Mending the blockage in credit generation

Bank of England

Sir Mervyn King, Governor of the Bank of England, took aim on Thursday at that part of the UK economy deemed to have been most badly broken by the financial crisis and the most difficult to repair: credit generation.

Data from the BoE show that outstanding loans to the UK’s private, non-financial companies – which form the backbone of the economy – have fallen by about £90bn, or 20 per cent, since the peak in October 2008. Lending to PNFCs has shown a year-on year contraction every month since June, 2009.

    Moreover, despite ultra-low BoE rates, the difference between that rate and what households and businesses pay to borrow remains very wide. In recent months, it has shown signs of growing wider – and for the smallest businesses, the differential is at a record.

    Banks say that lending is falling because businesses do not want to borrow and that rates cannot fall further because their own borrowing costs are rising. The BoE has conceded that demand is weak but concluded that if it was as weak as bankers say, spreads would be much tighter.

    What Sir Mervyn sketched out, therefore, was aimed at addressing what banks claim is the single largest obstacle to the distribution of affordable finance: their own rising costs. That is in part because rules force them to hold more assets that they can sell quickly – in other words, gilts instead of loans to business – and because as their own borrowings mature, they have to pay higher rates to replace them.

    To combat these problems, he signalled there is scope to relax current rules that force banks to keep large stores of liquid assets. Regulators around the globe may do so, too, he said.

    Second, he sketched the outlines of two facilities that will allow banks to cut their own borrowing costs, with the first of these likely to be aimed at new lending. This “Funding for Lending” programme, to be unveiled in conjunction with Treasury in a few weeks and with around £80bn available, would allow banks to use new loans to business and households as collateral. They could then swap the loan for longer term, lower cost funding that will, in turn, allow them to make further loans at lower interest rates. Sir Mervyn made clear that banks would not be allowed to borrow the full face value of any loan they made. That way, if the loan were not fully repaid, the Treasury would not suffer a loss.

    Nevertheless, the point of the new scheme is to reassure lenders who do extend new loans that they will not have to worry about running short of liquidity.

    The black cloud has dampened animal spirits so that businesses and households are battening down the hatches to prepare for the storms ahead.

    – Mervyn King

    Sir Mervyn said the BoE is dusting off its Extended Collateral Term Repo Facility, a weapon developed last year for use in emergencies. It also allows banks to swap assets – in this case, older loans, asset-backed securities and corporate bonds – which may be illiquid, for low-cost cash. The terms of the first offering will be announced on Friday and it is understood at least £5bn per month will be available.

    The repos could include some of banks’ most toxic loans – those to commercial real estate developers. The BoE has been quietly urging banks to “pre-position” portfolios of these loans in recent months. Currently, some £260bn of paper is available to be swapped into lower cost cash.

    However, the BoE intends to extract a stiff price. For example, a bank wishing to trade in £10m of commercial mortgage-backed securities that had once been rated AAA but had been downgraded to Aa, would only be able to borrow around £6.6m against that.

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