The strange case of ‘funding-for-lending’ confusion | FT Alphaville

The strange case of ‘funding-for-lending’ confusion

The market continues to chew over last week’s surprise announcement by the Bank of England and the Treasury about a collaborative funding initiative for UK banks under their joint auspices.

Under the initiative the Treasury will back a “funding for lending” programme, which is intended to reduce borrowing costs to those banks that engage in lending, while the Bank of England breathes life into a previously announced Extended Collateral Term Repo (ECTR), a cross between a UK LTRO equivalent and a credit easing programme.

The latter initiative is set to kick off tomorrow (Wednesday, June 20), with an auction offering at least £5bn in liquidity. The exact size of the auction will be revealed on Tuesday at 4pm.

As for the “funding for lending” programme, we’re still awaiting more details.

Nevertheless, the ratings agencies are already passing judgment. Fitch, for one, sees the initiatives as ratings neutral for UK banks.

Writing on Tuesday, the agency said:

Fitch Ratings-London-19 June 2012: A Bank of England liquidity facility should strengthen confidence in the UK banking sector by providing a more explicit promise of short-term liquidity support during any future market-wide shortage, Fitch Ratings says.

The impact of a separate “funding-for-lending” plan from the government and the BoE will depend on the final details, but is likely to be broadly neutral for banks if they pass on lower funding costs to their borrowers.

Under the liquidity plan, the BoE will activate the extended collateral term repo facility that it first announced in December. By offering to lend against a wide range of collateral, we believe the BoE is sending a clear signal that it is ready to continue to offer large-scale support if a further deterioration of the eurozone crisis were to disrupt liquidity. The facility is broadly similar to the SLS facility, now repaid, offered during the 2008-2009 market turbulence.

The details of the “funding-for-lending” programme are yet to be decided, but it will provide funding to banks over several years at rates below current market ones, passing on the UK sovereign’s lower cost of funds to banks.

While lower funding costs would normally help boost bank margins, the package is intended as a stimulus for the wider economy and we therefore expect it to be structured to try to ensure banks pass on the lower costs to customers. Such a programme could help increase lending to small and medium-sized enterprises that have previously baulked at the current cost of borrowing, but would be broadly neutral for the banks themselves. Both plans were announced by BoE governor Mervyn King and chancellor of the exchequer George Osborne last week.

So, as Fitch notes, the crux of the initiative will, most likely, be focused on boosting lending to small and medium sized UK companies, reducing their borrowing costs, and generally providing an economic stimulus for the country.

On that note, some of the points raised by John Rathbone, of JC Rathbone Associates, are rather interesting.

As Rathbone explained on Monday, neither initiative is completely unique. While the ECTR is reminiscent of the SLS programme, which was introduced during the height of the financial crisis, the “funding-for-lending” initiative is reminiscent in its own right to the “National Loan Guarantee Scheme” (NLGS), which was launched in March 2012.

Again, we are still awaiting details of the inner workings of the scheme, but in the meantime the NLGS sets a worrying precedent. For, while the initiative may work nicely on paper, confusion reigns amongst banks in terms of application and distribution of the discounted rates.

As Rathbone recounts:

While the details of the funding for lending scheme have yet to be announced, it is difficult to see how they will differ very much from the current National Loan Guarantee Scheme. This has been a spectacular failure to date as initially the banks made very little effort to promote it and now, having been in receipt of some gentle prodding, seem incapable of knowing how it works.

According to the government’s website, successful applicants will be able to cut 1% off their funding costs. Unfortunately, how this 1% is applied seems to stump the banks, although one would have thought that just reducing the loan margin by that amount would seem a logical answer.

Not according to one of our clients who successfully approached three banks for funding under this scheme. While all were prepared to make the required loan, one decided that he did not meet the relevant qualifications to justify the 1% subsidy; one decided that it should be paid as a one off upfront payment; the third has changed its mind about three times on the mechanics under which the subsidy should be paid and is coming back with a fourth attempt soon.

Given that the sole criterion to date from the Chancellor is that the savings the banks make from this new scheme must be passed on to the borrower, the chances of the scheme being successful would seem remote.

