British banking

Providing cover

The Bank of England offers banks some protection from the financial storm

AS THE global banking crisis has gone on, central banks have repeatedly had to improvise responses to an ever-worsening financial storm. In America, the Federal Reserve stretched its powers to the limit when it organised the rescue of Bear Stearns. Now the Bank of England has come up with an innovative plan—a “special liquidity scheme” that may provide at least £50 billion ($100 billion) to help troubled British banks.

The need for a new approach has been clear for several weeks. The most obvious sign has been the elevated (Libor) rate at which banks raise funds through the money markets. This is normally quite close to the Bank of England’s base rate, which sets the cost of overnight funds. When the crisis struck last August, however, it soared (see chart).

The Bank of England’s decision in December to conduct special auctions, providing three-month funds to banks, seemed to do the trick at the start of this year. But the relief was temporary, and the interbank rate has recently been painfully higher than the base rate. Since much lending is priced off three-month Libor, the tensions in the banking system have in effect wiped out much of the monetary easing from the three cuts in the base rate which have brought it down from 5.75% in early December to 5%.

The mutual mistrust among banks reflects worries about the bad loans they have made and their ability to raise funds in a hurry. The longer the mistrust persists, the greater will be the economic fall-out as banks cut back on their lending. That in turn threatens a vicious circle, in which banks’ balance-sheets deteriorate still further.

The central bank’s new scheme has been drawn up to arrest this danger. As Mervyn King, the governor of the Bank of England, said on Monday April 21st, it is “designed to improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks”.

The new scheme bears a resemblance to the $200 billion “Term Securities Lending Facility”, which the Fed unveiled in early March. As with the American facility, it involves the central bank swapping highly liquid assets for very illiquid assets held by banks. The British scheme will allow banks to swap high-quality mortgage-backed securities for Treasury bills. However, there are two big differences. First, the asset swaps will not be made available through auctions but will instead be a standing facility—available to banks on demand at any time over the next six months. Second, the swaps will be much longer, lasting for a year and renewable for up to three years; by contrast, the Fed’s swaps are for 28 days.

The banks are not getting this help, which will be available only for assets existing at the end of 2007 and cannot be used to finance new lending, for nothing. They will have to pay a fee and they will still be responsible for making good on any losses (although the taxpayer is at risk if one of the banks also fails). But the more important (informal) quid pro quo is that they begin to put their house in order. They must come clean on the losses they have incurred. And they must rebuild their capital.

Whereas banks in America and Europe have written down the value of their assets by tens of billions of dollars, British banks have merrily marked theirs down by far smaller amounts. Barclays, for instance, took a hit of just £1.6 billion, mainly on investments in derivatives and leveraged loans in 2007.

Their complacency is now wearing thin. Some analysts now expect that Royal Bank of Scotland, Britain’s second-biggest bank, will reduce the value of its assets by as much as £5 billion this week (from a writedown of £1.6 billion in 2007). Similarly some analysts think that Barclays may cut the value of its assets by another £6 billion.

As the big writedowns begin, British banks are now starting to beef up the capital that underpins their operations. Analysts expect that the Royal Bank will seek between £10 billion and £13 billion. Other banks are likely to follow including Barclays, which some analysts reckon may have to raise about £8 billion, and HBOS, which may need £11 billion.

Laurence Mutkin of Morgan Stanley, an investment bank, says that the Bank of England’s scheme should help bolster confidence by providing banks with greater certainty that their counterparties will not run out of cash. As important may be the fact that banks are finally admitting that they have skeletons in their cupboards, and that shareholders are being asked to share some of the pain of dealing with them.