NBFI funding to banks shifts from cheap to costly

A Bank of England working paper reveals that non-bank financial institutions (NBFIs) are the dominant providers of overnight liquidity to large UK banks in the gilt repo market.

Using proprietary transaction-level data from the Sterling Money Market Data (SMMD) spanning 2018 to 2024, the study shows NBFIs supply 6 to 12 times more liquidity than traditional interbank lenders.

The researchers developed a 'Spread-of-Spread' (SoS) measure to quantify the NBFI premium over interbank repo lending.

Before 2022, NBFI funding was cheaper, with an average SoS of -7 basis points.

However, this trend reversed, making NBFI funding more expensive and volatile after 2022, averaging around +10 basis points.

This shift highlights the evolving structure of liquidity provision post-global financial crisis, where NBFIs have become central to short-term secured funding for banks, particularly in the bilateral segment of the UK gilt repo market.

The paper identifies two key mechanisms driving the changing cost and volatility of NBFI liquidity.

First, an opportunity-cost channel: higher short-term interest rates lead NBFIs, such as investment funds and insurers, to pass on increased liquidity costs to banks, exceeding those transmitted through traditional interbank channels.

Second, a balance-sheet constraint channel: monetary tightening heterogeneously compresses NBFIs' balance-sheet capacity.

This increases the shadow cost of liquidity, amplifies margin-call pressures, and heightens the persistence of volatility in the Spread-of-Spread.

These dynamics show NBFIs, passive in normal times, become price-sensitive and withdraw liquidity when dealer balance sheets tighten, shaping secured bank funding costs.