The Bank of England’s new funding for lending scheme (FLS) is unexpectedly generous and will benefit banks and existing borrowers. Its impact on new lending, however, may disappoint unless the Bank simultaneously revokes its recent guidance to banks to raise their capital ratios further.

The effect of the scheme is to allow banks to refinance up to 5% of existing lending at a minimum interest rate approximately equal to the Treasury bill rate plus 25 basis points (bp), i.e. below 0.75% currently. They can borrow for up to four years and the minimum rate will apply as long as banks do not contract their loan books between now and the end of 2013. This represents cheap term funding – for comparison, banks paid an average 3.2% on new household time deposits in May. The scheme is structured similarly to the existing discount window facility (DWF) but with a longer term (i.e. up to four years versus one month) and much lower fee (the DWF charges 200 bp for lending against pools of loans).

Suppose that banks refinance the maximum 5% – £80 billion in aggregate – at the minimum rate, replacing funding currently costing 2 percentage points more (i.e. about 2.75%). This would represent a saving of £1.6 billion per annum, equivalent to 0.1% of GDP – small but not insignificant. Banks, of course, will be under strong pressure to pass on the saving to borrowers.

The minimum rate also applies to new lending. Banks, for example, could borrow at 0.75% to fund new mortgage loans, the interest rate on which averaged 3.75% in May. Suppose aggregate lending grew by 5% or £80 billion. A 3 percentage point spread on the new loans would imply an additional “gain” of £2.4 billion per annum (i.e. on top of the £1.6 billion from refinancing existing lending).

While banks are likely to take advantage of the opportunity to refinance cheaply, however, regulatory pressure to boost capital ratios coupled with a high current cost of capital may deter the desired expansion of lending, despite attractive spreads. The scheme’s implicit assumption, in other words, that funding – rather than capital – is the key constraint on credit supply may be flawed. The Bank’s Financial Policy Committee, of course, recently added to banks’ incentive to conserve capital by recommending that they increase buffers “in order to help to protect against the currently heightened risk of losses”.