The Bank of England (BofE) has shared an update on its work to design a facility allowing firms to borrow cash against gilts at times of severe market dysfunction, as part of its work to expand the tools available when severe dysfunction threatens UK financial stability.

The bank previously announced plans to tackle systemic risks in market-based finance by developing a new facility to allow it to lend to insurance companies and pension funds (ICPFs), including newly-resilient liability driven (LDI) funds.

This work was driven from the risks to the functioning of core markets posed by the growing role of leveraged non-bank financial institutions (NBFIs) and the demands for liquidity they place on the system, as seen in autumn 2022.

Whilst the BofE stressed that it is first and foremost for non-banks to manage the liquidity risks they face, it argued that safeguarding financial stability requires an effective public backstop.

Given this, the bank is developing a new lending facility designed to enable it to provide liquidity directly to NBFIs at times of severe liquidity stress in those markets, and help tackle any future episodes of dysfunction in core UK markets effectively.

According to the BofE, lending directly to NBFIs rather than purchasing assets offers four key advantages, including a decreased risk to public funds as the Bank would not bear the market risk of holding the purchased assets directly, and lower associated moral hazard of central bank asset purchases creating perverse incentives for NBFIs to take on more risk.

The BofE's report on its official market operations 2023-24 confirmed that the initial area of focus has been on designing the tool for supporting the gilt market, which reflects the gilt market’s size, interconnectedness to other markets and the real economy, and its importance to financial stability.

This is being developed in two phases, the first of which is focused on designing a facility allowing firms to borrow cash against gilts at times of severe gilt market dysfunction, which would be open to eligible insurance companies, pension funds and associated liability-driven investment funds.

"These sectors have been significant sellers of gilts in past stress episodes, and have higher levels of resilience relative to other non-bank sectors," the BofE stated.

"As the tool is intended to address gilt market dysfunction, rather than being a source of individual firm liquidity insurance, we expect this to be a contingent tool that the bank activates in stress, rather than a standing facility that is available at all times."

The BofE also confirmed that whilst this is an innovative facility, it will draw on traditional central banking principles: the facility will be priced to be attractive in periods of stress but expensive relative to market pricing in normal times; and the provision of liquidity to the system will be supported by prudent levels of haircuts.

This approach is expected to help ensure market participants are suitably incentivised to self-insure against a range of liquidity shocks and improve resilience.

In parallel to this work, the bank confirmed that it is at an early stage of exploring how access might be expanded in a second phase to reach a broader set of NBFIs that are relevant to the functioning of UK core markets.

However, this second phase of work will need to address three key challenges.

This includes deciding which other types of NBFI should be included to maximise the tool’s effectiveness in dealing with severe market dysfunction, and further safeguard UK financial stability.

In addition to this, the BofE will need to consider how to expand the facility to other categories of NBFIs that might have lower levels of resilience than insurance companies and pension funds, while ensuring those firms have sufficient incentives to improve their self-insurance against a range of shocks.

It will also need to understand how to operationally scale-up the tool to deal with a larger number of firms than the BofE engages with in its existing operations.

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