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Funding For Lending

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Published: 25th July 2012 by William Webster

The following explanation is about The Funding for Lending Scheme. It contains the main content of the The Bank of England's Explanatory Note of 13th July 2012 together with additional comments.

The Funding for Lending Scheme

The Scheme is designed to reduce funding costs for banks and building societies so that they can make loans cheaper and more easily available.

Access to the Scheme will be directly linked to how much each bank and building society lends to the real economy.

Those that increase lending will be able to borrow more in the Scheme, and do so at a much lower cost than those that scale back their loans.

The operation of the Scheme

Form of the loans

Over the eighteen months to the end of January 2014 – the ‘drawdown period’ – the Bank of England will lend UK Treasury Bills to banks and building societies (hereafter ‘banks’). These will be lent for up to four years, for a fee.

As security against that lending, banks will provide collateral – in the form of loans to businesses and households and other assets – to the Bank of England.

This type of transaction is known as a ‘collateral swap’. When the loans from the Bank of England mature after up to four years, the collateral will be swapped back again. This arrangement ensures that the risk from the loans remains the responsibility of the originating bank.

Banks can use the Treasury Bills they access in the Scheme to borrow money at rates close to the expected path of Bank Rate. Taking that rate together with the fee paid to the Bank of England gives the cost of funding for a bank using the Scheme.

Quantity

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). 5% of the stock of existing loans is equivalent to roughly £80bn across all eligible banks and building societies.

Any expansion of lending will be calculated on a ‘net’ basis – new lending into the real economy minus repayments. To count, lending must be in sterling to UK resident households or private non-financial corporations and in the form of drawn loans. Banks’ holdings of securities will not count.

Price

The price of each bank’s borrowing in the Scheme will depend on its net lending between 30 June 2012 and the end of 2013. For banks maintaining or expanding their lending over that period, the fee will be 0.25% per year on the amount borrowed. For banks whose lending declines, the fee will increase linearly, adding 0.25% for each 1% fall in lending, up to a maximum fee of 1.5% of the amount borrowed for banks that contract their stock of lending by 5% or more.

How will this help to support the economy?

A bank with an initial lending stock of £100bn that plans to shrink its lending by 5% can access £5bn of Treasury bills for a fee of £75m per year (a 1.5% annual fee). But if the bank shrinks its aggregate lending by 3% instead, it can save £30mn on its annual fee (it pays a 1% annual fee). That saving can be used by the bank to reduce loan rates so that it can achieve a 3%, rather than 5%, fall in lending.

The Scheme also encourages banks that had already been planning to expand lending to do so even more. They can gain additional access to the scheme, pound-for-pound with any increase in lending, provided they have sufficient collateral. A bank in this position can fund new lending at a cost of roughly Bank Rate plus 0.25%, much lower than current market term funding rates, even for the strongest banks. These lower costs can be passed on to borrowers, allowing such a bank to expand its lending by more than planned before the Scheme.

Protecting taxpayers’ money

The Bank of England takes a prudent approach to risk management and will only lend in the Funding for Lending Scheme to banks and building societies which meet the Bank’s minimum standard of creditworthiness.

To protect its balance sheet, Scheme participants will also be required to deliver a greater value of collateral than the quantity of UK Treasury Bills supplied. If any of the loans to households and firms posted as collateral – whether funded by the scheme or otherwise – are not repaid, then the associated losses will be borne by the lending bank. If any bank fails to return the Treasury Bills when due, the Bank can sell or retain the collateral taken to make good any loss it may face.

Comment

Commercial banks are reluctant to lend because:

  1. Increased capital and liquidity buffers have reduced their return on capital.
  2. Rising both wholesale and retail funding costs have squeezed margins.
  3. Economic uncertainty increases the fear of future credit impairment on loans.

This facility is aimed at getting credit flowing.  What’s new is that the cost of money is directly linked to net lending. The more banks lend, the cheaper the money.

There could be unintended consequences:

  1. Competition. Weak banks potentially benefit more than strong ones. The more expensive it is for a bank to fund itself the more incentive they have to draw under the facility.
  2. Subsidy. There is no guarantee there will be additional lending or cheaper lending. Banks could just draw the 5% from the BoE and use the money to reduce their funding cost and boost profits.
  3. Encumbrance. The BoE lends against security this increases encumbrance.  What happens if collateral values fall – will banks have sufficient high quality assets for margin calls? Aren’t unsecured senior debt holders (and potentially the FSCS) placed in an even more invidious position?  
  4. Equality. Will small banks and building societies have equal access to the facility?

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