Thirteen days in October:
how central bank balance
sheets can support monetary
and financial stability -
speech by Andrew Hauser
Given at the ECB's 2022 Conference on Money Markets
04 November 2022
Speech
Introduction
What a difference a month makes!
My original plan for this speech, back in early September, had been to talk through the
plans for
Bank of England's accelerating its unwind of Quantitative Easing (QE) by selling
government bonds.
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That story can still be told because QE sales began, successfully, on 1 November.
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But the tale also has a surprise new chapter a programme of temporary and targeted
asset purchases that ran for 13 days between 28 September and 14 October, aimed at
heading off a clear and present threat to financial stability.
Switching so rapidly from planned sales, to purchases, and back to sales again might
appear to some to imply a confusing or contradictory policy stance. But I want to show
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today how, through a combination of operational choices clear communications, robust
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tool design, and following through on pre-commitments it is possible to use the central
bank balance sheet to support both monetary and financial stability, in ways that reinforce
and complement, rather than undermine, either goal.1
In my remaining remarks I will first describe the events that triggered our extraordinary
intervention, and the ways in which we designed that intervention to maintain clear
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separation from the monetary stance drawing on national and international thinking that
has been underway since the 2020 'dash for cash'.
I will then explain why we have returned to asset sales in support of monetary stability, and
how those operations in turn have been designed to minimise the risks of triggering
renewed dysfunction.
Finally, I will conclude by identifying some possible lessons and next steps.
1) Using the central bank balance sheet to support financial stability: LDIs & gilts
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The story of recent weeks has already been widely reported and a detailed account can
be found in the two letters sent by Sir Jon Cunliffe, Deputy Governor for Financial Stability,
to the House of Commons Treasury Committee.2
For the purposes of my remarks today, the key facts are these.
Bank's Monetary Policy Committee (MPC)
On 22 September, the voted to fire the starting
gun for gilt sales, as it had signalled it was minded to do at its August meeting. Those
sales were designed to increase the pace of QE unwind that had begun in February (when
the MPC decided to cease reinvestment of the proceeds from maturing assets).3 Sales
were scheduled to start in the week of 3 October.4
the Government's
But within 24 hours, following the announcement of 'Growth Plan', gilt
market conditions began to deteriorate sharply. By the following Wednesday morning,
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thirty year nominal gilt yields had risen by 130 basis points (Chart 1, upper panel) twice
the increase ahead of the Covid lockdown in Spring 2020, and three times larger than any
other historical move over a similar period. As yields rose, we began to hear from the
'Liability Driven Investment (LDI)' funds through our market
managers of so-called
intelligence channels: first quietly, and then with increasing volume.
From the extraordinary days that followed, I want to explain four things: why the LDI funds
were so vulnerable to a large spike in yields; why we concluded asset purchases were
needed; how we designed those interventions initially; and how they evolved.
Why were the LDI funds so vulnerable?5
LDI funds provide defined benefit (DB) pension funds with leveraged exposure to
longerterm gilt yields. In a low rate environment, this strategy gives DB funds cover against
upside risks to the value of their liabilities, whilst also making room for them to hold riskier,
higher-yielding assets such as equities to boost returns. When yields rose sharply,
however, three key aspects of this strategy put LDI funds at the centre of the storm:
•
First, LDI funds' leverage left them particularly exposed to higher long-term
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yields (lower long-dated gilt prices) requiring extra resources to meet higher
margin calls and maintain positive net asset value (NAV);
Sources: Bank of England, Bloomberg Finance L.P.
•
Second, LDIs did not have sufficient financial resources of their own to meet
these extra needs. They therefore required urgent recapitalisation from their DB
scheme clients; but
•
Third, the mechanisms for securing that recapitalisation were designed for
calmer times, and hence were simply too slow to deal with the pace of
DB schemes typically had both the means and the incentive to
developments.
recapitalise (since persistently higher yields reduce the cost of future liabilities and
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hence boost the funding position of such funds)6 but those resources took too
long to mobilise.
As a result, by the evening of Tuesday 27 September, in the context of further steep rises
in yields, LDI fund managers concluded that they had no choice but to begin selling their
gilt holdings in large size to secure the necessary resources. Those sales, into already
thin markets, began to push yields up further. And that in turn risked triggering more
sales, feeding a self-reinforcing downward price spiral that could undermine financial
stability and lead to an unwarranted tightening of financing conditions and credit supply to
UK households and firms.
Why did we intervene using asset purchases?
In the midst of growing market-wide panic, we urgently considered potential solutions.
