Troubled Waters and the Bank of England’s Funding for Lending Scheme
With economies drifting into the doldrums, central banks are looking for ways to hoist more sail. Recently, the Bank of England unfurled its Funding for Lending Scheme, an economic jib of sorts that hopes to spur household and business loans. The Scheme will begin on August 1, 2012, and continue through 2013. Central bankers around the globe are keenly interested.
The Bank of England tacked hard toward stimulus last year as economic conditions began deteriorating. In early July, when the Bank explained the Funding for Lending Scheme, its Monetary Policy Committee also indicated that it would maintain the current policy rate at 0.5 percent and expand its asset-purchase program by £50 billion to £375 billion. A sharp drop in real GDP during the second quarter of 2012 confirms that the United Kingdom has entered a recession, with unemployment already hovering around 8 percent of the labor force, roughly where it’s been since 2009, and output still 4.5 percent below its 2008 business-cycle peak. Although inflation has been moderating, it remains above the Bank’s 2 percent target rate.
The Funding for Lending Scheme offers low-cost funding to banks that maintain their net lending to households and businesses despite the softening economy. The mechanics involve a collateral swap between a British commercial bank and the Bank of England’s Discount Window Facility, in which the commercial bank receives U.K. Treasury bills in exchange for acceptable collateral. The overall value of the Treasury bills that a bank might draw from the facility depends on the amount of outstanding loans that the bank currently holds and the amount of any net new lending that the bank undertakes prior to the Scheme’s expiration. The Bank of England will charge an annual fee for the Treasury bills, which will rise should the bank’s net lending fall.
At the outset, participating British banks can claim Treasury bills equal to 5 percent of their outstanding loans as of June 30, 2012. To do so, a bank must post preapproved collateral with the Bank of England’s Discount Window Facility, which then applies a haircut reflecting the collateral’s underlying risk and liquidity before discounting its value. In return, the bank receives nine-month U.K. Treasury bills.
After August 1, 2012, and throughout 2013, British commercial banks can acquire Treasury bills through the Scheme, pound-for-pound against any net new lending to the household or private nonfinancial corporate sectors of the U.K. economy. A 0.25 percent annual fee applies and stays the same as long as the participating bank’s net lending does not fall. The fee climbs to a maximum of 1.50 percent should the bank’s net lending falls 5 percent or more. Although the draw-down period ends next year, banks can borrow the Treasury bills for as long as four years. A participating bank must roll over the bills when they mature. To avoid a fiscal impact, a bank must return the Treasury bill 10 to 20 days prior to its maturity and before the U.K. Treasury issues a new nine-month bill.
Ideally, banks that receive the Treasury bills can sell them in financial markets—either directly or through repurchase agreements—to finance additional loans. Given current yields on U.K. Treasury bills, well-heeled British banks could finance a new loan at roughly 0.75 percent, which seems low relative to current LIBOR rates. (This calculation, however, does not factor in any Discount Window haircut on the bank’s collateral, which could be significant.) Alternatively, a British commercial bank could hold the Treasury bill on its balance sheet, perhaps as a way of building or maintaining liquidity that it finds preferable to other alternatives.
From a central banking perspective, the salient feature of the Bank of England’s Funding for Lending Scheme is that it attempts to spur bank lending to the household and business sectors without adding reserves to the banking system. It does not, therefore, pose a direct inflation risk. Traditional monetary policy tools—discount window lending and open-market operations—and many nontraditional methods—quantitative or credit easing—expand a nation’s monetary base, the grist of inflation.
Markets seem cautiously optimistic about the British program, and it has piqued policymakers’ interest. Still, the Scheme faces a number of uncertainties. For one, it assumes lending is lackluster primarily because banks’ profit margins on loans are low, but this premise may be a bit shaky or, at least, incomplete. Alternatively, creditworthy individuals and corporations willing to take on debt may simply be scarce. With economic activity contracting in the United Kingdom and slowing elsewhere, and with forecasters marking down their projections, potential borrowers may be insensitive to small cuts in borrowing costs. Corporations in the United Kingdom—like corporations in the United States—are accumulating cash balances and turning to bond markets when borrowing is necessary. Many banks are still trying to improve their balance sheets by deleveraging, dealing with problem loans, building capital, and improving liquidity. They have generally raised their credit standards. Small cuts in funding costs may not spur a reaction from them. Moreover, the uncertainties surrounding the euro crisis may have heightened the risk aversions on all sides of the market for bank loans.
In the same vein, the Funding for Lending Scheme would seem to provide the biggest subsidy to the weakest banks, those paying a premium for alternative funding sources because of the quality of their balance sheets. While those banks may benefit from holding T-bills on their balance sheets, they may remain reticent about lending, particularly in a dicey economy.
Programs like the Funding for Lending Scheme, which encourage lending to specific segments of the credit market, have a distinct fiscal-policy character, particularly when they leave the monetary base unaltered. To be sure, the Bank of England’s target—households and private nonfinancial businesses—is quite broad, but other central banks looking to the Scheme might consider narrower targets, such as the mortgage market, or the student loan market. Central banks that adopt such schemes may create a precedent that, somewhere over the horizon, could infringe on their independence. That could create rough seas, indeed.