(Nov 6): Banks are increasingly handing the Bank of England (BOE) some of their riskiest assets in exchange for cash.

The swap is happening on the BOE’s indexed long-term repo (ILTR) facility, which aims to help safeguard financial stability by providing liquidity to the banking system. This allows institutions to borrow cash against collateral at three levels of quality — and it’s the worst tier that is taking off this year.

These so-called Level C assets — including pools of residential mortgages, small business loans and consumer credit — made up almost half of the total at times in October. This week’s auction included £1.2 billion (RM6.54 billion), an 80% jump from a month ago.

While this exchange enables financial institutions to reduce the risk on their balance sheets, it might be storing up systemic risks for the future. The fact that banks are using poorer collateral could also be seen as an indication they are in greater need of cash right now.

“The collateral could provide less protection precisely when the BOE needs it,” said Ivan Sangiorgi, associate professor of finance at the ICMA Centre in the University of Reading’s Henley Business School. “The limited secondary-market liquidity of these assets could also complicate their valuation during periods of stress.”

From the BOE’s perspective, it’s aiming to enable lenders to source reserves for payments and precautionary reasons — and not only during times of crisis. It’s already managed to remove the stigma from using its short-term repo (STR) facilities, offering cheap financing to ensure there’s enough money flowing and creating a hot trade for banks.

It’s now managing to repeat the process with its longer term facility. With this weekly ILTR auction, banks can borrow money for six months. In total, Level C collateral has reached above £19 billion, according to Bloomberg calculations.

“The ILTR is designed to allow firms to use a broad range of assets as collateral while protecting the Bank through robust risk management,” said a BOE spokesperson.

The push to get banks to use these facilities comes after the BOE almost halved its gilt holdings to just below £500 billion from a peak around five years ago, effectively draining liquidity from the system.

It’s been “a measure of success for the BOE as they want participants to use their repo facility more,” said Hank Calenti, global market strategist at SMBC Bank International. “With hedge funds getting more active in the UK gilt space and quantitative tightening, banks have found it advantageous to use both the STR and ILTR.” 

Some market participants are calling for the BOE to make the long term repo facility even more attractive, or to make its operations daily.

Institutions have plenty of this Level C collateral as such loans are core to the business of UK banks and building societies. Converting them into reserves can therefore give a larger improvement in liquidity than pledging assets that are already relatively liquid, such as government bonds.

The increase in Level C collateral this year could also be fuelled by the maturing of loans under the BOE’s Covid-era Term Funding Scheme. This provided loans to small and medium-sized businesses during the lockdown, and there’s still about £36 billion outstanding, with the bulk concentrated among major UK high street banks. As the loans mature, institutions may need to replace this source of funding.

These assets can be expensive — and sometimes impossible — to monetise in private markets because they are relatively illiquid and risky, making the central bank one of the few lenders willing to do so.

It does come at a price: the BOE charges more for riskier collateral, meaning banks receive less cash against a given amount of assets. The spread over the BOE’s benchmark rate charged on Level C is 15 basis points, compared with five basis points for Level B and only three basis points for Level A.

It’s still a fairly limited extra cost. By contrast the BOE’s main short term repo facility does not accept this lower quality collateral, while the European Central Bank has tightened its collateral requirements.

If banks can routinely obtain liquidity against assets that are difficult to finance privately, this could potentially weaken incentives to develop alternative funding sources, Sangiorgi said. It would also be more difficult for the BOE to tighten its collateral requirements during periods of stress without exacerbating liquidity pressures.

“For much of Level C collateral, there simply isn’t a private repo market to turn to,” said Sangiorgi. “The important question is therefore whether the Bank’s risk-management framework remains sufficiently robust as Level C collateral is used increasingly.”

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