“Thus far the Bank of England and Government have tried several mechanisms for getting the banking markets and economy working again.
Temporary schemes have included the Special Liquidity Scheme (SLS) launched in April 2008 to improve the liquidity position of the banking system by allowing banks and building societies to swap their high quality mortgage-backed and other securities for UK Treasury Bills for up to three years.
“Although the drawdown period for the SLS closed on 30 January 2009, the scheme remained in place for a further three years. The SLS officially closed on 30 January 2012.
“Then there was the Credit Guarantee Scheme Facility and the Asset Purchase Facility.
“These schemes were put in place to ensure the stability of the financial system and to protect ordinary savers, depositors, businesses and borrowers. They were meant to oil the works and ensure that the financial systems didn’t grind to a halt in a very hostile market place. They were designed to prevent another Northern Rock. To that end they worked but they weren’t designed to kick-start the underlying funding markets or to provide a funding stimulus for vital markets such as the UK mortgage market.
“At a wider level, the Bank of England commenced Quantitative Easing (QE) in an endeavour to grow the money supply and increase economic activity. We’ll never know what would have happened without QE but the effects seem to me to be having a diminishing return right now.
CAPITAL AND LIQUIDITY
“With increasing regulatory demands and pressures on banks to increase capital and liquidity ratios and the impending effects of tighter controls under Basel III which kick off in January 2013, much of what the Bank of England has tried to achieve has been undone by the tightening regulatory requirements and nervousness among banks to take a risk in a hostile market.
“It would seem that much of the money that was created by QE has not found its way into the economy as intended but instead has languished in deposit accounts with the Bank of England.
“Arguably the Bank has made matters worse by paying a positive rate of interest on deposits held with it, something the ECB has recognised and just reversed for its deposits. Maybe the Bank of England should learn from them?
“In all though, we have seen a contracting Money Supply with the Money Multiplier, which you may remember from O-level economics, failing to operate. It is no wonder that economic activity has fallen. It could do nothing else.
“But at last the Bank of England and Government have realised this and launched the Funding for Lending Scheme (FLS).
“So what’s different about the new FLS and who is it aimed at?
“Well it isn’t accessible by every lender. It is aimed at banks and building societies that are participants in the Bank’s Sterling Monetary Framework (SMF) and signed up to the Discount Window Facility (DWF). It excludes any non-bank lenders which is a pity.
ASSET SWAP
"It has some similarities with other schemes in that what it actually does is swap one asset for another. In this case the Bank of England takes certain types of asset as security from the borrowing bank such as commercial loans, residential mortgage loans, covered bonds and residential mortgage backed securities to name but a few.
“It then lends Treasury bills with a lower aggregate value than the security (a “haircut” amount designed to protect the Bank against credit losses) to the participating bank. This is known in the trade as a “collateral swap” where one type of asset (less liquid) is swapped for something of higher liquidity and value in the secondary markets. In this case, UK Treasury Bills.
“The idea is that the UK Treasury Bills are eminently easier to obtain funding against at prime rates. Drawings under this facility will be between August 1st 2012 and January 2014 and any Treasury Bills borrowed will be repayable four years from drawdown. So far then this seems not unlike the Special Liquidity Scheme, so what’s different this time?
The key aspects of this scheme are:-
1. That pricing is dependent on the borrowing bank using the proceeds to use the facility to provide funding for real economy loans (that’s non-financial institution lending to you and me).
2. Each participating bank will be able to borrow an amount up to 5% of its stock of existing loans to the UK non-financial sector – ‘the real economy’ – as at end-June 2012, plus any expansion of its lending during a ‘reference period’ from that date to the end of 2013. There are strong incentives for banks to boost lending because every pound of additional lending increases the amount that a bank can borrow by a pound. For example, a bank that had a stock of lending to the real economy of £100bn in June 2012, and then lent a further £7bn by the end of 2013, would be eligible to borrow a total of £12bn in the Scheme (an initial allocation of £5bn plus a further £7bn additional lending).
3. The fee will be determined at the end of the reference period, based on Net Lending over the reference period. For FLS Groups whose Net Lending over the reference period as a whole is positive, the fee will be 25bp per annum. For Groups whose Net Lending over the reference period as a whole is negative, the fee will increase linearly from 25bp per annum if lending is unchanged up to 150bp per annum if lending falls by 5%. If lending falls by more than 5%, the fee will be 150bp per annum. This fee will apply daily to all drawings by Participants in an FLS Group, up to the Borrowing Allowance on that day, for the duration of the drawings.
4. If the aggregate drawings of an FLS Group on any day exceed its Borrowing Allowance on that day, the fee on the excess portion will be 150bp per annum.
5. Total cost of funds for banks will be the fee payable to the Bank of England plus the cost of borrowing in the market against the UK Treasury Bills which is expected to be close to the path of Bank Rate.
WILL IT WORK?
So the scheme is designed to reduce funding costs for banks if they target lending to the non-financial sectors of the market which the Government and Bank of England wish to revitalise. And if it works, easier access to cheaper bank borrowing should boost spending in the economy and in turn, higher spending should create jobs and raise incomes. That’s the theory in any event.
Will it work? Well who can say but at least it is incentivising the banks in a way that no other arrangement has thus far. Not all banks will be able to participate in this scheme in any event and non-bank lenders are once again out in the cold which is a pity as they really could do with some assistance.
This scheme does not provide all the answers.
Lending is for just four years and we have to remember that mortgages are usually for 25 years. We need other forms of funding to take off if only to refinance borrowing under this facility.
Dare I say it yet again, this may provide a short term solution and financially incentivise the banks but we need a healthy long term securitisation market to really provide the term funding that banks need for the mortgage market to once again be successful.
And we have to remember, that even if we sort out the funding issues, we still need customers prepared to borrow. Demand remains low in a nervous market.
So this gets a thumbs-up from me but it will not fix the markets on its own. One to watch methinks.
