The UK's Funding for Lending Scheme may be a politically attractive way to incentivise banks to step up lending to households and companies, but it could have some unintended side-effects.

The Bank of England’s new Funding for Lending Scheme (FLS) is already making a positive impact on the UK economy, with lenders showing tighter mortgage pricing. But it is also fundamentally changing the way that bank and building society treasurers in the UK are now planning their mid- to long-term funding strategies. It is giving them something of a headache as they seek to balance FLS, deleveraging, retail deposits and the wholesale funding markets – not to mention political considerations around increasing lending. 

Indeed, treasurers from many UK banks say that they see the FLS as a significant partial replacement for the wholesale funding market – at least for the medium term. The primary covered bond and securitisation markets – the wholesale markets open to banks that prefer not to access the expensive senior unsecured market – will slow down significantly. In the long run, spreads here may well contract as investors are denied supply of paper in the volumes they are accustomed to.

The FLS is designed to provide cheap finance for banks in return for an increase in lending to UK households and non-financial companies. Under the scheme, banks can borrow Treasury bills (T-bills) for up to four years at 25 basis points, as long as they are net lenders, while if they decrease net lending the cost of borrowing the T-bills increases pro-rata up to a maximum 150 basis points should their net lending decrease by 5% or more. The draw-down period is open until January 2014 – so banks can effectively plan on having funding for more than five years. And the size of the scheme is not limited – banks can borrow 5% of their stock of existing qualifying loans (£80bn [$129.5bn]) and then 100% of their additional net lending made from July 2012 to the end of 2013. Banks can either retain the T-bills, or repo them in the market or with the Bank of England for cash.

Through this simple mechanism the scheme provides a strong incentive for banks to lend more and a strong disincentive for them to lend less. Furthermore, for most UK lenders, other than those with the tightest spreads in the wholesale markets, using the FLS is still likely to be cheaper than accessing the wholesale market, even if they decrease net lending by 5% or more.

No more blockbusters

It is too early to assess precisely the impact of the FLS on banks’ funding activities, but the scheme will not prompt banks to leave the wholesale markets altogether. They will want to retain a presence in front of covered bond and asset-backed securities investors, in particular. Having spent time and money maintaining investor relationships, they will be reluctant to step away from these investors – thereby encouraging them to go elsewhere. But what it will do is reduce banks’ appetite for blockbuster deals in wholesale markets, with issue sizes likely to shrink significantly.

Several banks and building societies have privately suggested that while they will continue to come to the wholesale market precisely to maintain a market presence, even if it is more expensive than the FLS, they will do so in diminished sizes – for example, €500m covered bond deals rather than planned deals of more than €1bn.

Indeed, the FLS will continue the trend that has been seen over the course of 2012 – with lenders issuing less in the wholesale markets as they deleverage, while seeking a greater proportion of retail deposits. But the total pool of retail deposits is not completely price elastic: there is only a finite pool available and eventually banks will find they cannot continue to capture additional deposits without hurting profitability. Despite the current preference to access such deposits for funding over the wholesale market, some institutions are starting to feel the cost of doing so.

Hard habit to break

Until the FLS was introduced, new and evolving liquidity and capital adequacy regulations had been forcing banks to effectively hoard cash. Central bank funding was taken in size by banks, but was not obviously sent back out into the economy. This scheme aims to stop this effect – in a sense no longer permitting banks to hold on to cheap central bank liquidity and funding. The disincentive, via additional fees, to take the funding but not to then provide net lending is real.

But will the scheme change banks’ lending criteria? Indeed, when it was announced, the ability of the scheme attracted criticism that it will not help deliver finance to first-time buyers. The answer, of course, is that it will not significantly. Banks have learnt from the crisis and will remain reluctant to weaken their credit criteria – for instance, lowering minimum loan-to-value ratios for first-time buyers. While it may be politically unpalatable today for banks not to increase lending to households and non-financial businesses, it is in no one’s interest for them to materially weaken the criteria against which they write new loans. And if this is the case, it will be interesting to see how the UK banking sector as a whole is going to increase net lending between now and the end of 2013.

Anthony Whittaker is head of UK and Australasian bank asset and liability management and origination at Natixis.

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