The Bank of England's upcoming review of bank leverage rules could provide a significant boost to Britain's government bond market and reduce the government's borrowing costs by more than £1 billion annually, according to banking industry estimates. However, some former regulators have cautioned that easing the rules could weaken financial safeguards and increase risks within the banking system, Reuters reported.
The central bank is expected to provide an update on its review of leverage requirements in its half-yearly Financial Stability Report on Tuesday. The review comes after the Bank of England eased its primary capital requirements in December and follows similar regulatory relaxation in the United States, which intensified competitive pressures on British banks, according to Reuters.
Banks push for gilt exemption
Major UK lenders have argued that current leverage rules discourage banks from holding government bonds, known as gilts, because these assets count toward leverage calculations regardless of their relatively low credit risk.
According to Reuters, Barclays has proposed that the Bank of England exclude banks' holdings of unencumbered gilts—those that are not pledged as collateral—from leverage ratio calculations. The bank estimates that such a move could encourage lenders to purchase up to £150 billion of additional gilts, reduce average gilt yields by around 20 basis points, and lower the government's annual debt servicing costs by approximately £2.5 billion.
Lloyds Banking Group has presented a more conservative assessment but still believes regulatory changes could increase gilt demand by around £30 billion and reduce annual government interest costs by at least £1 billion, Reuters reported.
Analysts at Lloyds noted that increasing bank demand for gilts could be particularly attractive for the UK Treasury as it seeks to finance rising public expenditure while managing elevated borrowing costs.
Britain has become increasingly dependent on overseas investors, including hedge funds, to finance its growing public debt. This reliance has contributed to higher government bond yields, while domestic banks hold a smaller share of government debt compared with their counterparts across the eurozone.
Higher participation by UK banks in the gilt market could provide a more stable domestic investor base and potentially reduce financing costs for the government.
Former regulators warn against diluting safeguards
Despite industry support, several former regulators have expressed concerns about exempting gilts from leverage requirements.
Reuters reported that Sam Woods, who recently stepped down as the Bank of England's Deputy Governor for Prudential Regulation, had previously described a blanket exemption for government bonds as a significant and potentially risky change to the regulatory framework.
David Aikman, a former Bank of England official who helped design the original leverage rules and now serves at the National Institute of Economic and Social Research, also questioned whether exempting gilts addresses the underlying issue.
Aikman argued that if leverage requirements have become binding for several major UK banks while risk-weighted capital rules have not, regulators should instead examine whether the risk assessment framework for lending to non-bank financial institutions, including hedge funds, requires adjustment.
He also cautioned that government bonds are not entirely risk-free and pointed to lessons from the euro zone sovereign debt crisis, when close links between banks and government finances amplified financial instability.
Alternative regulatory changes under consideration
Rather than exempting gilts entirely, Reuters reported that the Bank of England may instead consider removing a cyclical component of the leverage ratio that is unique to the UK's regulatory framework.
Such an approach could provide banks with greater balance-sheet flexibility without fundamentally altering the role of leverage requirements as a safeguard against excessive risk-taking.
Broader financial stability issues remain in focus
The Financial Stability Report is also expected to include updates on other areas of concern beyond bank capital rules.
According to Reuters, the Bank of England is conducting its first stress test of private markets to assess how the sector would withstand a major geopolitical shock. The exercise reflects growing regulatory attention on private credit markets and other non-bank financial institutions.
The central bank is also continuing its review of the gilt repurchase, or repo, market. In September, it proposed introducing minimum risk margins, or haircuts, for gilt repo transactions that are not centrally cleared, with a comprehensive update expected in early 2027.
While the repo market plays an important role in supporting liquidity in UK government bonds, policymakers remain concerned that activity is concentrated among a relatively small number of hedge funds employing similar trading strategies. Regulators fear this concentration could reduce market resilience during periods of financial stress.
Balancing market support with financial stability
The Bank of England's review highlights the challenge of balancing support for government financing with maintaining robust financial safeguards. While banks argue that easing leverage rules could strengthen demand for gilts and lower borrowing costs for the government, regulators remain cautious about weakening measures designed to protect the financial system from future shocks.
The central bank's findings, expected alongside its Financial Stability Report, are likely to shape both the outlook for Britain's government bond market and the future direction of UK banking regulation, according to Reuters.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times.)
