Bank of England balance-sheet shift raises funding market risks for UK banks

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Highlights

Bank of England's reserves have declined, pushing banks’ usage of central bank repo facilities up to about £200 billion as gilt holdings are reduced.
Transition to heavier use of seven-day repo shifts commercial banks’ liabilities, creating regulatory tensions given leverage ratio constraints.
Despite proposed Prudential Regulation Authority relief, Barclays expects increased volatility in short-term funding markets as reserve scarcity intensifies for UK banks.

Reserve end-point and repo transition

As reported by Financial Times, the Bank of England is approaching the point at which its balance sheet aligns with the “Preferred Minimum Range of Reserves” outlined by Bailey, a threshold tied to commercial banks’ aggregate need for settlement balances and liquidity protection in periods of stress.

As the Bank runs down its gilt holdings, commercial banks’ use of central bank reserves borrowed through repo has climbed from almost zero to about £200 billion. The shift supports the post-crisis operating framework signalled by policymakers, with more reliance on central bank lending as reserves become less abundant.

Barclays strategist Moyeen Islam says in a report issued this week that the transition carries broader consequences because of the Bank’s size, its monopoly role in supplying reserves, and the effect that changes in its asset mix, including a heavier use of seven-day repo, have on banks’ liabilities.

Regulatory relief may not remove volatility

Islam’s argument is that Bank of England repo works for day-to-day liquidity management but is less attractive for banks when regulatory leverage ratios are taken into account. That creates tension between the central bank’s preferred balance-sheet structure and the regulatory constraints facing lenders.

The Prudential Regulation Authority is already examining the issue. In March it published a consultation proposing that banks be allowed to include drawings from standard central bank facilities without regulatory penalties, although emergency facilities would remain excluded.

Even if those proposals are implemented in a supportive form, Barclays still expects short-term funding markets to become more volatile as reserve scarcity starts to bite. That points to a more unstable operating environment for UK banks as the Bank of England moves deeper into its post-quantitative easing framework.

In our earlier article, we covered investors’ expectations that the Bank of England may slow or pause sales of long-dated gilts as quantitative tightening continues to strain demand at the long end of the curve. We noted that the projected pace of balance-sheet runoff increasingly relies on maturities rather than active long-bond sales, and that any shift could reopen debate about maintaining a more permanent gilt portfolio to support reserves and reduce reliance on short-term liquidity operations.

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