Tuesday, April 22, 2008

Bank of England’s clever swap shop

(FT) A moment of truth is arriving in the credit squeeze: a clear empirical test of whether it is a problem of bank liquidity or bank solvency is about to begin. The Bank of England’s new Special Liquidity Scheme is a cleverly designed and welcome move to ease liquidity troubles. It should lower the three-month interbank lending rate. But if the real fear is solvency – that too many bad loans were made at too low an interest rate – it will not make mortgages cheaper, or release wholesale funding for the banks.

Under the SLS, banks will be able to swap mortgage loans they made before the end of last year and now cannot sell on, for easily saleable short-term government bonds. The scheme should erase any fears that a UK bank will be unable to repay a loan because it is illiquid. If that is the reason why banks are reluctant to lend to each other, the SLS should solve the problem.

The design of the scheme looks good. In no way does it absolve banks of the consequences of their past lending mistakes – they keep all of the credit risk. The SLS targets the systemic risk caused by illiquid bank balance sheets.

Taxpayers are well protected. For every £1 of securities that banks swap in the scheme, they will receive significantly fewer government bonds; only high quality asset-backed securities are eligible to be swapped, and they will be valued at today’s depressed market prices.

Nor, quite rightly, does the scheme aim to boost new mortgage lending, despite the government’s obvious wish for that result. The swaps are available only for assets existing at the end of 2007, and are not available to non-bank lenders.

Finally, the SLS has a unique feature that may make it especially effective in bringing down the interbank Libor rate: the higher Libor is, the higher the fee that banks will pay to use it. In one sense that is perverse, because the more severe the problems in the interbank market are, the more expensive the SLS becomes. But in another sense it is canny. Libor is set by large commercial banks. They now have a direct incentive to quote lower rates, because the lower Libor is, the more cheaply they can refinance mortgages via the SLS.

More normal interbank lending rates will greatly reduce risks to the financial system, but will not necessarily increase the supply or lower the price of credit in the wider economy. Banks will be able to raise cash against their book of mortgages, but they will only lend that cash out if they can take on good risks at attractive rates. The SLS may fix liquidity – which is vital – but not the wider credit squeeze.

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