Help to UK credit supply is unlikely to raise demand

The Bank of England is to boost UK banks’ liquidity and launch a Funding For Lending scheme to provide loans to business and households. But these measures can work only if credit is stuck because of supply factors. In fact demand is constrained by a ‘black cloud’ of uncertainty. So although they may modestly boost confidence, this uncertainty remains the ultimate problem.

Besides Funding For Lending and additional liquidity, UK chancellor George Osborne and the central bank’s governor, Sir Mervyn King, in June announced help for housebuilding and infrastructure projects and said Britain’s new macroprudential regulator must also consider economic growth.

Under the key Funding For Lending scheme, the Bank of England will provide finance – reportedly £80bn – at below current market rates for several years to banks that re-lend it to households and firms outside the financial sector. A broad range of assets will be accepted as collateral, including loans to the wider economy.

However, the Bank and Treasury will ultimately be taking more risk on the public-sector balance sheet. It thus seems they now believe economic uncertainty is paralysing credit flow and think there is a role for the state to step in and underwrite some risk.

The additional liquidity facility for banks activates the central bank’s Extended Collateral Term Repo Facility that was announced in December 2011 but which had not been used. The Bank will each month auction at least £5bn of six-month funds, again accepting a wide range of collateral. The minimum bid rate is a quarter percentage point above bank rate, currently meaning 0.75% compared with six-month Libor of around 1.3%. The Bank hopes the facility will be attractive and – given the favourable pricing – that acceptance will not stigmatise the banks.

Surveys of firms show that uncertainty about demand – not a lack of access to credit – is the biggest restraint on investment.

Meanwhile the Bank’s new macroprudential watchdog, the Financial Policy Committee, must now explain how its actions are compatible with economic growth. This is aimed at preventing the committee from achieving financial stability by hiking bank capital buffers and deterring risk-taking, so significantly reducing the efficient allocation of capital in
the economy.

Buildings investment has been the key driver of the fall in total UK investment, so the scheme to underwrite financing for infrastructure projects and housebuilding is aimed at reversing that downward trend.

These credit easing measures do not prevent more quantitative easing though purchases of government bonds, however. In admitting that economic conditions have deteriorated since the Bank’s latest forecast, Sir Mervyn admitted that a 'black cloud' of uncertainty is restraining spending and pushing up the cost of finance. He conceded that targeted measures to reduce funding costs and further monetary easing are both possible – and that the case for a further monetary easing is growing. This could mean another £50bn of gilt purchases this summer.

But the scheme will work only if credit is stuck because of lack of supply rather than demand. It is true that economic uncertainty – particularly surrounding the eurozone – has raised bank funding costs with this increasing effective interest rates for the wider economy, but the 'black cloud' of uncertainty also affects firms' and households' desire to borrow – almost regardless of the
interest rate.

Many households are still trying to reduce debt and mortgage rates are still historically low. And surveys of firms show that uncertainty about demand – not a lack of access to credit – is the biggest restraint on investment. Even the Bank’s own credit-conditions survey shows demand for credit is generally falling.

So, with that 'black cloud' overhead, a small reduction in effective interest rates is unlikely to lead firms to embark on big investment projects. While some companies, particularly smaller firms, may benefit at the margins, we think the problem is as much about a lack of demand for credit as the supply. The scheme is thus not a magic wand solution: uncertainty will still weigh heavily
on sentiment.

And even if there is a serious credit supply problem, these schemes will address it only if expensive wholesale bank funding is the blockage. If banks aren't lending because of capital considerations, these measures may again have limited impact. Regulators are still putting pressure on banks to reduce lending risk. So while giving the Financial Policy Committee a growth mandate is welcome, this is for the future: it doesn't help the current situation.

This report must be read with the disclosures, analyst certifications and the disclaimer.