The Bank of England's ongoing review of how its leverage rules are applied could stimulate demand for British government bonds, lower government borrowing costs and change the shape of the gilt market, banks say. Lenders contend the current leverage framework discourages them from holding public debt and that adjusting it could lead to material benefits for the Treasury - but some former regulators caution that such a step would raise financial stability risks.
The central bank is expected to set out its progress on the leverage review in its half-yearly Financial Stability Report, scheduled for release at 0930 GMT on Tuesday. The review follows the BoE's decision in December to loosen its principal capital requirement and comes after a similar relaxation of U.S. leverage requirements in November, a move that heightened competitive pressures on British banks.
Banks argue that the existing leverage ratio - which compels firms to hold capital equal to a little over 3.25% of their assets to absorb losses - treats holdings of gilts in a way that discourages accumulation. Barclays, which serves more than 20 million customers in the UK, has urged the BoE to stop including banks' holdings of gilts when calculating that leverage ratio.
According to Barclays' calculations, exempting gilts from the leverage measure for so-called "unencumbered" gilts - those that are not pledged as collateral and are available to be sold - could allow UK lenders to expand their gilt holdings by as much as by up to
Barclays estimated that such an exemption would support up to and reduce average gilt yields by 0.2 percentage points on average, producing about per year in reduced interest cost for the government, Barclays said.
Lloyds, while forecasting a smaller shift, said a rule change might prompt an additional of additional gilt demand, and still estimated at least in annual interest savings for the government - an amount Lloyds' analysts noted was almost enough to cover a recently announced defence funding shortfall.
Both banks framed the potential rule adjustment as politically appealing because it would create a mechanical increase in domestic bank demand for gilt issuance at a time when Treasury officials are keen to broaden the investor base for UK debt. Britain has become more dependent on foreign investors, including hedge funds, to finance its borrowing, and domestic banks hold only about half as much government debt as their counterparts in the euro zone, bank analysts said.
Not everyone supports an exemption. Since launching the review the BoE has not announced whether it would exempt gilts from the leverage rules. Sam Woods, who until last week served as the Bank's deputy governor for prudential regulation, warned in October that exempting all gilts from the leverage ratio "would be a profound - and highly risky - change". Woods has now been succeeded by Katharine Braddick, a former senior Barclays executive.
David Aikman, who helped design the original rules at the BoE and is now director of the National Institute of Economic and Social Research, argued the leverage ratio was not intended to be the primary restraint on bank lending but has become the main constraint for three of Britain's seven biggest banks. He said the better course was to investigate why certain risk-weighted capital measures had fallen and recalibrate them, rather than carve out gilts from the leverage calculation.
"The answer isn’t to take the batteries out of the fire alarm, but to investigate what’s going on, figure out which risk weights have fallen too far and recalibrate those risk weights," Aikman told Reuters.
Aikman added that gilts are not risk-free and can lose value, and he pointed to experience from the euro zone debt crisis as evidence of the dangers when banks and sovereign finances become too closely linked. He said the BoE was more likely to remove a cyclical element of the leverage ratio that is unique to UK regulation than to exempt all gilts.
Observers are also watching for the BoE's stance on risks emerging from private credit markets and the gilt repo market. The central bank is conducting its first stress test of private markets' resilience to a major geopolitical shock. In the gilt repo market - which had in aggregate net borrowing in March - the BoE proposed in September minimum risk margins or "haircuts" for gilt repo trades that are not centrally cleared, and it has indicated a full update on that proposal is expected in early 2027.
Deputy Governor Sarah Breeden told an ICMA industry conference on May 28 that "doing nothing is not an option" in relation to the gilt repo market. The BoE has warned the market is concentrated among a small number of hedge funds pursuing similar strategies, creating the risk that trading in gilts could become difficult in a stressed environment.
The dollar-to-pound exchange rate used in the analysis was $1 = 0.7492 pounds.
Key points
- Adjusting how gilts are treated under the BoE's leverage ratio could boost bank purchases of government bonds and reduce the government's annual interest bill by more than .
- Banks differ on scale - Barclays projects up to more gilts, while Lloyds estimates about more.
- Policy adjustments under consideration may also include removing a UK-specific cyclical component of the leverage ratio rather than exempting gilts entirely.
Risks and uncertainties
- Former regulators warn that exempting gilts from leverage calculations could reduce banks' resilience and increase systemic risk - implications for the banking sector and sovereign debt markets.
- The gilt repo market remains concentrated and could become illiquid in stress, posing risks to gilt trading and market functioning.
- Any change in leverage rules could alter competitive dynamics between UK banks and foreign lenders, with potential unintended consequences for financial stability.