In the balance
17 September 2024
With the next wave of quantitative tightening on the horizon, Karl Loomes looks at the BoE's balance sheet and its shift towards the short-term repo facility
Image: stock.adobe.com/EdNurg
Since the 2008 financial crisis, the majority of the past 16 years have seen Bank of England (BoE) monetary policy focused on economic stimulation. Its twin remit of keeping inflation under control, and supporting a healthy, stable economy, has until fairly recently kept interest rates at record lows, and has had the Bank ‘printing money’ in the form of quantitative easing (QE).
Though high levels of inflation — driven predominantly by energy and oil prices — have brought about an immediate need to raise interest rates to help cool rising prices, the end of quantitative easing and a move to quantitative tightening (QT), was always going to be on the cards. The winding down of what the Bank calls its “extraordinary monetary policy operations”.
QT is, in effect, the process of the BoE ‘normalising’ its balance sheet; drawing down on its reserves (which were increased massively by QE) to “steady state” levels. The Bank sees this as enough to support the normal functioning of the banking system in a ‘demand driven’ framework. If quantitative easing is the process of printing money, then quantitative tightening is the process of taking that money back out of the system.
These central reserves, however, are a crucial element of a stable economy and a well-functioning banking system. Though the steady state levels should be enough for the normal functioning of the system in ‘normal’ times, flexibility in the Bank’s lending operations is still seen as key. This is where repo comes in.
Economics 101
The functioning of the myriad systems that the Bank of England and wider banking system utilise, is complex, and worth looking at in its own right.
The main tool the BoE can use to curb inflation is interest rates. A higher interest rate reduces spending in the economy (more incentive to save, higher mortgage and loan repayments, less incentive to borrow etc), curbing inflation, while a lower rate helps stimulate the economy.
This bank rate is only useful however, if commercial banks actually change their own rates in accordance with the BoE’s moves. The Bank ensures this through a number of facilities that ‘transmit’ the rate to the commercial market, the main one of which is the remuneration of its reserves held by commercial banks at bank rate.
With interest rates as low as they could go after the financial crisis, the other arm of monetary policy — money supply — was needed. More money in an economy, all other things being equal, should help stimulate growth.
The Bank does this not by printing physical money, but through its Asset Purchase Facility (APF) — an aptly named mechanism which buys bonds (the vast majority being gilts, though some corporate bonds as well) in the secondary market, through newly created funds (‘printing’ digital money) in its reserves.
This is quantitative easing, and the sustained level of asset purchasing in the years following the financial crisis has meant the BoE’s reserves were far above the levels needed for ‘normal’ market conditions.
Quantitative tightening — underway now for more than a year — is the reverse of this. The Bank has been allowing bonds to mature as well as actively selling them, and then ‘extinguishing’ the proceeds, effectively taking the cash it created during QE back out of the system.
With ample supply in reserves, commercial banks are able to borrow from the BoE at bank rate without any issues. As these reserves eventually get drawn down to minimal levels, itself an uncertain and likely changing metric, commercial banks may need to start borrowing cash in the money market, driving up rates.
In order to avoid this, and ensure that commercial rates hold near the bank rate independent of activities the APF undertakes with the Bank’s reserves, the BoE introduced the short-term repo facility (STR) in August 2022. Working as all repos do — borrowing cash secured against collateral — the STR will lend reserves at Bank rate.
So much…so soon?
What is perhaps more interesting about this facility, is the large amount of usage it has seen over the past 12 months. Though QT is underway, the Bank’s reserves are still far above the minimum threshold it has laid out — the point at which the BoE saw the necessity for the STR in the first place.
Admittedly the true number is unknown. The Bank refers instead to a Prefered Minimum Range of Reserves (PMRR) between £325 billion and £480 billion, but even so, by any estimate the current level (HSBC estimates APF holdings was around £690 billion in August) is still far in advance of even the upper end of the range.
