Wednesday, 6 March 2013

The fatally flawed FLS

The first results from the UK's Funding for Lending scheme have been released. As widely predicted, it has been a flop. Of the large banks who signed up for the scheme, only one - Barclays - has increased lending. The others - Royal Bank of Scotland (RBS), Lloyds Banking Group (LBG) and Santander - have all reduced net lending. To be fair to LBG and Santander, they have only done exactly what early in 2012 they said they would do, namely reduce retail lending, particularly mortgages. But that is exactly what the Funding for Lending scheme was supposed to prevent.

The origins of the Funding for Lending scheme lie in the Eurozone crisis. Roll back the clock to mid-2012, and we see a picture of tight credit conditions for customers, particularly higher-risk homebuyers and small businesses. In its first Financial Stability Report in June 2012, the Financial Policy Committee (FPC) attributed the difficult credit conditions to rising funding costs for banks: as banks' funding costs rose due to fears about Eurozone instability and contagion to UK banks, they passed those higher costs on to borrowers, raising interest rates and thereby reducing demand for loans. This was supported by SME representatives, who complained about high interest rates. It seems the excess liquidity created by QE wasn't enough to encourage lending. More was needed.

Initially, the Bank of England used an emergency liquidity scheme called the Extended Collateral Term Repo (ECTR) facility, which allowed banks to pledge a wide range of loans and securities in return for cash. This scheme ran for four months, June-September 2012. It was then effectively replaced by the Funding for Lending scheme, although it remains in place as an occasional emergency funding scheme to supplement the Bank of England's Discount Window Facility (DWF) and operational lending facility.

The Funding for Lending (FLS) scheme is subtly different from the ECTR. It accepts the same wide range of collateral, but instead of dishing out cash, it lends banks 9-month sterling Treasury bills. Banks can then use these as high-quality collateral in the funding markets, which should reduce their cost of funding to somewhere close to the policy rate (currently 0.5%). This is really a variant of the DWF, which lends gilts against a wide range of collateral for the same purpose.  The difference is that T-bills have shorter maturities, so carry lower interest rates (typically 0.3-0.4%) and need to be rolled over sooner.

Where the FLS differs wildly from the DWF and the ECTR is in the obligations it places on borrowers. FLS borrowing incurs a fee, which increases if borrowers reduce their lending to non-banks (corporates and households). The way the fee works is somewhat complicated, but the Bank of England has helpfully released some worked examples so we can all understand it. The useful example in relation to LBG, RBS and Santander is the third one, which shows that a bank that reduces its lending substantially during the reference period (July-December 2012), as all three have, will pay 1.25% over the standard 0.25% fee on all its borrowings under the scheme. That is quite a hefty hike.

But it obviously wasn't hefty enough to deter banks from borrowing money under the scheme then deliberately reducing lending to meet operational targets. And doing some basic calculations quickly shows that the 1.25% hike actually isn't necessarily that much of a deterrent. Assuming the high-quality collateral allowed them to borrow from the funding markets at 0.5%, the initial cost of FLS funding on the base stock of lending was 0.75%. That is a very considerable reduction on the prevailing funding spreads at the time, as this chart from the June 2012 Financial Stability Report shows:


































So for the last 6 months, these banks have benefited from much reduced funding costs for their EXISTING operations. Now they will have to pay an additional 1.25% for that funding: but even then it is only 2%, which is still less than other forms of funding at the start of the FLS scheme.  It is particularly telling that the banks that have participated in the scheme but failed to increase their lending are generally regarded as weak by the markets. LBG and RBS would have been facing much higher funding costs than those in the chart. I have no doubt that these banks did the number crunching just as I have, and realised that it was in their interests to participate in the scheme even though they had no intention of increasing net lending any time soon.

However, developments since the FLS was introduced have rather changed things. For a number of reasons, of which in my view by far the most important is the calm in the Eurozone following the ECB's announcement of OMT (although the FLS scheme itself is also a factor), market funding costs for UK banks have fallen considerably over the last 6 months.


































There is now little difference between market funding costs for well-regarded banks and the FLS scheme. (Not that LBG is a well-regarded bank - but that's another story!)

Both LBG and RBS claim, in their respective 2012 results, that they expect to lend more FLS-funded mortgages in 2013. And the Bank of England echo this in the February inflation report, claiming that the FLS scheme "takes time" to get going. I am unconvinced.

Don't misunderstand me. I have no doubt that RBS and LBG do indeed intend to lend more at some point. But it won't be because of the FLS scheme. They will lend more when they have reduced their balance sheets to a size compatible with meeting regulatory capital requirements without diluting shareholders' equity (remembering that a lot of that equity in both cases belongs to the state). And - more importantly - when households and businesses are showing better risk profiles. Banks only lend when the risk-return profile is right for them. Throwing money at them, whether excess reserves via QE or cheap market funding via collateral enhancement (which is what FLS is), DOES NOT MAKE THEM LEND.

