Bank of England could boost gilt demand with leverage rule tweak, banks say

Banks have suggested that the Bank of England could stimulate demand for British government bonds, known as gilts, by modifying existing leverage rules. This adjustment could potentially lead to significant savings for the government, with estimates suggesting over £1 billion annually in reduced debt interest payments. However, this proposal is met with caution from former regulators, who express concerns that such a change might introduce or exacerbate financial risks within the system. The specific mechanism involves altering rules that govern how much leverage banks can employ, which in turn influences their appetite for holding government debt.

In parallel, the U.S. financial regulatory landscape is facing its own set of proposed changes. The Federal Reserve's plan to reform the Dodd-Frank Act Stress Tests (DFAST) by introducing an averaging method for calculating the stress capital buffer is expected to have a substantial impact. Analysis indicates that approximately 75% of banks subjected to testing in both 2025 and 2026 would experience higher capital depletion under this new framework. The proposed reform shifts the calculation of the stress capital buffer from a single-year assessment to an average of results over two consecutive years, aiming to smooth out volatility but potentially leading to increased capital requirements for a majority of institutions.

The Bank of England's potential leverage rule tweak is seen as a way to make gilts more attractive to banks, thereby supporting the market for government debt. This could be particularly relevant during times of market stress or when the government is issuing large amounts of debt. The savings of over £1 billion annually stem from lower borrowing costs for the government if demand for its bonds increases and yields fall. The counterargument, voiced by former regulators, centers on the potential for increased systemic risk if banks take on more leverage, which could amplify losses during downturns.

The DFAST reform's impact on U.S. banks is a direct consequence of how the stress capital buffer is calculated. By averaging the results over two years, banks that experienced a particularly benign stress test in one year might see their required capital buffer increase if the other year was more severe. Conversely, banks with a severe test in one year and a benign one in the next might see their buffer decrease. The projection that 75% of banks would face higher capital depletion suggests that, on average, the two-year period is likely to be more stressful than a single year's worst-case scenario for most institutions, necessitating larger capital reserves.