In a recent speech from the Bank of England’s governor Andrew Bailey, he outlined the central bank’s thinking of how interest rate risk is managed across the financial system.
His comments below:
While outright asset purchases bring interest rate risk on to the central bank, a portfolio of repos – effectively loans against a wide range of collateral – does not. There is still some risk associated with repos – the contingent risk that the borrower will default on the loan. But this risk can be mitigated with conservative ‘hair cuts’ to the collateral provided to ensure that it is sufficient to recover any losses. So the absence of interest rate risk substantially mitigates the financial risk on the central bank balance sheet.
And in line with the fundamental principle of minimising market distortions from central bank operations, financial risk is best managed and distributed by the financial sector unless there is a strong policy case for the public sector to take on the risk (as was the case with QE). So from this perspective, providing central bank reserves through repo-operations has much appeal.
In fact, repos score very well against all of our principles. Notably on delivering our core mandate, and transparency and accountability, repos provide a lot of flexibility around monetary control choices. Say if Bank Rate were ever to return to its effective lower bound, a repo portfolio could quickly be displaced by asset purchases, or a funding scheme, for monetary policy purposes. By contrast, outright gilt holding are less straightforward to unwind.
In addition, a repo portfolio can offer a reliable and flexible source of additional high-quality liquid assets for the financial system. That is because our repo facilitates liquidity upgrade transactions, where firms gain the most liquid asset, central bank reserves, when undertaken against illiquid collateral.
We should recognise, however, that a move from a supply-driven system where reserves are created through outright asset purchases to a demand-driven one where reserves are created in repo operations would amount to a substantial change in how we and commercial banks operate and interact. Not only would financial firms be able to source liquidity directly from the Bank at a much greater scale, they would also need to do so as part of their business-as-usual liquidity management. We at the Bank of England have much work ahead of us too, in deciding on the appropriate assets as we go forward, in reviewing our facilities to enable this, and in ensuring that both we and firms are ready for them.
And even if we do eventually settle on an approach based on repos, there are important issues to consider when determining the terms on which liquidity is provided, related to the endogeneity of reserves demand. Should we, for example, incentivise firms to hold higher levels of reserves in normal time through generous terms of supply – or should we incentivise more active liquidity managements by firms and greater ‘recycling’ of a smaller overall level of reserves in money markets? The former increases the Bank’s footprint in markets. The latter places greater reliance on the active use of our facilities in stress to allow reserves to expand rapidly and at scale.
Expanding the pre-positioning of collateral at the Bank is one way in which we can ensure that the system can expand rapidly and at scale when it needs to through secured lending, allowing for a lower level of reserves in ‘normal’ times.
Admittedly, lending this way leaves banks with a higher level of encumbered assets – assets that are effectively set aside to allow banks to access reserves through repos. And if reserves are provided entirely through repos, that level may end up uncomfortably high. It is not clear what level of asset encumbrance is sensible or feasible, especially to allow for sufficient emergency liquidity support. Silicon Valley Bank and the speed and scale of the run on its deposits is again a case in point. Yes, this is an issue we need to review, but I am so far not convinced that encumbrance from reserves provision would be large as a share of commercial bank balance sheets.
So there is more work to be done before we can draw firm conclusions. While the STR [short-term repo facility] is in place to pick up any emerging scarcity of reserves, we are not on a fast track to an entirely repo-based approach to providing central bank reserves. We still have a substantial portfolio of gilts on the asset side of the Bank’s balance sheet through the APF [asset purchase facility], and that will take time to unwind.