Government’s plan to subsidise credit could easily backfire

USUALLY, formal dinners at Mansion House in the City are highly enjoyable but somewhat predictable affairs. This one was unusually exciting. For the first time I can remember, the speeches from George Osborne and Sir Mervyn King included major news bombshells. The Bank is launching an £80bn “funding for lending” plan to cut the cost of credit and boost its availability; it will this morning announce a new liquidity programme worth at least £5bn a month; and the governor was as explicit as he could possibly be that more quantitative easing is on the cards. King was extremely gloomy, warning that conditions had deteriorated over the past four weeks.

It is absolutely right for the central bank to provide liquidity to private banks if the markets seize up; that is its core role as lender of last resort. It makes sense for the Bank to be on standby ahead of Greece’s elections this weekend. But the fact that this liquidity will be provided cheaply (rather than at a penal rate) will be seen as an unnecessary hidden subsidy.

The funding for lending plan is much more controversial. While it will be widely welcomed, it is a major gamble. I’m certainly not sold on it. At the moment, banks can raise financing from the markets, but this is costly. The Bank thinks that the best way to reduce businesses’ and consumers’ cost of borrowing (an objective it supports) is to make it cheaper for banks to raise funds – while simultaneously making this cheap funding contingent on them lending at a lower cost. Banks will be able to hand over any new loans they make to the non-financial sector – mortgages, consumer loans, loans to small business – to the Bank of England, which will use these assets as collateral against which to lend money to the banks. There will be a haircut to try and reduce the risk to the Bank if the value of the asset collapses. Borrowing against collateral in this way is currently done privately – but the Bank scheme will be designed to be cheaper and thus to reduce banks’ funding costs. The pricing will reward banks that lend the most and pass on low interest rates.

There are problems with this. It could encourage dodgy lending, given that the Bank of England will underwrite some risks. It involves trying to plan the volume of credit by private banks. It aims to boost all forms of credit – but since when is the UK’s problem insufficient credit card borrowing? If the view is that small firms are being deprived of funds, then why subsidise all loans?

There are two reasons why it’s hard to get a mortgage: new regulations and the risk of further declines in house prices and increased unemployment, which would cause huge losses to lenders. Small business loans have been crippled by the need to hold much more capital against them. The story is similar in other areas. Since August 2011, the average rate on a tracker mortgage is up 0.51 percentage points, the rate on a 2-year fixed 90 per cent loan to value mortgage is up 0.54 points, the rate on credit card debt by 0.57 points and a 2-year fixed mortgage with 75 per cent loan to value is up 0.66 percentage points. This has been caused by a combination of regulatory changes (banks need to hold much more capital in reserve and also more liquidity), higher risk and increased bank funding costs. The problem is not the swap rates, which have remained roughly constant. Instead, banks, because of regulations, now need to rely far more on sterling time deposits. To attract savers, these have shot up by 0.4 percentage points over that period. Why not simply suspend such regulations? That would cut the cost of credit without necessitating any grandiose and risky new government schemes.