes will be closely watched by financial institutions, investors, and policymakers alike, as they navigate the delicate balance between stimulating the economy and ensuring financial stability.