The fundamental flaw in FLS is that it assumes that corporates and households both want to borrow more and can afford to do so. Neither is true. Corporates have been paying off debt at a considerable pace, and according to the Bank of England's February inflation report, many have large cash balances that they are not investing. Large corporations have also been taking on debt, but much of that has been to refinance existing debt obligations at lower rates or to buy back equity. Household deleveraging currently seems to have slowed down, but that doesn't mean they want to take on more debt: real incomes are falling due to wage restriction, consumption tax rises, benefit cuts and inflation in essential goods, so many have stopped paying off debt because they cannot afford the repayments, not because they don't want to pay it off - and those people cannot take on more debt. And many others don't want to take on debt. Borrowing to fund consumption is definitely out of fashion.

There are of course still households and corporations who do want to borrow. But by and large these are the riskiest ones - first-time-buyers and new small businesses. And they don't want to pay the sort of rates that banks want to charge. The FLS scheme could indeed help these, and there is just a chance that it may still do so: although the fall in market funding costs discourages banks from borrowing any more from the scheme, it may make the penalties for reducing lending rather expensive for those who have already borrowed from the scheme (though there is provision for banks to pay back these loans early). But neither category can provide the UK economy with the major boost it desperately needs. After all, if first-time buyers buy houses, they may spend less into the economy - unless they were previously renting, in which case the effect is most likely a wash. And the failure rate for new small businesses in an economic slump is frightening.  If the Chancellor was hoping that the FLS would kickstart the UK economy, he is doomed to disappointment.

There is no way that policies designed to increase the indebtedness of households and corporates can succeed. The private debt overhang in the UK economy is crippling; households' debt levels are frighteningly high, and although corporates have been deleveraging there is no real evidence that they have any intention of borrowing to invest in growth-making opportunities: caution is the name of the game at the moment.  And structural problems in the labour market are depressing demand. The IMF noted on a recent blog post that private debt levels across Europe, including the UK, are a considerable drag on growth, and suggests measures rather different from those currently favoured by the Coalition government (my emphasis):
Given the downdraft on consumption and investment, fiscal policy should emphasize long-term measures to raise primary balances and/or cyclically adjusted balances—as opposed to headline deficit targets. Structural measures on the supply side (labor and product market reforms) are crucial to offsetting some of the output cost of depressed demand. We also need to take a second look at whether the legal framework supports timely workouts of household debt.
So a much slower pace of fiscal adjustment, structural supply-side reform, and debt relief for households. As has already been suggested by a very large number of people, from respected economists to yours truly. Welcome aboard, Madame Lagarde.

The FLS is just another example of the Chancellor messing around with money instead of addressing the real issues. And because it depends on increasing household and corporate indebtedness when the private sector is already weighed down by debt, it isn't going to solve anything. Like the rest of the Government's economic policies, it is built on a false premise. It is fatally flawed.







11 comments:

  1. Excellent! Just wondering why you didn't mention the fact that FFL substitutes government money for private savings and thereby depresses retail savings rates and the income of savers. Clearly this transfer of income (from savers to the banks) has had a negative effect on consumption and hence growth. In short, the negative effects of the reduction in returns to retail savings outweighs any positive effects of increased borrowing.

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    1. I agree that FLS may have had some effect on rates to savers, but I think most of the fall in deposit rates is due to the general depression of funding rates since FLS started, which as I said in the post is in my view mainly because of the calm in the Eurozone and very low policy rates. In fact banks at the moment are increasing the proportion of their lending that is funded from retail deposits.

      I don't agree that the negative effect of reduction in returns to savers necessarily outweighs positive effects of borrowing. Most savers don't spend the returns on their savings - they are capitalised into savings balances. The only people that do generally spend the returns are middle-income retired people, which is a relatively small group compared to the economy as a whole.

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    2. Money market rates may have fallen since the start of the FFL, but the money offered by the government under the FFL must be priced at less than the market rate because it has conditions attached to it that do not apply to money from the market. Any such sub-marketrate funds will crowd out higher priced retail rates, and reduce the price offered to retail depositors. I think the BOE has now accepted this point.

      More importantly, you seem to be suggesting that the marginal reduction in demand from the aggregate loss to savers (due to reduced retail interest rates), which can also be seen as a net gain to banks from attracting retail savings deposits, is less than the marginal increase in demand as a result of increased lending by banks - which you describe as a flop. Certainly your suggestion that only a small group of people actually spend the interest earned on their savings suggests that you either don't agree that money is fungible or that you believe the rest don't see earned interest as part of their total wealth.

