Threadneedle Street's tightening grip on liquidity forces big banks to pay customers more for their money
The Bank of England’s ongoing balance sheet reduction is beginning to bite, with lenders now offering unusually high deposit rates in a bid to retain liquidity – a signal that market conditions are tightening more sharply than officials had perhaps anticipated.
For the first time since the early months of the pandemic, some UK banks are offering rates on overnight deposits equal to the Bank of England’s base rate of 4.25 per cent, according to the latest Sterling Overnight Index Average (SONIA) data. This rare convergence reflects banks’ growing appetite for liquidity as the central bank drains reserves from the system through active gilt sales and maturing asset run-offs.
“The severity of the current liquidity squeeze may be underappreciated,” Moyeen Islam, a strategist at Barclays told Bloomberg. “It’s another indicator that liquidity conditions are tighter than the BoE thinks.”
These dynamics are being closely watched by the Bank’s policymakers as they edge towards the lower end of what is known as the Preferred Minimum Range of Reserves (PMRR) – the level of reserves they believe is necessary to avoid dislocations in money markets. Analysts have suggested that this threshold may be reached sooner than anticipated, potentially by the second quarter of 2026.
Surge in repo facility usage
On Thursday, banks tapped the BoE’s repo facility for a record £70 billion, another stark reminder of the liquidity pressures building within the system. That figure dwarfs the typical weekly usage of the longer-term Indexed Long-Term Repo (ILTR), which has been drawing closer to just £1 billion.
In response, the BoE’s executive director for markets, Vicky Saporta, has encouraged banks to make greater and more routine use of longer-term central bank borrowing. “Firms must now fully consider the changing liquidity environment and their plans to source reserves within that,” she said in a recent speech in Helsinki.
From next week, the BoE will increase the weekly size of the ILTR from £25 billion to £35 billion, raising the central bank’s total liquidity provision capacity to £840 billion. The borrowing terms will also shift – with banks required to pay a spread of 0.03 percentage points over Bank Rate for high-quality collateral, and more for lower-grade assets.
“Firms should now be looking to use these facilities for routine liquidity management, not just as backstops,” Saporta added.
Implications for lending, rates and market confidence
In normal conditions, banks typically pay depositors rates lower than the Bank Rate and earn a spread by depositing excess cash with the BoE. But the compression of that spread – now virtually eliminated in some quarters – suggests that the scramble for liquidity is weighing heavily on balance sheets.
This has implications for broader lending behaviour and deposit pricing. A more competitive deposit market could raise banks’ cost of funds and exert pressure on margins, particularly in mortgage and commercial lending segments where rate competition remains fierce.
The liquidity backdrop also complicates the Bank’s messaging on monetary policy. While the Monetary Policy Committee (MPC) opted to keep the base rate unchanged at its latest meeting, signs of tightening in the money markets may prompt a reassessment of the pace at which quantitative tightening (QT) continues.
Islam noted: “There is growing evidence that the market is closer to equilibrium reserve position, calling into question the need for a further renewal of active QT.”
With the BoE running down its balance sheet at a pace of £100 billion a year through a mix of non-reinvestment and active gilt sales, the road ahead may require a more measured approach. Any acceleration in market strain could undermine the Bank’s goal of a smooth exit from the era of extraordinary liquidity support.
A delicate balancing act
The central bank is attempting to shift liquidity provision from passive mechanisms – such as remunerated reserves – to more traditional tools like repos. While this represents a reversion to pre-crisis orthodoxy, it is fraught with risk. A misjudged pace could lead to unintended spikes in funding stress or volatility in short-term interest rates.
Already, SONIA has been trending closer to the base rate, narrowing the spread to just three basis points, while the 90th percentile of overnight transactions has reached full alignment at 4.25 per cent.
Officials insist they are monitoring these indicators closely. However, with inflation still above target, and mortgage markets delicately balanced, the BoE may soon face calls to either ease the pace of QT or bolster liquidity provision further. The alternative is pressure that may stop or even reverse the recent trend of mortgage interest rate cuts.
Have something to say about this story? Let us know in the comments below.
