Criticism of the Bank of England’s special liquidity scheme as an unwarranted bail-out of UK banks misses the point. The scheme creates a level playing field for them to compete against US and eurozone financial institutions that already enjoy similar facilities.
The Federal Reserve’s decision to replicate the arrangement by which European Union eurozone banks have been able to monetize bonds backed by mortgages into hard cash on repo was driven by the fear that US broker-dealers were vulnerable to insolvency. Similar concerns presumably lay behind the UK government’s decision to underwrite the Bank of England’s new facility.
With covered bond and RMBS markets shut, and senior unsecured funding avenues extremely expensive, UK banks were in a hole. The BoE has given them a spade to dig themselves out, when they would prefer a mechanical digger.
The BoE is desperate that the offer should not be seen as a bail-out. The onerous terms reflect that. With moral hazard at the forefront of his mind, the BoE’s governor, Mervyn King, states that the scheme is designed to increase liquidity in the system purely to protect the wider economy and not to save the skins of irresponsible lenders. Of course, had they acted sooner, the authorities could have financed Northern Rock in this way.
This may be a bail-out for the banking system, but it is not a hand-out. And the cost should not be measured purely in terms of the banks’ direct cost of funding through the mechanism, which is far from generous. The bigger banks are under pressure to recapitalize and possibly curtail cash dividends, reducing returns on equity and total shareholder returns and leaving executives to face the wrath of owners.
The key concern is not so much that the bail-out constitutes unfair state support for the industry, protecting it from the consequences of its own failures, but rather that the scheme has been hijacked by another political dynamic. The strong possibility of a sharp UK housing market correction, aggravated by domestic banks’ inability, or unwillingness to grow their assets because of an inability to finance efficiently – if at all – has the government worried that it will be caught up in the blame. The danger is that the government wants the scheme to revive mortgage lending – raising the prospect of a correction delayed, more borrowers sucked into debt secured on overvalued collateral and banks gummed up with more bad loans.
For those worried by such a prospect, the good news is that the SLS will not be available for the financing of assets that came onto the balance sheet from 2008. The haircuts the BoE applies could amount to as much as 25%, compared with a paltry 2% at the European Central Bank. Also, only triple-A assets are eligible – unlike the Fed and ECB programmes, which go down to single-A bonds. Furthermore, the banks are completely on the hook for credit and market risk. In keeping with its long-held stance, the BoE has ensured that both factors are none of its concern. The key positive for banks is that the tenor of the funding can be extended to three years – this is secured-term financing at spreads close to Libor.
Will the SLS work? Strains are still apparent in the inter-bank market. There are few signs that banks are becoming more willing to lend to one another – or to their customers. Sterling Libor remains close to 100 basis points above the base rate, and the facility does nothing to change that. April’s sharp correction in credit spreads, the most obvious measure of creditworthiness, wasn’t matched in the money markets. And pity the smaller lenders without securitization or covered bond programmes who take their liquidity from the inter-bank market.
Nevertheless, the markets’ initial reaction to the SLS was overwhelmingly positive and the reason for that is clear – £50 billion of term funding that wasn’t there before. Almost instantly, one bank cut its mortgage rates to customers, yet it remains to be seen if the government’s wish for lending to return to normal will occur any time soon.