The Bank of England’s new “special liquidity scheme” may prove ineffective because of its unattractive fee structure.

The scheme appears to be in the spirit of the term auctions of three-month funds last autumn . These attracted no bidders because the Bank set the minimum bid rate at a penal level.

The fee payable on a swap of mortgage-backed securities for Treasury bills will be the spread between three-month LIBOR and the three-month gilt repo rate – currently about 100 basis points. A floor has been set at 20 basis points but is irrelevant. Banks will use Treasury bills to obtain funds in the market at the gilt repo rate. Their total cost of funding – including the fee – will therefore equal LIBOR.

The scheme will help any institutions currently unable to access interbank funds at LIBOR but seems unlikely to result in a significant reduction in the current wide LIBOR-Bank rate spread. There is a danger that use of the scheme will be interpreted as an admission of weakness. The major banks may have agreed to participate in the scheme regardless of their need for funds to mute this signalling effect.

The scheme differs significantly from the Federal Reserve’s term securities lending facility, in which fees are set in an auction subject to a minimum for AAA-rated asset-backed securities of 25 basis points. Details of the latest auction show that some participants paid the minimum fee, implying the swap will have allowed them to obtain funds in the market significantly below LIBOR. The Bank of England appears to have rejected a comparable fee structure because of “moral hazard” concerns.

The relatively restrictive nature of the scheme suggests the LIBOR-Bank rate spread will remain elevated and the onus will be on the Bank’s Monetary Policy Committee to bring market rates down via further cuts in its Bank rate .