One deliberate side-effect of the Bank of England’s quantitative easing program is that their purchases of bonds will be financed by creating central bank reserves.  Literally the UK banks’ combined reserve accounts at the BoE will be credited with £75 bln (created with a wave of the BoE’s magic wand).  The BoE has decided to go down this path, hoping for the following result:

Lets follow the money (always a useful exercise).  A UK bank (lets assume LLOY as a proxy for the UK banking sector) buys £75 bln of bonds in the marketplace (the BoE has indicated this would comprise £50 bln in gilts and £25 bln in corporate bonds).  Assume further that the gilts are bought from institutional investors and the corporate bonds are newly issued by non-bank UK companies.  LLOY pays for these bonds by handing over its depositor’s cash : £50 bln to the institutions and £25 bln to the companies.  The UK companies have therefore just borrowed £25 bln of term money.  Institutional liquidity has just increased by £50 bln – they will want to reinvest this cash in either more gilts (bought from the Debt Management Office, thereby effectively monetising UK Government debt issuance) or corporate bonds or by buying equities.  Anyone still worried about how the DMO is going to sell the mountain of gilts it needs to shift this year can now rest easy.  However in reality LLOY is acting as an agent for the BoE and so LLOY sells the £75 bln of bonds to the BoE.  The BoE pays for these bonds by crediting LLOY’s reserve account with £75 bln.  The BoE pays the Bank Rate on these reserves (currently 0.5% p.a.) so it is going to make a profit on its holding of bonds.  But what about LLOY?  It is paying its depositors far more than the Bank Rate (Libor is still a shade under 2%) so it will take most of the £75 bln out of its reserve account, leverage it up to, say, £150 bln and lend this out to borrowers (10 year gilts at 3% would do nicely as they eat up little Tier 1 capital – there are £590 bln Gilts outstanding and the DMO is going to be selling new gilts like hot cakes!).  Then LLOY can afford to pay its depositors Libor on their £75 bln and still turn a profit.  In reality Libor is going to trend down towards the Bank Rate at the same time. Whether Gilts are over-valued is a question for the future (the view that Gilts offer return-free risk). In the meantime, has the DMO sold all its gilts yet?