More 'bumps in the Road' Likely as Bank of England Shrinks Balance Sheet, Official Says

Bank of England's Balance Sheet Reduction May Cause Market Volatility

By David Milliken

LONDON (Reuters) -Money markets are likely to see more "bumps in the road" as the Bank of England reduces its balance sheet, but BoE liquidity facilities are working well to smooth them, a senior official said on Friday.

Vicky Saporta, the BoE's executive director for markets, said a spike in borrowing costs in the gilt repo market last week showed the likely issues as the BoE, like the U.S. Federal Reserve and the European Central Bank, reduces the volume of assets on its balance sheet.

The assets - mostly government bonds it bought as part of quantitative easing from 2009 to 2021 - peaked at the equivalent of more than 40% of annual economic output in late 2021 and are now below 25%, broadly similar to the Fed, due to quantitative tightening and banks' repayment of COVID-era loans.

Saporta said banks wanted to hold 375-540 billion pounds ($503-$725 billion) of reserves at the BoE, based on a central bank survey, less than current holdings of 630 billion pounds and a peak of nearly 1 trillion pounds in 2021.

The upper level of that "preferred minimum range of reserves" could be reached late next year, based on the current pace of QT, but it may take until mid-2027 if banks continue to increase their use of the BoE's liquidity facilities, she added.

"We are going to be having bumps in the road and we will have to learn by doing," Saporta said in a speech at an ECB conference on money markets. 

She highlighted a spike in overnight rates on the gilt repo market, which financial market participants use to borrow cash from each other, using British government bonds as collateral.

These rose more than 30 basis points above the BoE's 4% Bank Rate last week, the largest such spike in more than a decade, before returning to their more normal spread of 5 bps.

Saporta said the upward move reflected large repayments of COVID loans by banks, the October month-end, the end of the Canadian financial year and spillovers from the U.S. repo market.

The move reversed after increased use of the BoE's repo facilities, she said. Last week banks borrowed a record 97.8 billion pounds from the BoE's weekly short-term repo.

"As long as spikes in repo rates do not threaten monetary or financial stability, we see these as a natural consequence of the financial system adjusting to the evolving liquidity landscape," she said.

The BoE was reviewing the pricing of separate ad-hoc facilities - which allow banks to borrow from the BoE at shorter notice and at a higher rate, she added.

($1 = 0.7451 pounds)

(Reporting by David Milliken; Editing by Hugh Lawson)