A private sector led response was much the preferred outcome. But none of the options
identified proved workable. The LDI funds did not have, or could not identify, sufficient
amounts of readily-marketable collateral to raise cash in the market (such collateral had
either already been sold or encumbered in the LDI strategy itself). Recapitalisation by DB
funds would take too long. And forbearance or stays by trustees, regulators or banks was
either infeasible, too modest in size, or too threatening to the interests of innocent parties.
If temporary central bank liquidity assistance might be required, much our preferred
approach from a financial risk perspective was to lend against collateral, either via the
banking system, or directly. It rapidly became clear, however, that this too could not be
the main solution. LDI funds needed less leverage, not more, to avoid going into negative
NAV. Just as they lacked sufficient collateral to borrow from the market, they lacked
sufficient collateral to give to us too. And the DB schemes were too numerous and
slowmoving to do so in their stead.
So, reluctantly, we began to contemplate targeted gilt purchases.
How was our initial intervention designed?
Any intervention had to meet three key criteria: it had to provide a credible window for the
LDI funds to return themselves to greater resilience; it had to avoid creating a 'cliff edge' at
the end of that window that might re-trigger financial instability, making credible exit
with the MPC's monetary policy strategy.
impossible; and it had to avoid interfering
These were challenging design goals. Fortunately, we were not starting from scratch. In
2020, following the Covid 'dash for cash', the Bank's Financial Policy Committee (FPC)
underscored the need for a comprehensive strategy for strengthening vulnerabilities in the
liquidity management of Non-Bank Financial Institutions (NBFIs).7 Front and centre in this
strategy was the need for stronger private self-insurance, market infrastructure and
liquidity regulation. But the FPC also identified the need to develop more targeted central
bank tools that could step in when genuine tail risks arose, but did so in a way that
adhered strictly to the longstanding principle of the central bank acting only as a backstop.
I set out some possible criteria for such tools in a speech in January 2021;8 and the Bank
for International Settlements established a working group, which I co-led with the Federal
Reserve's
Lorie Logan, to identify a broad menu of potential operational design features.
The conclusions of that group were published this Spring.9
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To deliver our goals in responding to the LDI crisis, we made four key design choices
summarised in Table 1. First, the purpose of the intervention announced on the morning
of Wednesday 28 September was clearly linked to the Bank's financial stability objective,
and followed a recommendation from the FPC. Second, the intervention was explicitly
temporary: the thirteen day period was chosen in light of market intelligence to provide a
challenging, but achievable, window for the lion's share of
the necessary LDI adjustment,
the MPC's QE unwind sales programme
before re-started. Third, the intervention was
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targeted solely at the assets most affected by the LDI issue initially long-dated
conventional gilts, later extended to index-linked gilts (ILGs). And fourth, our operations
were positioned as a genuine backstop, aimed not at purchasing a set quantum of assets,
or at achieving a particular level of yields, but instead at purchasing only as many assets
as required to resolve the financial stability issue and recatalyse the market. That
approach was implemented, amongst other things, using a system of reserve pricing.
Finally, HM Treasury confirmed that it would stand behind the financial risks of the
operation, covering the Bank against any financial losses but also benefiting from any
upside.10
Table 1: Comparing gilt purchases for financial stability & monetary stability purposes
Financial Stability Monetary Stability
purchases (October 2022) purchases (QE)
Aimed at reducing the risk of a self-
reinforcing downward price spiral triggered
QE aimed at easing monetary conditions in
by LDI vulnerabilities. FPC recommended
Purpose and pursuit of the inflation target. MPC voted
action to tackle financial stability risk; MPC
governance11 on quantity targets; Bank executive
informed, in line with the Concordat
implemented.
regarding balance sheet operations;12 Bank
executive implemented.
Temporary: purchases took place for only
Duration of High level targets for purchase, unwind and
as long as required by financial stability
purchases and exit sales programmes voted on by MPC as
issue. Unwind of those purchases to occur
plan part of its monetary policy process.
in a timely and orderly way.
at assets most affected by Appropriately broad based to achieve
Targeted:
Asset selection
financial stability issue. monetary policy goals.
Backstop pricing: to ensure the facility
did not unduly interfere with price discovery
Priced to deliver
Pricing or substitute for the need for market
MPC-determined quantity targets.
participants to manage their own risks over
the medium term.
How did the programme evolve?
Inevitably, the operation of a new tool of this kind involved some learning-by-doing.
