Central banks worldwide are grappling with a troubling paradox: the very tools designed to prevent market collapses are now creating new risks. Policymakers, including the Bank of England's Chief Economist Huw Pill, have begun voicing concerns that anti-crisis mechanisms are not only driving up leverage but may also be quietly disrupting the transmission of monetary policy. Pill describes this dilemma as a game of "whack-a-mole," noting the irony that vulnerabilities are being manufactured by the very measures intended to reduce them. Currently, this cycle has entered a new phase of leverage accumulation, with no clear solution in sight.
Shifting Roles: From "Lender of Last Resort" to "Market Maker of Last Resort"
The traditional function of a central bank is to act as a "lender of last resort," providing liquidity during bank runs. However, following the 2008 financial crisis and the 2020 pandemic, major central banks like the Federal Reserve and the Bank of England expanded their roles to become "market makers of last resort." They directly intervened in corporate and government bond markets to ensure their normal functioning. While such market support during crises is often necessary to prevent a systemic collapse, the problem arises when market participants come to expect a central bank safety net. This expectation encourages them to take on more risk and leverage, a dynamic particularly evident in the U.S. Treasury market.
Leverage Expands: Hedge Funds Hold $2.4 Trillion in U.S. Treasuries
According to estimates from the Dallas Federal Reserve, hedge funds held $2.4 trillion in U.S. Treasuries by the end of 2024, up from just $600 billion a decade ago. These funds are primarily used for two types of arbitrage trades: the "basis trade" between Treasury bonds and futures, and arbitrage between bonds and interest rate swaps. Because each trade's profit margin is extremely thin, hedge funds must use up to 100 times leverage to generate meaningful returns. The price of this high leverage is fragility. In 2020, a collapse in the U.S. Treasury basis trade forced the Federal Reserve to intervene. In 2025, signs of turmoil in swap trades prompted the Trump administration to retreat on tariff policies.
Hidden Subsidies: Central Bank Support Lowers Government Borrowing Costs
Pill further pointed out that this mechanism is quietly suppressing government bond yields, effectively providing a hidden subsidy for government borrowing. He explained the logic: "There is a large amount of British government debt that needs to be absorbed. How do you support the purchase of this debt? Make it attractive. How do you make it attractive? There are market imperfections that create arbitrage opportunities, but the profits are small. How do you make the profits meaningful? Allow leverage to accumulate." This benefits the government through lower yields, the financial industry through extracted rents, and the central bank through a liquid, functioning market. But this system works only until it fails. Pill also worries that this implicit guarantee seeps into monetary policy, weakening the effect of tightening by stimulating borrowing and depressing bond yields.
History Lessons: The "Powder Keg" Left by QE
Pill noted that the massive bond purchases (quantitative easing) by central banks in 2020 stabilized markets but also left behind excess liquidity. This surplus became a "powder keg" when the Russian invasion of Ukraine triggered an energy crisis, amplifying inflationary pressures and complicating subsequent monetary policy tightening. He cited a relatively successful case: in September 2022, when the UK government's "mini-budget" triggered turmoil in the gilt market, the Bank of England conducted a "temporary, targeted" bond purchase program. This successfully halted the selling spiral without deviating from its overall monetary tightening stance.
Moral Hazard Rising: The Precedent of the 2023 Bank Rescues
The report also highlighted that central banks are backtracking on moral hazard management. During the 2023 U.S. banking crisis, the Federal Reserve accepted Treasury bonds as collateral at face value rather than market value, effectively providing banks with extraordinary support. This emergency lending tool later became a funding channel used even by healthy banks, effectively loosening monetary policy through the "back door," forcing the Fed to tighten terms before the tool expired. Japan is reportedly planning to use a similar Federal Reserve emergency lending facility to support the yen without selling its large holdings of U.S. Treasuries.
Finding a Way Out: A Modern "Bagehot Principle"
Facing this dilemma, Pill calls for a modern version of the "Bagehot Principle." The classic principle, proposed by 19th-century economist Walter Bagehot, states that central banks should lend freely to banks, but only against good collateral and at a penalty rate. This design provides liquidity during crises while using the penalty rate to constrain moral hazard and make shareholders pay for excessive risk-taking. However, extending this principle to modern bond markets still lacks a clear framework. The journalist James Mackintosh admitted, "I don't know how to break this cycle—crisis requires a bailout, a bailout leads to more leverage, and more leverage leads to a new crisis. I fear we are firmly in the latest phase of leverage accumulation." He noted, however, that at least central bank officials are still thinking about the problem, even if they do not yet have a good answer.
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