Indeed, the ability of the banks to even calculate the saving is likely to be a painful process requiring protracted negotiation.

Perhaps these discount distribution and application vagaries will still be outlined. Nevertheless, as Rathbone points out, adhering to the sole criterion of cost-of-funding savings being passed on to borrowers, may prove more difficult to apply universally than expected.

The fact that some banks are already struggling with the mechanics of how to pass on such savings — whether to pass them on as upfront payments, or in some other fashion — speaks of the challenge at hand.

Reducing the loan margin would, of course, seem the logical approach, yet for some reason — if what Rathbone says is true — banks don’t seem to go for it. Why this is, we don’t know. Perhaps it is linked to the complexities posed to banks’ hedging, accounting or even curve forecasting, discounting, or cash-flow procedures. Or some other arcane trivialities.

Either way, it seems clearer rules and procedures are needed, as perhaps is some consultation from the banks themselves (perhaps that’s what’s going on right now?).

As to the ECTR, it’s worth pointing out that the scheme also carries a credit easing criteria since funds are only distributed on the proviso that they are used to bolster lending, something which was never strictly enforced by the ECB in the criteria for its LTRO programme.

But as Rathbone states, while this seems a sensible proviso it does increasingly apply a secondary function to the BoE’s financial policy committee, by charging it with the objective to support the economic policy of the government.

This charge naturally undermines the Bank’s independence:

It would appear that having been given its independence to set monetary policy by the last Labour government, the Conservatives are looking to take back control by placing regulation and how it should be applied back under political influence.

We believe there are also other implications.

For one, we wouldn’t be surprised if the “you must lend” proviso, would significantly diminish the attractiveness of the programme this Wednesday.

Second, assume the main reason banks are not lending is down to them having to hold back larger chunks of liquidity to meet regulatory standards and to guard against the unexpected deterioration of legacy loans, as well as new loans.

That’s to say, assume banks are not lending (at low rates) because they believe freshly extended loans may deteriorate quicker than they themselves can source the regulatory-required liquidity buffers to support the loans.

In short, assume the banks are not lending because they don’t believe there are enough credit worthy businesses and people out there to guarantee safe returns. That high rates are therefore a function of the risk of return embedded in new loans.

“Forcing” the banks to lend could therefore turn out to be nothing more than a disguised sovereign-sponsored subprime lending programme. Albeit one which lowers subprime rates for borrowers, by passing on the lower costs of the sovereign borrower to the market. Nevertheless, not yet one which takes the absolute risk of non-performance away from the banks and onto the sovereign– hence why banks may still be doubtful about participation.

Unless the sovereign underwrites the risk of non-performance directly for all loans (as is now being done in some distressed eurozone countries), and thus forgoes altogether the credit intermediation role provided by banks — which is all about determining and pricing the risk of return — it seems illogical that it can force “independent” banks to lend profitably (or at least in a way that doesn’t force banks to dedicate even more capital to liquidity buffers). This is because independent banks have to operate with profits in mind. If they evaluate that high rates are the only way to ensure a return on their investment, it’s difficult to have them lower the rates.

High rates are now much more a function of how banks view the risk of return, than a function of cost of funding. Thus, having a sovereign synthetically lower the cost of funding — provided it is passed on to the borrower — doesn’t change the risk associated with the loans. Hence why some banks might feel it is more logical to pass on such “savings” as upfront payments, and stick to the rates their risk models dictate. After all, if the loans deteriorate in the future it is still the bank that is stumped with having to dedicate more liquid assets to liquidity buffers.

In any case, it’s no surprise that the banks are confused. The programme in many ways undermines the independence of the banking sector itself, while posing existential questions for banks, as well as their right to profitability.

Not to mention the fact that if sovereigns do increasingly become non-profit funding sources for the economy, “time depreciation of money” will only be accelerated. With that, long-term “savers” will be compromised further.

Related links:

Her Majesty’s LTRO? – FT Alphaville
Operation Black Cloud: snap reactions – FT Alphaville
Beyond scarcity series - FT Alphaville