Special Liquidity Scheme

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On Apr. 21, 2008, the Bank of England launched a scheme to allow banks to swap temporarily their high quality mortgage-backed securities and other securities for UK Treasury Bills. This was called the Special Liquidity Scheme.

With markets for many securities closed, banks had on their balance sheets an ‘overhang’ of these assets, which they cannot sell or pledge as security to raise funds. Their financial position has been stretched by this overhang so banks have been reluctant to make new loans, even to each other.

Under the Scheme, banks can, for a period, swap illiquid assets of sufficiently high quality for Treasury Bills. Responsibility for losses on their loans, however, stays with the banks. By tackling decisively the overhang of assets in this way, the Scheme aims to improve the liquidity position of the banking system and increase confidence in financial markets.[1]

Fitch Ratings said the Bank of England's announcement that it would launch a Special Liquidity Scheme was a positive market development for UK banks because the scheme should improve access to liquid assets for UK banks and building societies and it offers longer maturities than some are able easily to obtain in the markets. [2]

How It Works

  • THE PROBLEM

Bank A wants to borrow money from its counterparts to fund new business, but Bank B is concerned that Bank A might have significant exposure to bad debt, so is unwilling to lend money unless Bank A pays a significant premium above the Bank of England's base rate.

This breakdown of trust between banks has driven up London Interbank Offered Rates (LIBOR) - measurements of the rates at which banks are lending to each other -which filter through to mortgage and corporate borrowing rates.

  • THE SOLUTION

Bank A needs to reassure Bank B that its books are healthy and that it will not have any problem repaying its debts. To make its balance sheet stronger, Bank A takes some of its mortgage and other asset-backed securities - packages of debt that it owns - to the Bank of England.

The Bank of England accepts the securities on a short-term basis, trading them for Treasury Bills - a form of short-term government bonds - though Bank A remains responsible for any losses on the loans.

  • THE PACKAGE

The value of the Treasury Bills given to Bank A varies depending on when the debt packaged into the securities matures and with which currency they are involved.

For every £100 of sterling securities made up of floating or fixed-rate mortgages maturing within three years, Bank A receives £88 of Treasury Bills. It pays a fee for the swap, equal to the difference between three-month Libor and the three-month interest rate for borrowing against the security of government bonds.

  • THE PRICE

The fee will be payable and recalculated every three months as an incentive to banks to close the gap between base rates and LIBOR. Only premium asset-backed securities, those with AAA-rated debt, can be used under the swap system.

If the debt rating of the assets is downgraded during the life of the swap, the bank will have to replace them with new AAA-rated assets.

  • THE CONCLUSION

At the end of the year, Bank A swaps the Treasury Bills back for the securities, though it can renew the swap for another year, up to a total of three years. [3]

References

  1. Special Liquidity Scheme. Bank of England.
  2. Fitch: Bank of England Special Liquidity Scheme a Positive for U.K. Banks. Forbes.com.
  3. "How the Bank of England’s Special Liquidity Scheme Will Work. Telegraph.