Some of that learning was for market participants, as they adjusted to the differences
between temporary, targeted purchases in support of financial stability (which were new)
and QE (which was well understood). One reading of the very sharp fall in long-maturity
conventional and ILG yields when purchases were first announced (Chart 1, upper panel)
is that at least some market participants initially thought that the Bank had really restarted
QE. Lower yields were helpful in calming the immediate panic. But, had they persisted,
disproportionate falls far below market-clearing levels would have overly dampened the
incentive for LDI funds to improve their resilience (by relaxing the need to meet margin
- an excessively large 'cliff edge' as the end
calls or avoid NAV triggers) in turn creating
date approached.
11
Further information on the roles of the Bank's statutory policy committees can be found
here for the FPC
and here for the MPC
12
The MPC and the Bank's Sterling Monetary Framework (bankofengland.co.uk)
Bank's operations really were positioned as a
As it became apparent to the market that the
backstop (with pricing designed to exclude opportunistic offers), and that relatively few
LDIs were incentivised to sell (Chart 1, lower panel), yields gradually picked up. That
pickup sharpened LDI incentives, increased the chances of private sector gilt buyers
alongside the Bank's
emerging operations, and reduced the potential for an end-period cliff
edge. Those market incentives were further reinforced by clear and unambiguous
- -
messaging to LDI funds both publicly and privately that the facility would indeed close
as intended on Friday 14 October.
Just as the market's approach evolved, so did ours. In particular, as we entered the final
week of the programme, our close liaison with LDI funds, their DB fund clients and broader
market participants, threw up a number of new pieces of information. First, LDI funds
clarified their own estimates of the scale and shape of their need to sell gilts as the
recapitalisation process progressed. And, second, some LDI funds were able to identify a
range of less marketable non-gilt collateral that, if lent out for cash, might help bridge
delays in recapitalisation. In response, we increased the maximum size of our daily
operations from £5bn to £10bn on Monday 10 October, and launched a new Temporary
Expanded Collateral Repo Facility (TECRF), accepting corporate bonds down to a credit
rating equivalent to Baa3/BBB-.13
LDI funds were also increasingly highlighting challenges they faced in selling the
necessary quantity of ILGs. We did not include ILGs in our initial purchase operations, for
three reasons. First, the policy-related exclusion of ILGs from past QE operations meant
we had no pre-existing operational capacity to purchase them. Second, the highly illiquid
(and typically one-way) market for ILGs complicated pricing, and risked leaving the Bank
acting as a frontstop rather than a backstop. And, third, in the early stages of the
LDI funds' own
programme when estimates of their necessary gilt sales were still poorly
ability
defined, it had seemed that market makers' to purchase ILGs from LDIs and sell
equivalent conventional gilts into our operations, warehousing the inflation basis risk, might
prove sufficient.
As it became increasingly clear that these assumptions might be challenged, a team of
Bank staff began working around the clock to build the necessary capacity to add ILGs to
our purchase operations. When real yields began to move up sharply during on Monday
10 October, as LDIs attempted to sell into the open market, we took the decision to extend
our operations to cover ILGs from the start of Tuesday, subject to the proviso that we
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would not buy at yields lower than the closing level the previous day a design feature
aimed at reinforcing the backstop nature of our operations and preventing the sudden
collapse of real yields in a potentially one-way market.14
Taken together, these decisions provided the space, the means and the incentives for
LDIs to increase their resilience significantly by Friday 14 October. Some of that increase
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took place through sales of gilts to us we eventually bought £19.3bn of gilts,
three-quarters of which took place in the final week of operations. But that figure was
- and that's because the scheme also provided
much lower than some early estimates
time for LDIs to raise cash from their DB scheme clients, and enabled some private market
gilt activity to restart too, allowing some funds to liquidate in the secondary market. Our
ongoing market intelligence discussions gave assurance that the facility could close as
scheduled, and that fears about the potential for an immediate cliff edge would prove
unfounded.
To deliver the goals we set out for the facility, the key remaining challenge is to unwind the
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assets accumulated in a way that is both timely underscoring the strictly temporary
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nature of the intervention and orderly ensuring that the unwind does not itself
materially impair market functioning. We have been working at pace to design an exit
strategy that meets these goals, and will be announcing our initial approach shortly. Just
as our financial stability purchases differed in important ways from QE so our initial
financial stability sales will too: there will be no binding volume target for sales, but rather
a demand-led approach guided by market appetite.
2) Using the central bank balance sheet to support monetary stability: QE unwind
While the Bank has used the balance sheet to support financial stability, we also continue
to face equally pressing concerns on the monetary stability side, where the challenge is
how to ensure policy is set appropriately to deal with elevated inflation.
