By David Milliken
LONDON, July 6 (Reuters) - The Bank of England could give Britain's government bond market a boost this week and lower public borrowing costs by more than £1 billion ($1.3 billion) a year, banks say — but some former regulators warn a change in rules to achieve this would increase financial risks.
The BoE is reviewing how its leverage rules operate — which banks argue discourage them from holding public debt — after loosening its main capital requirement in December. It is due to
give an update on its plans in its half-yearly Financial Stability Report, released at 0930 GMT on Tuesday.
The central bank's review into leverage rules and other buffers follows a relaxation of U.S. leverage requirements in November, a development that increased competitive pressures for British lenders and potentially undermined broader resilience, nearly 20 years on from the global financial crisis.
Barclays, with over 20 million UK customers, has called on the BoE to stop counting banks' holdings of British government bonds, known as gilts, towards a leverage ratio which requires banks to have capital worth somewhat over 3.25% of their assets to help cover any losses.
A change here could encourage British banks to hold up to £150 billion more gilts, lower average yields by a fifth of a percentage point and save the government £2.5 billion a year in debt interest at a time of stretched public finances, Barclays said.
This change should only apply to 'unencumbered' gilts — those that banks are free to sell and are not already pledged as collateral in another transaction, Barclays added.
Other banks see a sizeable if smaller gain too. Lloyds said a change might only lead to a £30 billion increase in gilt demand, but it still sees at least a £1 billion a year reduction in interest payments for the government — almost enough to cover a funding shortfall in defence plans announced last week.
"Supporting the bid for gilt issuance has become a primary concern for the Treasury. A regulatory change that mechanically raises bank gilt demand is politically attractive," Lloyds fixed income analysts Karim Henide and Sam Hill wrote.
Britain's government has become increasingly reliant on foreign investors including hedge funds to finance its borrowing — one factor behind higher yields — while British banks only hold half as much domestic bank debt as their euro zone peers.
PROPOSALS 'TAKE THE BATTERIES OUT OF THE FIRE ALARM'
Since launching the review, the BoE has not said if it supports exempting gilts from leverage rules.
However, Sam Woods, who was the BoE deputy governor for prudential regulation until last week, told financiers in October that exempting all gilts from leverage rules "would be a profound — and highly risky — change".
Woods has been succeeded by Katharine Braddick, previously a senior Barclays executive.
Other former regulators have also voiced concerns.
David Aikman, who worked on the original rules at the BoE and is now director of the National Institute of Economic and Social Research, said the leverage ratio was not intended to be the main brake on banks' lending, as it now is for three of Britain's seven largest banks.
But the fact that separate risk-weighted capital rules were no longer a barrier suggested something else was askew — possibly on how the risk of lending to hedge funds and other non-bank financial companies was assessed — and exempting gilts from the leverage ratio was not a solution, he said.
"The answer isn't to take the batteries out of the fire alarm, but to investigate what's going on, figure out which risk weights have fallen too far and recalibrate those risk weights," he told Reuters.
Gilts were not risk-free and could still fall in value, while the euro zone debt crisis of the early 2010s showed what could go wrong if the health of banks and government finances became too intertwined, he said.
Instead, the BoE was likelier to scrap a cyclical component of the leverage ratio that was unique to UK regulation, he said.
PRIVATE CREDIT AND GILT REPO REMAIN UNDER SCRUTINY
Other things BoE watchers are looking out for are updates on risks posed by private markets — where the BoE is undertaking its first stress test of the sector's resilience to a big geopolitical shock — and plans for the gilt repo market, which had £74 billion in aggregate net borrowing in March.
In September, the BoE proposed minimum risk margins or "haircuts" for gilt repo transactions that are not centrally cleared, with a full update due in early 2027.
On May 28, Deputy Governor Sarah Breeden told the ICMA industry conference that "doing nothing is not an option".
Day-to-day, the gilt repo market boosts liquidity in British government debt, but the BoE has warned it is dominated by a handful of hedge funds pursuing similar strategies, creating the risk that gilts become hard to trade in a crisis.
($1 = 0.7492 pounds)
(Reporting by David Milliken, Editing by William Maclean)
