Global Insight Perspective
Significance	The Bank of England has unveiled a £50-billion scheme under which banks can swap high-quality mortgage-backed loans for U.K. Treasury Bills and then use these bonds as collateral for loans from other banks.
Implications	The U.K. government is scrambling for initiatives to help cash-strapped banks cope with the extended lack of liquidity within the U.K. and global financial markets.
Outlook	Although the proposals have been welcomed by banks and are an important step forward, they will by no means bring an end to the credit crunch. A number of other developments are ideally needed for the full benefits of the plan to be felt throughout the financial markets.

The Bank of England yesterday unveiled a scheme designed to boost liquidity within the United Kingdom's financial markets and ease the extended deadlock in the credit markets. The scheme would allow banks to temporarily swap their high-quality mortgage-based assets and other securities for government bonds, in the form of U.K. Treasury Bills, thereby making it easier for banks to borrow from and lend to each other, since the bonds would act as collateral for loans from other banks. The aim of the scheme is to encourage greater inter-bank lending, which has dried up in recent months as a consequence of banks’ concerns and uncertainties about each other’s financial health in light of their potential exposure to the U.S. sub-prime mortgage problem. Increased inter-bank lending would in turn facilitate lending to individual borrowers within the United Kingdom, who have seen the number of available loans (especially for mortgages) fall considerably since mid-2007 as a consequence of banks having reduced funds to draw on. The problem has been further exacerbated by the fact that the shortage of liquidity has significantly pushed up market interest rates, which in turn has lifted the interest rates charged by commercial lenders for a large number of home loans. Consequently, many mortgage rates have actually risen despite the three 25-basis-point interest-rate cuts enacted by the Bank of England between December 2007 and April 2008 (which have taken its key lending rate down from 5.75% to 5.00%). This in turn has undermined the Bank of England's monetary control of the economy, forcing the central bank to devise a new scheme through which it is aiming to influence the availability of credit and market interest rates.

How Will it Work?

The scheme has been labelled in several quarters as a major U-turn by the Bank of England, which is seen as being more conservative in its support for commercial banks than its European or U.S. counterparts. The swaps would only be available for assets already in existence at the end of 2007. A six-month window to carry out these swaps starts from 21 April, and they will be for one year (unless the assets mature within one year) since bonds with any longer lifespan would be added to the national debt. However, the swaps may be renewed for a total of up to three years. During the lifetime of the swap, banks will have to pay a fee based on the spread between the three-month London Inter-Bank Offered Rate (LIBOR) and the cost of three-month government debt. LIBOR is the interest rate that banks charge to lend to each other. The scheme is due to end in October 2011, by which time all assets will have been returned to the banks, and all Treasury Bills to the Bank of England. A further security built into the scheme is that participants will not be able to use the swapped assets to finance new lending. A concern thath has been raised is that the scheme, although easing the deadlock in inter-bank lending, does not ensure that lending to individual borrowers will become easier, or that there will be an increase in the number and availability of cheaper mortgage deals.

Chancellor Alistair Darling is also set to meet the Council of Mortgage Lenders (CML) today to discuss a number of initiatives he would like them to adopt, and he will ask them to pass on the benefits of falling interest rates and government support to individual mortgage holders. The range of initiatives includes lenders offering a wider range of flexible mortgage deals allowing borrowers to overpay or underpay depending on their abilities. Darling has also floated the idea of a ”mortgage holiday“ that would permit homeowners in financial difficulties to take a break from their payments. Darling is also due to press lenders, as well as banks, to declare the full extent of their losses in order to increase transparency in the hope that this will boost stability and confidence in the U.K. financial system.

Costs of Lending

The Bank of England has indicated that use of the scheme is likely to be around £50 billion (US$99 billion) "initially"; however, Bank of England Governor Mervyn King has suggested that the scheme could eventually reach double this amount. King defended the scheme, saying that the move was essential to protect the rest of the economy from the credit freeze; however, he said that the real effect of the initiative would only become clear in two months’ time. The scheme is also formulated so as to minimise the risk to taxpayers by stressing that banks will need to provide the Bank of England with assets of significantly greater value than the Treasury Bills received. Furthermore, if the value of the assets provided falls or they are down-rated, the banks will need to provide more, and replace them with alternative highly-rated assets or return some of the Treasury Bills. However, because of the nature of the scheme and the high level of state involvement, the European Commission has launched an investigation into the bailout plan to determine if it breaks European Union (EU) rules on state aid.

Outlook and Implications

The Bank of England's special liquidity scheme is clearly a very welcome and important step in trying to restore confidence in the financial markets, getting banks lending to each other again, and hopefully bringing down market interest rates. For the scheme to have the maximum beneficial impact, several other developments ideally need to happen in tandem. These include greater transparency from banks regarding their losses and exposure to the sub-prime crisis, steps by the banks to improve their balance sheets (today's rights issue announced by the Royal Bank of Scotland is likely to be a taste of more to come), and a commitment by banks to quickly reflect any fall in market interest rates in their products and loan rates to customers.

The announcement by the Royal Bank of Scotland (RBS), the United Kingdom's second-largest bank, that it has launched a rights issue to raise funds in order to shore up its finances in the wake of a £5.9-billion write-down on sub-prime mortgage-related assets demonstrates the timeliness of the Bank of England's decision to offer the mortgage swap. RBS is hoping that the rights issue, whereby companies issue extra shares to raise money, will raise £12 billion (over a third of the company's present market value). The move comes alongside the bank’s plan to dispose of certain parts of its business, such as its insurance arm, which includes businesses such as Churchill and Direct Line, which should raise £4 billion. The company has defended the move by stating that the extra money needed is a consequence of the ”severe and increasing deterioration in credit market condition[s], the worsening economic outlook and the increased likelihood that credit markets would remain difficult for some time.“ Speculation has increased that Barclays Bank and Halifax Bank of Scotland (HBOS) are contemplating similar initiatives, demonstrating that although the Bank of England's scheme will hopefully unblock the credit market, banks are not willing to simply rely on this source of funding.

It is also important to be realistic about what this scheme can, and should, achieve. With the economic environment deteriorating and more and more businesses, consumers, and homeowners set to be adversely affected, banks are likely to—and indeed should—limit the amount that they lend anyway, even if liquidity becomes increasingly available and cheaper. What is important is that banks have the necessary funds available to lend sensibly to consumers, businesses, and house buyers who have good credit ratings and are not over-stretching themselves. A further point about the scheme is that although it tackles the local issues arising from the credit crunch in the United Kingdom, it does little to address the global nature of the problem, as demonstrated by the fact that a U.S. Federal Reserve scheme worth US$200 billion unveiled last month to help mortgage markets had no effect on the U.K. lending situation. As a result, the move may well provide only temporary relief to domestic banks and borrowers, and the same issues could resurface in the not-too-distant future.

Furthermore, although the scheme will hopefully provide some support to the housing market by making it easier for banks to obtain funds for mortgage lending, it remains highly likely that house prices will fall this year and next. Indeed, a sharp correction is still very possible. Even if mortgage rates do come down, affordability is still stretched and buyer interest is likely to remain relatively muted—particularly given the worrying and uncertain economic outlook. Banks will still be looking for higher deposits from house buyers, and will also be more careful with regards to the amount that they are prepared to lend. Consequently, mortgage activity is likely to be well below recent levels anyway, even if the credit crunch eases. Indeed, an orderly, gradual, and limited correction in the housing market would be beneficial for the economy—what is undesirable is a sharp, destabilising plunge in house prices.