The UK's credit guarantee scheme is designed to unclog markets rather than offer banks cheap funding.

The Debt Management Office has announced that the guarantee fee will be 50 basis points per annum plus the median five-year credit default swap spread for the borrowing institution during the 12 months to 7 October. Averaged across banks, this spread is likely to be in the region of 100 bp (see Chart 1.3 in the August Inflation Report), implying a total fee of about 150 bp.

According to Bank of England, the one-year interest rate on unsecured commercial bank borrowing stood at 5.8% late last week, 240 bp above the rate on government borrowing. A fee of 150 bp would therefore allow a significant reduction in banks’ cost of funding compared with recent extreme levels.

Also welcome is that the fee will be not be linked to current CDS prices. As previously argued, the effectiveness of the special liquidity scheme (SLS) has been reduced because it becomes more expensive when LIBOR rates rise – the time banks most need to use it.

However, an all-in cost 150 bp above government borrowing rates still represents expensive funding by historical standards – the differential between one-year rates for unsecured bank and government borrowing averaged 30 bp in the 10 years to mid-2007, before the credit crisis erupted. This suggests the spreads of household and corporate borrowing rates above Bank rate will remain under upward pressure, while banks’ efforts to rebuild capital from retained earnings will be constrained.

The new scheme will be a big earner for the Treasury: 150 bp on an expected £250 billion take-up equates to £3.75 billion per annum. The SLS is likely to generate a further £1.5 billion (based on an assumed average 75 bp fee on take-up of £200 billion), suggesting a total payment from banks to the Treasury / Bank of England of about £5.25 billion pa.

The Treasury statement on recapitalisation plans states that the banks concerned have agreed to maintain lending to homeowners and small businesses at 2007 levels over the next three years. While helpful, this begs the question of why the government is allowing Northern Rock to shrink its mortgage book by £20 billion per annum in 2008 and 2009. Rock borrowers forced to refinance their loans are absorbing a significant portion of other banks’ lending capacity.