British banks are increasingly turning to the Bank of England’s funding facilities to pledge higher-risk and potentially less liquid assets as collateral, exposing the central bank to a growing pool of loans and securities tied to areas such as vehicle leasing, store-card lending and buy-to-let mortgages.
A Reuters review of Bank of England filings shows that banks pledged £1.9 billion of the central bank’s highest-risk category of collateral, known as “Level C”, at its weekly auction for six-month funds on August 18. That was the largest amount since March 2020 and roughly three times the £600 million pledged a week earlier.
The increase has pushed the total value of Level C collateral held by the BoE through its Indexed Long-Term Repo facility to about £17.8 billion, according to Reuters calculations. That compares with £8.7 billion a year earlier and less than £1 billion in mid-2024.
The figures provide a window into an unintended risk that can emerge as central banks unwind years of extraordinary monetary stimulus. By accepting a broad range of collateral, the BoE can provide banks with access to central-bank liquidity while reducing the amount of cash circulating in the financial system following the reversal of its £895 billion quantitative-easing programme.
But the growing use of riskier assets raises questions about the quality and liquidity of collateral ultimately sitting on the central bank’s balance sheet, particularly if private markets become less willing to finance such assets during a period of financial stress.
The BoE said the ILTR was specifically designed to allow financial institutions to use a broad range of assets as collateral. At the same time, its risk-management framework protects the central bank from potential losses.
The facility has become so relevant since the BoE began reversing quantitative easing in 2022. Commercial banks use reserves held at the central bank to settle wholesale transactions, and the ILTR provides a mechanism for banks to obtain term funding against eligible assets as the stock of excess reserves in the financial system declines.
Level C collateral has represented roughly one-fifth to one-quarter of collateral accepted through the ILTR over the past year. Its share has not changed dramatically, but the absolute amount has more than doubled as banks have made greater use of the facility.
“The BoE has got good reasons for wanting to buy grade C assets but there’s a risk that if they do too much then that can encourage bad lending. I think they probably understand that already,” said William Allen, a visiting fellow at the National Institute of Economic and Social Research and a former head of the BoE’s money markets division.
The BoE said it continually reviews its collateral framework to ensure that it remains consistent with its risk-tolerance objectives.
The central bank also protects itself by applying larger “haircuts” to riskier assets. That means banks receive less funding than the face value of the securities they pledge, providing the BoE with a buffer if the collateral loses value. Banks also pay a higher interest rate when using riskier collateral.
Still, the composition of the eligible assets underpins the tension between providing liquidity to the banking system and maintaining strict standards around what a central bank is willing to accept.
Reuters’ analysis of the BoE’s Level C collateral list found several types of assets that are no longer accepted under tighter European Central Bank rules. These include securitized debt linked to mortgages and other loans, as well as assets backed by vehicle leases and higher-risk consumer credit.
This has gained attention because securitization played a central role in the build-up to the 2008 global financial crisis. Packaging loans into securities enabled lenders to transfer credit risk and generate new lending, but the process also helped obscure the underlying risks in some parts of the financial system.
The ECB has tightened its collateral rules in recent years amid concerns that eligibility for central-bank operations can effectively create an additional source of demand for assets that may become difficult to sell during a market shock.
The BoE’s broader framework therefore gives British banks greater flexibility in accessing central-bank liquidity, but potentially leaves the institution more exposed to assets whose market liquidity could deteriorate sharply in stressed conditions.
“It is possible that the non-BoE market for these assets might not be as active as it was because there’s a lower appetite for credit in private markets,” said Moyeen Islam, a fixed-income analyst at Barclays.
That concern comes as private credit has expanded into a roughly $3.5 trillion global industry. The sector has attracted investors with the prospect of higher yields than traditional fixed-income markets, while regulators have increasingly scrutinised underwriting standards, valuation practices and the ability of borrowers to withstand higher financing costs.
The assets eligible for the BoE facility provide examples of the types of credit exposure involved.
Investec-linked Temese Funding has loan notes backed by heavy-equipment and vehicle leases, according to S&P Global. The leases include large payments due toward the end of their terms, commonly known as balloon payments. The ECB effectively excluded such products from its eligible collateral pool in January following changes to its rules, according to an analysis by law firm Jones Day.
The BoE does not disclose which specific securities from its Level C list are actually pledged by banks through the ILTR.
Among the eligible securities are also notes issued by Harben Finance, which public filings show is controlled by Barclays and holds payments from buy-to-let mortgages originated by Bradford & Bingley, the former UK lender that was rescued by the British government during the 2008 financial crisis. Some tranches of the debt have been downgraded twice by Fitch Ratings and once by S&P Global over the past year.
Other eligible assets include loan notes backed by credit-card receivables from KKR-backed NewDay, whose lending has included higher-risk borrowers, according to Fitch.
The BoE’s collateral list also includes debt issued in 2024 by the Small Business Origination Loan Trust, which packages repayments from business owners who obtained financing through Funding Circle’s lending platform.
S&P Global said in an August 21 note that almost one-fifth of the loans in that Funding Circle pool were likely to default. Funding Circle declined to comment.
The immediate risk to the BoE is mitigated by its haircuts, pricing and other safeguards. The larger issue is what the expanding use of Level C collateral says about the underlying credit market.
If banks increasingly need the central bank as a source of liquidity for assets that private investors are reluctant to finance, the ILTR could become an important backstop for segments of the credit market. That would strengthen the BoE’s role as a liquidity provider, but could also increase pressure on the central bank to distinguish between temporary liquidity problems and deterioration in the underlying quality of bank assets.
For now, the rise in Level C collateral does not by itself indicate that British banks are facing a systemic liquidity crisis. It does, however, show that the BoE is accepting exposure to parts of the credit market that European regulators have moved to treat more cautiously, making the quality of its collateral pool a crucial issue for financial stability.