It is sometimes suggested that monetary and financial stability goals can conflict. We
certainly took care to ensure clear separation between our extraordinary purchases and
as I've
QE, just described. But in truth, monetary and financial stability are much more
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commonly complements rather than substitutes and this case was no exception.
Eliminating the risk of a self-reinforcing downward price spiral taking hold at the long end
of the yield curve allowed the MPC to stay rigorously focused on its own goals. And that
includes beginning the programme of gilt sales it voted for in September.
MPC's
QE unwind is not the active tool for monetary policy tightening. That role is played
by Bank Rate. But it does support that tightening process. And it has other important
benefits too. It helps alleviate collateral shortages distorting market functioning. It reduces
the size of the central bank balance sheet. It helps return public sector interest rate risk
exposure to levels closer to those initially envisaged. And it increases the headroom
available for future QE, should that ever be needed.
It is worth reminding ourselves just how big the numbers are. The gilts accumulated under
QE account for around a third of the bonds in issue, and of annual UK GDP (Chart 2).
Sources: Bank of England, UK Debt management Office, Reserve Bank New Zealand, The New Zealand
Debt Management Office, Federal Reserve Bank New York, FRED by Federal Reserve Bank of St Louis, Bank of
Canada, ECB, Reserve Bank Australia, Australian Office of Financial Management, BIS Debt Statistics
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Numbers like that are not unique to the UK, as the chart shows and you can make a
decent start on working off those stocks just by allowing assets to mature naturally without
MPC's decision to do just that in February,
reinvestment. Indeed, since the the stock of
Such 'passive
QE assets has fallen by nearly £40bn on a purchase proceeds basis.
unwind' will
subtract a further £40-50bn per annum, on average, in coming years (Table 2).
composition of the UK's QE asset portfolio means that relying on this
But the size and
mechanism alone would yield an exceptionally drawn out unwind. Left to its own devices,
the last gilt bought as part of QE would take 49 years to mature (Chart 3); the last
corporate bond would take 96 years.
Table 2: APF QE maturities over 12 month periods*
Gilts Corporate Bonds
£ billions
2022/23 35 1
2023/24 49 1
2024/25 87 1
2025/26 52 1
2026/27 38 1
2027/28 36 1
2028/29 41 2
2029/30 54 1
*Data reflect current APF QE holdings; 12 month periods run
from 22nd September.
Sources: Bank of England; Bank calculations
Of course, even if QE sales are necessary, that does not mean they should be executed
blindly, or regardless of any broader impact. The Bank has consistently stated that it
would conduct any asset sales programme in a gradual, predictable and orderly way, so
as not to cause additional disruption to the functioning of financial markets.15
That objective is being delivered in four ways.
First, the MPC has adopted a progressive and heavily telegraphed approach to
developing and communicating its unwind programme. High level principles were set
out in August 2021; reinvestment was ceased in February 2022; staff were asked to work
on a strategy for gilt sales in May 2022; and a provisional plan for those sales was
announced in August 2022, with a final vote in September 2022. Taking maturities and
sales together the overall pace of unwind is not materially faster than that adopted by a
And the MPC's consistent messaging is echoed in
range of other central banks (Chart 4)
a very stable path for market expectations of unwind over the past six months (Chart 5).
Source: Bank of England, UK Debt Management Office, Reserve Bank New Zealand, the New Zealand
Debt Management Office, Federal Reserve Bank New York and Bank of Canada.
Source: Bank of England Market Participants Survey; Bank calculations
Second, the operational delivery of QE sales can be, and has been, adjusted in light
of market conditions. The MPC itself has set a high bar for changing its high level
unwind vote, in order to maintain predictability, and focus on Bank Rate as the active
monetary policy tool. But it has given delegated authority to Bank staff to adjust the
operational delivery of that plan in light of market developments (Table 3).16
In light of recent events, we have exercised that discretion in two ways:
- By delaying the start of QE sales by a month we avoided the worst of the gilt market
turbulence, and reduced Q4 QE sales by a third. Realised volatility and bid/ask
spreads, though still elevated, have been on an improving path since mid-October
(Chart 6).
- By skewing QE sales in Q4 to the short and medium-maturity buckets,17 we have
avoided the part of the market most affected by the LDI crisis. Doing so also
focuses our initial sales on sectors that have been particularly affected by
QE-related collateral shortages, as shown by the elevated gaps between yields on
gilts and swaps at the shorter end of the curve (Chart 7).
These adjustments have been welcomed by market participants. But gilt market
functioning remains highly sensitive to developments. So we will continue to monitor
market functioning closely, drawing on a wide range of qualitative and quantitative market
intelligence.