This, however, is what the Bank expected, according to a recent speech by Victoria Saporta, BoE executive director for markets. Speaking at the Association for Financial Markets in Europe (AFME) in July, Saporta said: “We welcome the increased use of the STR as a key mechanism in ensuring interest rate control as we normalise our balance sheet.”
It is possible, of course, that the Bank’s PMRR is wrong, and the current reserve levels are the point at which the STR is actually needed. As Andrew Bailey, Governor of the Bank of England, said in May at the London School of Economics: “Quantifying the PMRR is easier said than done. It cannot be objectively observed, it is likely to evolve over time, and it will be affected by our decisions.”
If this is the case, the threshold levels may be very wrong, but the STR is working as planned.
Daniela Russell, head of UK rates strategy at HSBC, suggests the current uptake in the STR is not yet a sign of trouble. She notes: “The BoE has welcomed the rise in STR usage and it is showing that it is doing the job it is designed to do. While the increase in take up has risen considerably since the start of the year, the pace of increase has been steady over time.
“Furthermore, it largely reflects the same participants rolling their drawings from one week to the next.”
Pooja Kumra, senior European and UK rates strategist at TD Securities, highlights another potential reason behind the high usage: “A possible reason may also be due to the months where there are gilt redemptions — the weeks which are linked with month-end, quarter-end etc. I think that could create much greater intensity in how much the take-up has been.”
Russell does add a word of caution however: “There is no doubt that strong progress is being made in balance sheet reduction and the BoE is monitoring a number of metrics for signs of stress. If STR usage started to rise more rapidly, then this could signal increased signs of stress.”
Kumra also notes that the make-up of the institutions who are borrowing is key: “It is basically the non-banks, like the liquidity-driven investments (LDIs) and pension funds, that are actually reaching out to banks to borrow.”
“That is why I feel the BoE is a bit more calm about it — as there are still ample reserves for banks compared to pre-Covid times,” she adds.
This, itself, could be an issue the Bank needs to address. She continues: “I think the BoE needs to actually pin down who these counterparties are. If there is some way the banks are making ‘unnecessary’ money out of this entire policy, then the BoE should consider making the STR a better way of circulating money.
“What is not clear is, who are the counterparties, and if there is an arbitrage in this movement of STR money?”
Long-term repo
Saporta also spoke about the importance of longer-term lending facilities as key to the new demand driven framework. The BoE’s indexed long-term repo facility (ILRF) serves this purpose, helping keep the long-end of the yield curve lower in much the same way the STR does the short-end.
As the bank continues to draw down its reserves, it looks set to lean on the ILRF even more. According to Saporta: “We are in the process of reviewing the calibration of the ILTR to ensure that it is effective and attractive enough to support potentially large provision of reserves. We will be engaging further with the market later in the year, including through a discussion paper.”
She notes: “As we are moving towards the PMRR and before we reach it, we expect frictions in the distribution of reserves to lead to pockets of reserve demand appearing which could lead to periods of market rates moving upward.”
Adding: “That makes it possible that reserves could settle for periods above the PMRR, and correspondingly we will expect firms to come to our repo facilities — either the STR or ILTR — to source reserves.”
Russell highlights the importance of the long-term facility as another indicator of potential problems. She says: “Other metrics to watch are ILTR usage, general repo conditions and cover ratios at the APF operations.”
By the Bank’s own estimates, the STR alone will likely not be enough to supply reserves at the level it expects in the PMRR, and will instead need to be supplemented through longer-term operations — the ILTR. This six month repo facility also has the added advantage that it accepts a broader range of collateral — including non-high-quality liquid assets (HQLA) — opening up the sterling monetary framework to a wider range of firms. As Saporta puts it: “This will aid the distribution of reserves where they are needed.”
Kumra suggests, however, the STR is currently still the dominant facility for banks: “It is because the STR is still cheaper — it comes at Sterling Overnight Index Average (SONIA). The ILTR comes with haircuts, and it depends on the level of collateral.”
