Is the Bank of England subsidising the banks through the Special Liquidity Scheme?

On my way to Gatwick Airport to participate in a conference in Riga (Latvia) on economic challenges faced by the Baltic countries, I noticed a sign post for the village of Pratts Bottom. It reminded me of why I love living in this country. I am sure I really could find Little Whinging in Surrey if I looked long enough.

This naturally brings us to the question as to whether the Bank of England subsidises the banks through its newly created Special Liquidity Scheme (SLS). The scheme is a swap of one-year maturity Treasury Bills for illiquid mortgage-backed securities, covered bonds (Pfandbriefe), and asset-backed securities backed by credit card receivables. Let’s refer to this collection of bank assets as MBS (for mortgage-backed securities).

The securities offered by the banks in the swap are either valued at market prices (if there is a functioning market, which typically is not the case) or by the Bank of England. Haircuts (discounts) are applied to this valuation, ranging from 12 percent on floating rate and short maturity fixed-rate debt to 22 percent on long-term fixed rate debt.

Then there is the fee for this swap or, equivalently, for this collateralised (against MBS) borrowing of TBills by the banks. Here’s what the Bank of England says:

“The fee payable on borrowings of Bills will be the spread between 3-month LIBOR and 3-month General Collateral gilt repo rate, as observed by the Bank, subject to a floor of 20bps. The fee may vary at the Bank’s discretion.”

This is somewhat cooky, but certainly not cheap. You would have expected the fee for each pound’s worth of TBills borrowed (against the MBS collateral) to depend on the difference between the one-year collateralised borrowing rate for banks and the rate on one -year Treasuries. It’s not clear where the three month rates used by the Bank of England come from.

In any case, what this means is that even if we ignore the haircut, the banks borrow through the SLS from the Bank of England at an unsecured rate (LIBOR) although their borrowing is secured against MBS. That’s pretty tough. In addition, because of the haircut, the banks have to over-collateralise their borrowing. If the haircut, expressed as a fraction, is h – with a haircut of 22 percent, h = 0.22 – then for each £ worth of collateral offered, the banks can borrow only 1-h worth of TBills.

LIBOR has become the rate at which banks don’t lend to each other in the interbank market, so it is certainly possible, indeed highly likely, that the market rate for borrowing against the kind of MBS collateral the banks are offering to the Bank of England would have been higher than LIBOR.

The fact that the Bank of England makes secured loans to the banks at a rate below what these banks would have paid in the market does not, however, mean that the Bank of England is subsidising the banks. Instead what it is doing is correcting a form of market failure, illiquidity, without subsidising the banks.

The Bank of England’s loan of TBills is a subsidy only if these are provided at a price below the Bank of England’s risk-adjusted marginal cost of funds. That does not seem likely, given the fact that the BoE prices the MBS securities offered as collateral and applies serious haircuts to these valuations.

Once more (because I get more confused correspondence about the issue than about any other economic issue): the price charged can be less than what it would cost the banks to obtain the funds in the market without this being a subsidy, if the market price exceeds the marginal cost of funds to the Bank of England. That is the indeed the case. The welfare economics case for the Bank of England doing this is exactly that the funds it provides are priced both below the (distorted, illiquid) market price and above the Bank of England’s own marginal cost of funds (for those of you who cannot get enough of this, there is a paper on subsidies and related issues by Mark Schankerman and myself).

The spread of the Bank of England’s risk-adjusted marginal cost of funds over the risk-free rate is equal to p/(1-p) times the excess of the risk-free rate over the rate the Bank of England would receive in the event that both the bank offering the collateral and the issuer of the collateral default. The probability of a joint default of the borrower and the issuer of the collateral is p. If, for instance, the Bank of England were to receive nothing (neither interest nor principal) in the event of a joint default of borrower and collateral, the rate the bank would receive given joint default is -1 and the spread of the Bank of England’s marginal cost of funds over the risk-free rate is (approximately) equal to the joint default probability (the exact spread is p/(1-p) times (1 plus the safe rate)).

Ideally, the risk-free rate would be measured by the 1-year TBill rate, but it is instead approximated by the Bank of England with the 3-month General Collateral gilt repo rate.

Even over a one-year horizon, the likelihood that both the borrowing bank and the collateral will go belly-up must be very small indeed. The Bank of England’s risk-adjusted cost of capital is therefore only slightly higher than the risk-free rate. It is certainly lower than LIBOR. So there is no subsidy involved in the Bank’s SLS.

Of course, it is possible that the highly unlikely event of a simultaneous default by the borrowing bank and by the issuer of the MBS offered as collateral does materialise. In that case the state, that is, the tax payers or the other beneficiaries of public spending are out of luck and out of pocket. But that risk was properly priced ex ante, and while it would be appropriate to curse the Gods, it would not be appropriate to curse the Bank of England.

Unlike the Fed, the Bank of England does not appear to want to be in the business of subsidising the banking sector or of helping to recapitalise it through quasi-fiscal sleight of hand. Long may it remain that way.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website