Bank of England will need to claim £95bn from UK government
Since bond market news is zeitgeist, it seemed prescient to talk about this specific case study - bond losses and your tax pounds.
There are so many uses for a platform like the Insurer of State - since bond market news is zeitgeist, it seemed prescient to talk about this specific case study. That's because the Insurer of State could be used to "indemnify" the Treasury for a whopping loss it's on the hook for.
You've probably heard of "QE". It was a rather unprecedented and novel means through which the UK's Central Bank (The Bank of England) could keep the economy and commercial liquidity afloat after The Great Recession. Did you know that owing to the "tightening" (QT) decisions being made over the money supply, it's set to lose the UK taxpayer a cumulative £95 BILLION by 2034? Taxpayers have fully underwritten the losses - if only they had an Insurer of State able to indemnify them for this.
QE was not a UK-only programme, most Western economies used the tools. The EU Central Bank (ECB) is sitting on a far larger stockpile of bonds. Whilst proponents of the scheme would likely chastise you for calling QE "money printing", it was absolutely a process of "money creation".
Money is created by banks everyday - there's nothing controversial about that.
The QE programme didn't just "conjure money", it used a vehicle known as the "APF" (Asset Purchase Facility) to go out and buy a bunch of Gilts and bonds. This put money in the hands of the market - and expanded the money supply, which its proponents in turn argue prevented economic armageddon.
QE will doubtless be the subject of debate amongst both citizens, policymakers and economists for a good while - it is not relevant per se to our project herein ~ James York
The Bank of England simply loaned the APF the money. As with all borrowing - the risk was deficit, default or insolvency of the APF. Whilst the loan(s) facility was created at a relatively nominal rate, the loan still needed servicing with interest and repayment. It is here where the APF comes into vinegar. Gilts carry a coupon, but also have a face value. That value can be less than the purchaser paid. This project isn't about Gilts - but it serves to understand what the Insurer of State is designed to mitigate for the taxpayer and HM Government.
If the Bank of England needed to draw out money from the money supply or dispose of this £659bn [as at September '24] pile of bonds it holds - which was nearer £900bn at its peak - then it risked the APF making a "loss" on its trade. To mitigate this - the Bank of England and HM Treasury exchanged a rather delightfully understated series of letters in which HM Treasury agreed to "underwrite" any theoretical future losses.
Why? Well, if the bonds can reduce in value, they can also go up! At the time - the scheme made the Treasury a fortune. Between 2009 and 2022, the APF’s activities generated positive net cash flows from the APF to HMT, peaking at a cumulative £123.8 billion at end-September 2022 {Source: Bank of England}.
In what must constitute as one of the most expensive letterheads in history - there is no scenario currently projected by the Bank of England where the APF makes anything less than a loss of £50bn over its lifetime (that would include any cumulative gains over the period 2012-2024 onward).
Perhaps policymakers preferred cake now rather than cleanup later being a worry. It is understandable - after all the balance sheet of the Bank of England is, technically, the balance sheet of the Treasury. One might view these "indemnities" as crudely as interdepartmental transfers. Yet, they have a huge affect on the state's finances and everyone's taxes.
It is not for this project to comment on the suitability of monetary policy choices - this is a project to create indemnity policy. That is something mutually exclusive ~ James York
Worried we might be now, though. Because at a time where UK Gilt yields are under pressure - the previous MPC meeting of the Bank of England agreed that during 2025, another £100bn of its bond holdings would be sold off. That's on top of existing borrowing needs, as well as the £142 billion additional borrowing over the Parliament term that the Chancellor announced in October '24. Supply and demand rules are fairly stubborn - so it would seem the secondary market for existing gilts would pay less for older stocks - when it can buy bonds currently at higher rates.
In the Insurer of State doppelganger UK - the Treasury can place a "claim" with the Insurer of State for all the losses it has underwritten. The Insurer, tasked to manage all state risk is bound to admit all liability over which the government has obligation, too. It agrees to begin indemnifying the Treasuring and therefore the Bank of England - using its tools.
"APF 1" is created. It is not quite an "Asset Purchase Facility", rather a Loss Purpose Vehicle. The Insurer of State creates a loan facility where the nominal interest rate is always set at an arbitrary number of basis points "below" the coupon of the bonds the money will be used to purchase. The only bond it can buy is a Perpetual. The coupon for this bond is a perpetual fixed "fraction" of the total income generated by the State Insurance Premium - which is a fee levied on ALL insurance purchases within the UK economy (the rate of which may vary class by class from time to time.)
Unlike the APF - the "APF 1" LPV isn't buying a bond that can be sold on. Nor does the bond ever "mature". As long as the SIP yields >0 pence per year, a coupon can be paid. Since the "loan" the LPV uses to buy Perpetuals is also a floating rate tethered [at basis points below] the coupon "slice" the LPV is entitled to from SIP income - the vehicle can never become insolvent or default on payments.
Why is this useful?
Presently, HM Treasury is bound to pay back the Bank of England for its APF losses of £95bn through to 2034. It will use either tax or more borrowing to do so. The more borrowing it needs, the more the rates challenge state fiscal headroom. Paying off more debt losses with more debt. It's precisely what Chancellor Osbourne cited as his motive for taking the surplus that the APF originally generated in the first place.
Instead, the Insurer of State creates a new font sovereign capital. A well that exists in a closed loop - one that is not "distress accumulating". Perpetuals are therefore best described as a form of "Synthetic" National Debt.
Naturally, rules and fiscal responsibility will be required to use this vehicle - but that will be part of the IOS's relationship with the OBR and HM Government. It will be a key element in the Act of Parliament required to create the Insurer of State in the first place.
The next effect, however, should in the short to medium term - be less government borrowing requirements on the gilt market. If there is less "supply" of gilts or the expectation for less need for it - then this closed loop system may have the positive effect of reducing the debt burden and onward servicing costs of traditional National Debt.
As with all our posts, this is designed to encourage engagement, further debate and interest in supporting further quantitative economic modelling to stress test the qualitative theory.