Central banks worldwide are grappling with a troubling paradox: the very tools designed to prevent market meltdowns are now breeding new risks. On August 15, reports from international media highlighted growing concerns from policymakers, including Bank of England Chief Economist Huw Pill, who has publicly warned that crisis-response mechanisms are not only pushing up leverage but also quietly distorting monetary policy transmission.
Pill described this dilemma as a "whack-a-mole" problem, stating, "Ironically, the vulnerabilities are being created by the very mechanisms that were introduced to reduce them." Currently, this cycle has entered a new phase of leverage accumulation, with no clear solution in sight.
Role Shift: From "Lender of Last Resort" to "Market Maker of Last Resort"
The traditional role of a central bank is as a "lender of last resort," providing liquidity support during bank runs. However, after the 2008 financial crisis and the 2020 pandemic, major central banks like the Federal Reserve and the Bank of England expanded their role to become "market makers of last resort," directly intervening in corporate and government bond markets to ensure their proper functioning.
As reported, market support during crises is often necessary to prevent a downward spiral in the financial system. The problem arises when market participants develop an expectation of a central bank "backstop," leading them to take on greater risks and higher leverage. This logic is particularly evident in the U.S. Treasury market.
Leverage Expansion: 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. Treasury securities by the end of 2024, a dramatic increase 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 per-trade profits are extremely thin, hedge funds must employ up to 100 times leverage to generate meaningful returns. The cost of this high leverage is fragility. In 2020, a collapse in the Treasury basis trade forced the Fed to intervene, and in 2025, signs of turmoil in swap markets prompted the Trump administration to retreat on tariff policies.
Hidden Subsidies: The Central Bank Backstop Lowers Government Borrowing Costs
In media interviews, Pill further noted that this mechanism is quietly depressing government bond yields, effectively providing a hidden subsidy for government borrowing. He explained the chain of logic: "There is a large supply of UK government bonds needing to be absorbed. How do you support the purchase of these bonds? Make them attractive. How do you make them attractive? There are market imperfections that create arbitrage opportunities, but the profit margins are small. How do you make the profit meaningful? Allow leverage to build up."
"This is good for the government because it can sell bonds at lower yields. It's good for the financial industry because they can extract rents. It's good for the central bank because the market looks liquid and functioning. But all of this holds true—until it doesn't." Pill also worried that this implicit guarantee could "seep into" monetary policy, stimulating borrowing and lowering bond yields, thereby weakening the impact of monetary tightening.
Historical Lessons: The "Powder Keg" Left by QE
The report cited Pill's view that the massive bond purchases (quantitative easing, or QE) by central banks in 2020, while stabilizing markets, also left behind an excess of liquidity. This excess liquidity became a "powder keg" after the Russian invasion of Ukraine triggered an energy crisis, fueling inflation and complicating subsequent monetary policy tightening.
Pill also pointed to a relatively successful case: in September 2022, the UK government's "mini-budget" triggered turmoil in the gilt market, forcing leveraged pension funds to sell bonds. The Bank of England, while maintaining its monetary tightening stance, conducted a "temporary, targeted" purchase of gilts, successfully breaking the selling spiral without deviating from its overall monetary policy goals.
Rising Moral Hazard: The 2023 Bank Rescue Precedent
The report also noted that central banks are backtracking on managing moral hazard. 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 tool later evolved into a funding channel used even by healthy banks, operatively loosening monetary policy through a "back door." This forced the Fed to tighten the terms before the facility expired. Japan is now planning to use a similar emergency lending facility from the Fed to raise funds to support the yen, while avoiding selling its massive holdings of U.S. Treasuries—an approach that may follow the same pattern.
Finding a Way Out: A Modern "Bagehot Principle"
Facing this dilemma, Pill has called for establishing a new version of the "Bagehot principle" suitable for modern markets. The classic principle, proposed by 19th-century economist Walter Bagehot, dictates that a central bank should lend freely to banks, but only against good collateral and at a penalty rate. The logic is to provide liquidity during a crisis while using the penalty rate to constrain moral hazard, making shareholders pay for excessive risk-taking.
However, extending this principle to modern bond markets lacks a clear framework. The author of the report, James Mackintosh, admitted, "I don't know how to break this cycle—crisis requires a bailout, bailouts lead to more leverage, and more leverage leads to a new crisis. I fear we are firmly in the leverage accumulation phase of the latest round of the cycle." He also noted that at least central bank officials are still thinking about the problem, "even though they don't have a good answer yet."
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