Liquidity and the next 12 months
On 19 September the BoE is set to outline the next 12 months of quantitative tightening. While the Bank has always made its intentions clear — that a slow and steady level of active selling is necessary so as not to cause any shocks to the market — there is some speculation that their success at this may allow them to step up sales. The Bank, it should be said, has not indicated this.
Kumra believes the levels set to be announced will not change. “I doubt the Bank will increase it, because it is not just the £100 billion that will be removed from their balance sheet, they also have Term Funding Scheme with additional incentives for SMEs (TFSME) loans redeeming, and they were around £125 billion. This means that the preferred reserves will actually be hit by the end of next year, so they do not have to be aggressive.”
The make-up of the gilt sales are also important. Currently, the Bank is selling bonds with a maturity over three years. There are some indicators that gilt liquidity in terms lower than this may be lagging. A report in the Financial Times highlights a number of big banks calling for sales of near-term bonds by the APF.
These near-term gilts are much-used as collateral in the repo market, so the potential for a knock-on effect on rates and the money market is something to watch for. Arguably, this highlights what the Bank sees as a crucial role for the STR facility: helping maintain rates, flexibility, security and a supply of reserves while it undertakes QT as it sees fit.
The impact of this move, and the Bank's liquidity requirements (12 September saw the BoE ease up on expected Basel rules in line with the US Fed), could have a dramatic impact on the industry.
As Darren Crowther, general manager, Securities Finance and Collateral Management at Broadridge, puts it: “The push from the Bank of England to focus on the short-term repo facility to support monetary policy and offer increased liquidity comes at time of transition and introduction of new liquidity venues and liquidity tools.”
According to Alex Knight, head of EMEA at Baton Systems: “This major move means financial institutions must gear up for a new wave of liquidity management. The transition isn't just about adapting, it's about banks leading the charge in a fast moving market, streamlining operations, reducing costs, and ultimately maximising the use of their assets.
“Only by making these operational changes can banks harbour any hope of meeting these BoE liquidity demands without maintaining excessive buffers.”
Keep an eye out
All signs, currently at least, suggest the STR is working as planned, bringing flexibility and security to the system while the BoE continues its QT programme. With Bank reserves still having some way to go before steady state levels are reached, central banks in the US and Europe undertaking similar actions, and with a backdrop of Basel 3.0 being reassessed, there is a lot to keep an eye on.
In the words of Victoria Saporta — “Let’s get ready to repo!”
Though high levels of inflation — driven predominantly by energy and oil prices — have brought about an immediate need to raise interest rates to help cool rising prices, the end of quantitative easing and a move to quantitative tightening (QT), was always going to be on the cards. The winding down of what the Bank calls its “extraordinary monetary policy operations”.
QT is, in effect, the process of the BoE ‘normalising’ its balance sheet; drawing down on its reserves (which were increased massively by QE) to “steady state” levels. The Bank sees this as enough to support the normal functioning of the banking system in a ‘demand driven’ framework. If quantitative easing is the process of printing money, then quantitative tightening is the process of taking that money back out of the system.
These central reserves, however, are a crucial element of a stable economy and a well-functioning banking system. Though the steady state levels should be enough for the normal functioning of the system in ‘normal’ times, flexibility in the Bank’s lending operations is still seen as key. This is where repo comes in.
Economics 101
The functioning of the myriad systems that the Bank of England and wider banking system utilise, is complex, and worth looking at in its own right.
The main tool the BoE can use to curb inflation is interest rates. A higher interest rate reduces spending in the economy (more incentive to save, higher mortgage and loan repayments, less incentive to borrow etc), curbing inflation, while a lower rate helps stimulate the economy.
This bank rate is only useful however, if commercial banks actually change their own rates in accordance with the BoE’s moves. The Bank ensures this through a number of facilities that ‘transmit’ the rate to the commercial market, the main one of which is the remuneration of its reserves held by commercial banks at bank rate.
With interest rates as low as they could go after the financial crisis, the other arm of monetary policy — money supply — was needed. More money in an economy, all other things being equal, should help stimulate growth.
