Bank of England Weighs Leverage Rule Review that Could Slash UK Borrowing Costs but Heighten Systemic Risks

As Britain grapples with elevated public debt and volatile global markets, the Bank of England is preparing to weigh in on potential changes to its leverage rules that could significantly lower government borrowing costs — but at the potential expense of financial system resilience, according to industry analysts and former regulators.

The central bank is expected to provide an update on its review of leverage requirements and related buffers in its half-yearly Financial Stability Report, due for release at 0930 GMT on Tuesday. The review follows a relaxation of the Bank’s main capital requirement in December and comes amid looser U.S. leverage rules introduced in November, which have intensified competitive pressures on British lenders.

Barclays has been particularly vocal, urging the Bank to exclude British government bonds, known as gilts, from the leverage ratio calculation that requires banks to hold capital equivalent to slightly over 3.25% of their assets. Such a change could encourage UK banks to hold up to £150 billion more gilts, reduce average yields by around 0.2 percentage points, and save the government approximately £2.5 billion annually in interest payments at a time when public finances remain under strain.

The bank specified that any exemption should apply only to “unencumbered” gilts not already pledged as collateral elsewhere.

Lloyds offered a more conservative assessment, suggesting the change might generate around £30 billion in additional gilt demand but could still deliver at least £1 billion in annual interest savings — nearly enough to offset a recent defense funding shortfall.

“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 grown increasingly dependent on foreign investors, including hedge funds, to finance its borrowing — a dynamic that has contributed to higher yields. Domestic banks currently hold only about half as much government debt as their eurozone counterparts.

Caution from Former Regulators

The potential shift has drawn sharp warnings from some former Bank officials. Sam Woods, who served as 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 since been succeeded by Katharine Braddick, formerly a senior executive at Barclays.

David Aikman, who helped shape the original rules at the Bank and now directs the National Institute of Economic and Social Research, argued that the leverage ratio was never designed to serve as the primary brake on bank lending. He noted that the fact that other risk-weighted capital rules were no longer constraining banks suggested deeper issues, possibly related to how risks from lending to hedge funds and non-bank financial institutions are assessed.

“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,” Aikman told Reuters.

He cautioned that gilts are not risk-free assets and could still lose value. The euro zone debt crisis of the early 2010s demonstrated the dangers of too close an entanglement between bank health and sovereign finances, he added.

Aikman suggested the Bank was more likely to eliminate a UK-specific cyclical component of the leverage ratio rather than implement a broad gilt exemption.

The review also encompasses other areas of potential risk. The Bank is conducting its first stress test of private markets’ resilience to a major geopolitical shock. Additionally, it is examining the gilt repo market, which had £74 billion in aggregate net borrowing in March.

In September, the Bank proposed minimum risk margins or “haircuts” for non-centrally cleared gilt repo transactions, with a full update expected in early 2027. Deputy Governor Sarah Breeden told an industry conference in May that “doing nothing is not an option” regarding the gilt repo market. While the market enhances day-to-day liquidity in government debt, the Bank has warned it is dominated by a small number of hedge funds pursuing similar strategies, creating potential difficulties in trading gilts during periods of stress.

The Trade-Off Between Fiscal Relief and Stability

The proposals come against a backdrop of stretched public finances and elevated borrowing needs. Any reduction in gilt yields through increased bank participation could provide meaningful fiscal breathing room. However, the trade-off involves fundamental questions about the appropriate level of financial system safeguards and the role of banks in holding sovereign debt.

The Bank’s review is more like a broader reassessment of regulatory frameworks in response to changing market conditions and international developments.

However, Tuesday’s Financial Stability Report will offer the clearest indication yet of the central bank’s thinking on these critical issues. The outcome is expected to have lasting implications for Britain’s bond market, banking sector, and overall economic strategy in an uncertain global environment.