The origins of the Funding for Lending scheme lie in the Eurozone crisis. Roll back the clock to mid-2012, and we see a picture of tight credit conditions for customers, particularly higher-risk homebuyers and small businesses. In its first Financial Stability Report in June 2012, the Financial Policy Committee (FPC) attributed the difficult credit conditions to rising funding costs for banks: as banks' funding costs rose due to fears about Eurozone instability and contagion to UK banks, they passed those higher costs on to borrowers, raising interest rates and thereby reducing demand for loans. This was supported by SME representatives, who complained about high interest rates. It seems the excess liquidity created by QE wasn't enough to encourage lending. More was needed.
Initially, the Bank of England used an emergency liquidity scheme called the Extended Collateral Term Repo (ECTR) facility, which allowed banks to pledge a wide range of loans and securities in return for cash. This scheme ran for four months, June-September 2012. It was then effectively replaced by the Funding for Lending scheme, although it remains in place as an occasional emergency funding scheme to supplement the Bank of England's Discount Window Facility (DWF) and operational lending facility.
The Funding for Lending (FLS) scheme is subtly different from the ECTR. It accepts the same wide range of collateral, but instead of dishing out cash, it lends banks 9-month sterling Treasury bills. Banks can then use these as high-quality collateral in the funding markets, which should reduce their cost of funding to somewhere close to the policy rate (currently 0.5%). This is really a variant of the DWF, which lends gilts against a wide range of collateral for the same purpose. The difference is that T-bills have shorter maturities, so carry lower interest rates (typically 0.3-0.4%) and need to be rolled over sooner.
Where the FLS differs wildly from the DWF and the ECTR is in the obligations it places on borrowers. FLS borrowing incurs a fee, which increases if borrowers reduce their lending to non-banks (corporates and households). The way the fee works is somewhat complicated, but the Bank of England has helpfully released some worked examples so we can all understand it. The useful example in relation to LBG, RBS and Santander is the third one, which shows that a bank that reduces its lending substantially during the reference period (July-December 2012), as all three have, will pay 1.25% over the standard 0.25% fee on all its borrowings under the scheme. That is quite a hefty hike.
But it obviously wasn't hefty enough to deter banks from borrowing money under the scheme then deliberately reducing lending to meet operational targets. And doing some basic calculations quickly shows that the 1.25% hike actually isn't necessarily that much of a deterrent. Assuming the high-quality collateral allowed them to borrow from the funding markets at 0.5%, the initial cost of FLS funding on the base stock of lending was 0.75%. That is a very considerable reduction on the prevailing funding spreads at the time, as this chart from the June 2012 Financial Stability Report shows:
So for the last 6 months, these banks have benefited from much reduced funding costs for their EXISTING operations. Now they will have to pay an additional 1.25% for that funding: but even then it is only 2%, which is still less than other forms of funding at the start of the FLS scheme. It is particularly telling that the banks that have participated in the scheme but failed to increase their lending are generally regarded as weak by the markets. LBG and RBS would have been facing much higher funding costs than those in the chart. I have no doubt that these banks did the number crunching just as I have, and realised that it was in their interests to participate in the scheme even though they had no intention of increasing net lending any time soon.
However, developments since the FLS was introduced have rather changed things. For a number of reasons, of which in my view by far the most important is the calm in the Eurozone following the ECB's announcement of OMT (although the FLS scheme itself is also a factor), market funding costs for UK banks have fallen considerably over the last 6 months.
There is now little difference between market funding costs for well-regarded banks and the FLS scheme. (Not that LBG is a well-regarded bank - but that's another story!)
Both LBG and RBS claim, in their respective 2012 results, that they expect to lend more FLS-funded mortgages in 2013. And the Bank of England echo this in the February inflation report, claiming that the FLS scheme "takes time" to get going. I am unconvinced.
Don't misunderstand me. I have no doubt that RBS and LBG do indeed intend to lend more at some point. But it won't be because of the FLS scheme. They will lend more when they have reduced their balance sheets to a size compatible with meeting regulatory capital requirements without diluting shareholders' equity (remembering that a lot of that equity in both cases belongs to the state). And - more importantly - when households and businesses are showing better risk profiles. Banks only lend when the risk-return profile is right for them. Throwing money at them, whether excess reserves via QE or cheap market funding via collateral enhancement (which is what FLS is), DOES NOT MAKE THEM LEND.
The fundamental flaw in FLS is that it assumes that corporates and households both want to borrow more and can afford to do so. Neither is true. Corporates have been paying off debt at a considerable pace, and according to the Bank of England's February inflation report, many have large cash balances that they are not investing. Large corporations have also been taking on debt, but much of that has been to refinance existing debt obligations at lower rates or to buy back equity. Household deleveraging currently seems to have slowed down, but that doesn't mean they want to take on more debt: real incomes are falling due to wage restriction, consumption tax rises, benefit cuts and inflation in essential goods, so many have stopped paying off debt because they cannot afford the repayments, not because they don't want to pay it off - and those people cannot take on more debt. And many others don't want to take on debt. Borrowing to fund consumption is definitely out of fashion.
There are of course still households and corporations who do want to borrow. But by and large these are the riskiest ones - first-time-buyers and new small businesses. And they don't want to pay the sort of rates that banks want to charge. The FLS scheme could indeed help these, and there is just a chance that it may still do so: although the fall in market funding costs discourages banks from borrowing any more from the scheme, it may make the penalties for reducing lending rather expensive for those who have already borrowed from the scheme (though there is provision for banks to pay back these loans early). But neither category can provide the UK economy with the major boost it desperately needs. After all, if first-time buyers buy houses, they may spend less into the economy - unless they were previously renting, in which case the effect is most likely a wash. And the failure rate for new small businesses in an economic slump is frightening. If the Chancellor was hoping that the FLS would kickstart the UK economy, he is doomed to disappointment.
There is no way that policies designed to increase the indebtedness of households and corporates can succeed. The private debt overhang in the UK economy is crippling; households' debt levels are frighteningly high, and although corporates have been deleveraging there is no real evidence that they have any intention of borrowing to invest in growth-making opportunities: caution is the name of the game at the moment. And structural problems in the labour market are depressing demand. The IMF noted on a recent blog post that private debt levels across Europe, including the UK, are a considerable drag on growth, and suggests measures rather different from those currently favoured by the Coalition government (my emphasis):
Given the downdraft on consumption and investment, fiscal policy should emphasize long-term measures to raise primary balances and/or cyclically adjusted balances—as opposed to headline deficit targets. Structural measures on the supply side (labor and product market reforms) are crucial to offsetting some of the output cost of depressed demand. We also need to take a second look at whether the legal framework supports timely workouts of household debt.So a much slower pace of fiscal adjustment, structural supply-side reform, and debt relief for households. As has already been suggested by a very large number of people, from respected economists to yours truly. Welcome aboard, Madame Lagarde.
The FLS is just another example of the Chancellor messing around with money instead of addressing the real issues. And because it depends on increasing household and corporate indebtedness when the private sector is already weighed down by debt, it isn't going to solve anything. Like the rest of the Government's economic policies, it is built on a false premise. It is fatally flawed.