The Bank does this not by printing physical money, but through its Asset Purchase Facility (APF) — an aptly named mechanism which buys bonds (the vast majority being gilts, though some corporate bonds as well) in the secondary market, through newly created funds (‘printing’ digital money) in its reserves.
This is quantitative easing, and the sustained level of asset purchasing in the years following the financial crisis has meant the BoE’s reserves were far above the levels needed for ‘normal’ market conditions.
Quantitative tightening — underway now for more than a year — is the reverse of this. The Bank has been allowing bonds to mature as well as actively selling them, and then ‘extinguishing’ the proceeds, effectively taking the cash it created during QE back out of the system.
With ample supply in reserves, commercial banks are able to borrow from the BoE at bank rate without any issues. As these reserves eventually get drawn down to minimal levels, itself an uncertain and likely changing metric, commercial banks may need to start borrowing cash in the money market, driving up rates.
In order to avoid this, and ensure that commercial rates hold near the bank rate independent of activities the APF undertakes with the Bank’s reserves, the BoE introduced the short-term repo facility (STR) in August 2022. Working as all repos do — borrowing cash secured against collateral — the STR will lend reserves at Bank rate.
So much…so soon?
What is perhaps more interesting about this facility, is the large amount of usage it has seen over the past 12 months. Though QT is underway, the Bank’s reserves are still far above the minimum threshold it has laid out — the point at which the BoE saw the necessity for the STR in the first place.
Admittedly the true number is unknown. The Bank refers instead to a Prefered Minimum Range of Reserves (PMRR) between £325 billion and £480 billion, but even so, by any estimate the current level (HSBC estimates APF holdings was around £690 billion in August) is still far in advance of even the upper end of the range.
This, however, is what the Bank expected, according to a recent speech by Victoria Saporta, BoE executive director for markets. Speaking at the Association for Financial Markets in Europe (AFME) in July, Saporta said: “We welcome the increased use of the STR as a key mechanism in ensuring interest rate control as we normalise our balance sheet.”
It is possible, of course, that the Bank’s PMRR is wrong, and the current reserve levels are the point at which the STR is actually needed. As Andrew Bailey, Governor of the Bank of England, said in May at the London School of Economics: “Quantifying the PMRR is easier said than done. It cannot be objectively observed, it is likely to evolve over time, and it will be affected by our decisions.”
If this is the case, the threshold levels may be very wrong, but the STR is working as planned.
Daniela Russell, head of UK rates strategy at HSBC, suggests the current uptake in the STR is not yet a sign of trouble. She notes: “The BoE has welcomed the rise in STR usage and it is showing that it is doing the job it is designed to do. While the increase in take up has risen considerably since the start of the year, the pace of increase has been steady over time.
“Furthermore, it largely reflects the same participants rolling their drawings from one week to the next.”
Pooja Kumra, senior European and UK rates strategist at TD Securities, highlights another potential reason behind the high usage: “A possible reason may also be due to the months where there are gilt redemptions — the weeks which are linked with month-end, quarter-end etc. I think that could create much greater intensity in how much the take-up has been.”
Russell does add a word of caution however: “There is no doubt that strong progress is being made in balance sheet reduction and the BoE is monitoring a number of metrics for signs of stress. If STR usage started to rise more rapidly, then this could signal increased signs of stress.”
Kumra also notes that the make-up of the institutions who are borrowing is key: “It is basically the non-banks, like the liquidity-driven investments (LDIs) and pension funds, that are actually reaching out to banks to borrow.”
“That is why I feel the BoE is a bit more calm about it — as there are still ample reserves for banks compared to pre-Covid times,” she adds.
This, itself, could be an issue the Bank needs to address. She continues: “I think the BoE needs to actually pin down who these counterparties are. If there is some way the banks are making ‘unnecessary’ money out of this entire policy, then the BoE should consider making the STR a better way of circulating money.
“What is not clear is, who are the counterparties, and if there is an arbitrage in this movement of STR money?”
Long-term repo
Saporta also spoke about the importance of longer-term lending facilities as key to the new demand driven framework. The BoE’s indexed long-term repo facility (ILRF) serves this purpose, helping keep the long-end of the yield curve lower in much the same way the STR does the short-end.