Bank of England Page 15
Source: Bloomberg Finance L.P., Bank calculations
Source: Bloomberg Finance L.P., Bank calculations
Third, we have designed QE gilt sales operations to work with the grain of the
market, wherever possible. Potential purchasers are able to bid for the full range of our
holdings right across the short and medium buckets. The core auction mechanics are very
similar to those used during QE, including an allocation methodology that ensures bonds
are sold in a transparent and predictable way, where demand is highest, and without
unduly impacting market prices. Operations will be frequent, and modestly sized, to avoid
overloading the market. To minimise interference with the issuance programme of the
UK's Debt Management Office's
(DMO), we will not schedule sales operations on the
same day as the DMO is also selling, nor will we sell a specific gilt that the DMO is also
selling a fortnight either side of any DMO sales event in that gilt. And we will endeavour to
ensure a sufficient gap between supply events of the same maturity. Bank and DMO staff
are in close touch at an operational level to ensure both organisations can fulfil their
respective remits.18
Fourth, we have introduced a new Short Term Repo (STR) facility to ensure that QE
As
exit does not put undue upwards pressure on short term money market rates.19
QE assets fall, so does the aggregate stock of central bank reserves used to fund them.
When that level falls below that required by commercial banks to meet their payments
obligations and broader liquidity needs, absent any action from us, banks would start trying
to borrow reserves in money markets, causing short-term interest rates to rise significantly
relative to Bank Rate, impairing the transmission mechanism for monetary policy (Chart 8).
Our best guess is that point lies some years away. Chart 9 compares a simple projection
reserves (extrapolating the MPC's chosen QE unwind pace,
of future and adding in
scheduled maturities of the Term Funding Scheme with incentives for Small and Medium
Sized Enterprises
('TFSME')) with our latest survey-based estimate of the aggregate
preferred minimum range of reserves demand (or
'PMRR').20 And you can see that the
two don't
intersect till 2026 or later.
Source: Bank of England, Bank calculations
But such estimates are highly uncertain.21 In the United States, during a previous QE exit
phase in 2019, short term rates rose sharply (Chart 10) and much earlier in the exit cycle
than similarly-derived Federal Reserve estimates suggested was likely.22
Source: Federal Reserve Bank of New York, Federal Reserve Board
There are various ways to deal with this uncertainty. One, now adopted by the US, is to
build in a much bigger buffer, planning to halt QE unwind much earlier than the central
case estimate suggests. Another, that we have chosen to adopt, is to offer banks an
alternative source of reserves, so that they can continue to meet their liquidity needs as
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and when they arise allowing QE unwind to continue. The STR, which went live on 6
October, offers reserves holders the ability to borrow unlimited amounts of reserves for 7
days, at Bank Rate, secured against the highest quality collateral.23 The STR is designed
to be freely usable from the start: the vast majority of reserves holders who are also active
in money markets already have access to the facility; and the PRA has confirmed that it
judges use of the STR to be routine participation in sterling money markets, and intends
that it should be seen as such by bank boards and overseas regulators.24
Conclusions and next steps
Let me conclude.
Over the past six weeks, we have clearly demonstrated that it is possible to use the central
bank balance sheet to support both monetary and financial stability whilst maintaining
clear separation between those goals. This case study will be of lasting interest to us and
other central banks.
At the same time, key challenges remain.
In the short term, to solidify that separation we must execute a timely and orderly unwind
of the assets accumulated as part of the financial stability purchase operations, whilst also
delivering the MPC's QE unwind programme. In doing that
we will need to remain
sensitive and, if necessary, appropriately responsive to still-febrile market conditions.
In the medium term, there are clearly other profound lessons to be learned: about how to
continue improving the resilience of non-banks to liquidity shocks; about how to build the
lessons from this experience into further refinements to the central bank balance sheet
toolkit, including through the development of effective tools for lending to non-banks; and
about the appropriate long-term shape of central bank balance sheets as QE unwind
progresses.
I look forward to discussing these and other issues with you here today.
I am grateful to Joshua Jones for his help in preparing this speech, and to Paul Alexander,
Callum Ashworth, Andrew Bailey, Sarah Breeden, Jon Bridges, Rohan Churm,
Rand Fakhoury, Lydia Henning, Tom Horn, James Howat, Joshua Lillis, Clare Macallan,
Finn Meinecke, Arif Merali, Ali Moussavi, Rupal Patel, Rhys Phillips, Huw Pill,
Dave Ramsden, Matt Roberts-Sklar, Andrea Rosen, Martin Seneca, Daniel Walker and
Jack Worlidge for their helpful comments and suggestions.