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    3. It seems you have not read my description of how FLS works, nor the link to the BoE's explanatory note. The government does not offer "money" under the FLS. It lends UK T-bills for a fee in return for less liquid collateral. Those T-bills can be used in the funding markets to reduce the cost of PRIVATE sector funding. Neither the government nor the BoE dish out money under the scheme. The fee for FLS T-bill borrowing is 0.25% rising by stages to 1.5% as a borrower reduces lending. Market funding costs have to fall by at least that much as a result of using higher-quality collateral for FLS to be worth while. The problem is that market funding costs have fallen ANYWAY, so there is much less benefit from FLS collateral. The FLS itself may have contributed to the general fall in sterling funding costs, but as I noted in the post, the extent of this is unknown.

      Regarding interest on savings. Eh? People always spend the interest on their savings when they get it, do they? I don't think so. Only people who rely on that interest for income will spend it. The rest will capitalise it. Of course money is fungible, and of course people see earned interest as part of their total wealth. But that has nothing to do with spending decisions.

      If FLS had worked as expected, the demand from increased borrowing should have outweighed the loss to savers. But you do not know to what extent the fall in rates to savers was due to FLS. There are other factors as well.

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    4. Of course I read your blog carefully before commenting. Regardless of the technicalities, the purpose of the FFL is to lower the cost of money to banks and thereby increase their expected return on lending. This competes with retail savings deposits and reduces the price banks are willing to pay on them, which reduces the real incomes of all savers. This reduction in real incomes reduces aggregate demand. The question is whether or not any anticipated increase in loans could offset this fall. It is the net effect on aggregate demand that matters and that has not been addressed; it is assumed that the FFL will have only positive effects or, at worst, no effect. In fact the net effect may be to depress aggregate demand in the economy.

      Do you really think that changes in wealth and in real income in particular "has nothing to do with spending decisions"? Perhaps your next blog could elaborate on that rather worrying suggestion.

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    5. I am not disagreeing with you about the negative effects to savers, although as I have now said several times it is by no means clear to what extent the fall in retail deposit interest rates is due to FLS. However, I dispute your conflation of wealth and income. When people's preference is to save - which is the case at the moment - they do not spend earned interest unless they have to. If they can, they add it to wealth. Therefore it is by no means clear that reducing rates to savers depresses demand, except in the case of the small group of savers who depend on interest on savings for their essential income. I am unconvinced that wealth effects necessarily encourage people to spend when the general economic mood is risk-averse and thrifty.

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  2. The nonsense runs even deeper than Frances claims. That is, the immediate response to the crunch, which was brought about by excessive and irresponsible lending, was to cut interest rates so as to – er – encourage more lending.

    If we replaced M.P.s with inmates of lunatic asylums, my guess is we’d be better off.

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  3. FLS is just another half-thought solution from the Treasury/BoE with main aim to support the ridiculous high house prices.
    Any FTB buying into it, is destined to end up in negative equity (unless ofcourse the BoE decides to destroy all pensions and private savings by keeping the rates low for another two decades).

    The treasury should stop the half-baked solutions and should examine otherways of getting the economy rolling.
    Perhaps:
    -Reduce income taxes and introduce LVT taxes. This way low/middle incomes will have more disposable income while all the unearned land wealth will be taxed.
    -Tax land banks so builders will start building.



    I do disagree about the savers impact. The ISA/Fixed bonds rates have decreased substantially. Last year some banks were offering 4.25-5% and now i have not heard anything been offered above 2-3%.
    If this continues, it will have long term implications since people who would have saved would need now to drop into benefits and will have to be supported by the goverment.

    SK

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  4. I was wondering if in the UK, you have all loans guaranteed by the government? I know in the USA, they are not yet all guaranteed, but I believe that is what the banks and the Fed ultimately want. All loans guaranteed would make them rated highly, even though they are pigs with ribbons on them.

    I wonder if the Fed is using the threat of negative interest rates as a catalyst for the government to take on this risk? Banks want risk free lending, Frances, as you have said elsewhere on this blog. So, is that the ultimate central bank blackmail and won't this wreck havoc on governments, forcing them to cut all other spending?

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  5. @SK people who live off gilt coupons are already functionally supported by government. Reshuffling this support towards means tested channels should be cheaper as some have non gov income. Equivalently the government could just make gilt coupons means tested :-).

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  6. My income has nose dived 70% solely thanks to FLS
    The same thing has happened to numerous friends who are now forced to sell homes they love and no they are not big expensive homes but small simple ones
    Without a shadow of doubt this governments deliberate attack on the millions of pensioners who have absolutely no option but to depend on savings income is criminal and treachury
    Many of them are widows who rely on life interest and cannot touch the capitol
    I can but hope the backlash against this government whose 3 principal members promised faithfully to help savers
    Instead they have totally decimated our lives and there is absolutely not onebiota of merit in FLS or destroying pensioners who were comfortable and at least able to spend and treat their grandchildren reduced to the most abject poverty

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