As the bank continues to draw down its reserves, it looks set to lean on the ILRF even more. According to Saporta: “We are in the process of reviewing the calibration of the ILTR to ensure that it is effective and attractive enough to support potentially large provision of reserves. We will be engaging further with the market later in the year, including through a discussion paper.”
She notes: “As we are moving towards the PMRR and before we reach it, we expect frictions in the distribution of reserves to lead to pockets of reserve demand appearing which could lead to periods of market rates moving upward.”
Adding: “That makes it possible that reserves could settle for periods above the PMRR, and correspondingly we will expect firms to come to our repo facilities — either the STR or ILTR — to source reserves.”
Russell highlights the importance of the long-term facility as another indicator of potential problems. She says: “Other metrics to watch are ILTR usage, general repo conditions and cover ratios at the APF operations.”
By the Bank’s own estimates, the STR alone will likely not be enough to supply reserves at the level it expects in the PMRR, and will instead need to be supplemented through longer-term operations — the ILTR. This six month repo facility also has the added advantage that it accepts a broader range of collateral — including non-high-quality liquid assets (HQLA) — opening up the sterling monetary framework to a wider range of firms. As Saporta puts it: “This will aid the distribution of reserves where they are needed.”
Kumra suggests, however, the STR is currently still the dominant facility for banks: “It is because the STR is still cheaper — it comes at Sterling Overnight Index Average (SONIA). The ILTR comes with haircuts, and it depends on the level of collateral.”
Liquidity and the next 12 months
On 19 September the BoE is set to outline the next 12 months of quantitative tightening. While the Bank has always made its intentions clear — that a slow and steady level of active selling is necessary so as not to cause any shocks to the market — there is some speculation that their success at this may allow them to step up sales. The Bank, it should be said, has not indicated this.
Kumra believes the levels set to be announced will not change. “I doubt the Bank will increase it, because it is not just the £100 billion that will be removed from their balance sheet, they also have Term Funding Scheme with additional incentives for SMEs (TFSME) loans redeeming, and they were around £125 billion. This means that the preferred reserves will actually be hit by the end of next year, so they do not have to be aggressive.”
The make-up of the gilt sales are also important. Currently, the Bank is selling bonds with a maturity over three years. There are some indicators that gilt liquidity in terms lower than this may be lagging. A report in the Financial Times highlights a number of big banks calling for sales of near-term bonds by the APF.
These near-term gilts are much-used as collateral in the repo market, so the potential for a knock-on effect on rates and the money market is something to watch for. Arguably, this highlights what the Bank sees as a crucial role for the STR facility: helping maintain rates, flexibility, security and a supply of reserves while it undertakes QT as it sees fit.
The impact of this move, and the Bank's liquidity requirements (12 September saw the BoE ease up on expected Basel rules in line with the US Fed), could have a dramatic impact on the industry.
As Darren Crowther, general manager, Securities Finance and Collateral Management at Broadridge, puts it: “The push from the Bank of England to focus on the short-term repo facility to support monetary policy and offer increased liquidity comes at time of transition and introduction of new liquidity venues and liquidity tools.”
According to Alex Knight, head of EMEA at Baton Systems: “This major move means financial institutions must gear up for a new wave of liquidity management. The transition isn't just about adapting, it's about banks leading the charge in a fast moving market, streamlining operations, reducing costs, and ultimately maximising the use of their assets.
“Only by making these operational changes can banks harbour any hope of meeting these BoE liquidity demands without maintaining excessive buffers.”
Keep an eye out
All signs, currently at least, suggest the STR is working as planned, bringing flexibility and security to the system while the BoE continues its QT programme. With Bank reserves still having some way to go before steady state levels are reached, central banks in the US and Europe undertaking similar actions, and with a backdrop of Basel 3.0 being reassessed, there is a lot to keep an eye on.
In the words of Victoria Saporta — “Let’s get ready to repo!”
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