TEXT-Bank of England statement =2

SPECIAL LIQUIDITY SCHEME: INFORMATION The Bank of England has announced a new scheme to enable banks and building societies to swap temporarily assets that are currently illiquid in exchange for UK Treasury Bills. This briefing note provides information about the purpose and nature of this initiative, to accompany the Bank's news release. ADDRESSING THE PROBLEM

Financial markets are not working normally, which if left unchecked will have an impact on the wider economy. Across the world, there is a lack of confidence in assets created from packages of bank loans, most notably mortgage-backed securities. That lack of confidence was prompted by the downturn in the United States housing market and, in particular, the problems associated with sub-prime mortgages there. The markets that normally trade these assets have, in effect, closed, so it has become very difficult for banks to exchange these assets for cash - the assets are currently `illiquid'. As a result, banks in all the major financial centres have on their balance sheets an `overhang' of these assets, which they cannot readily sell or use to secure borrowing. It is not that banks, at least in the United Kingdom, have made unsustainable losses. But by stretching their balancing sheets, this overhang has created uncertainty about the financial position of banks. They have, as a result, been reluctant to lend, even to each other. That reluctance is evident in the interest rates charged on interbank lending, which have risen, even though Bank Rate has fallen. This situation is affecting all banks and building societies and has started to affect their willingness to lend money to individuals and businesses. It had been hoped that these problems would be resolved as markets returned to normal. But it is now clear that there is no immediate prospect that markets in mortgage-backed securities will operate normally. The situation will improve only if the overhang of illiquid assets on banks' balance sheets is dealt with. Only then will banks be willing to lend to each other and, importantly, to the wider economy.

CENTRAL BANK OPERATIONS

Banks routinely borrow money from central banks in exchange for assets. They do so to manage their day-to-day cash needs as they lend and borrow funds. In response to the stresses in financial markets, central banks worldwide have extended their lending facilities. Since August, the Bank of England has increased by 42% the amount of central bank money made available to financial institutions. It has increased from 31% to 74% the proportion of its lending to the market that is for a term of at least three months. Since December, the Bank has also widened the range of high-quality assets accepted in its 3-month lending operations to include mortgage-backed securities. The stock of outstanding lending against that wider range of collateral is £25bn. These changes have aimed to alleviate the problem of financing the large overhang of illiquid assets on banks' balance sheets.

THE NEW SCHEME

To tackle this problem decisively, the Bank of England has designed a Special Liquidity Scheme to allow banks and building societies to swap for up to three years some of their illiquid assets for liquid Treasury Bills. The purpose of the scheme is to finance part of the overhang of currently illiquid assets by exchanging them temporarily with more easily tradable assets. The banks can then use these assets to finance themselves more normally.

All of the banks and building societies that are eligible to sign up for the standing deposit and lending facilities within the Bank's Sterling Monetary Framework will be able to take part in the Scheme.

Usage of the scheme will depend on market conditions.

Discussions with banks suggest that initial use of the scheme will be around £50bn.

The Scheme will involve the Government, through the Debt Management Office, issuing new Treasury Bills to lend to the Bank of England.

Banks will be required to pay a fee to borrow the Treasury Bills. The fee charged will be the spread between the 3-month London Interbank interest rate (Libor) and the 3-month interest rate for borrowing against the security of government bonds, subject to a floor of 20 basis points.

This scheme will be completely ring-fenced from and independent of the Bank of England's money market operations. So it will not interfere with the Bank's ability to implement monetary policy.

The facility has three important characteristics:

(I) LONG-TERM ASSET SWAPS

Banks will be able to enter into new asset swaps at any point during a six-month window, starting today. To provide banks with the certainty about liquidity that is needed to boost confidence, assets will, unless they mature within one year, be swapped for one year and banks will have the opportunity, at the discretion of the Bank of England, to renew these transactions for a total of up to three years. So by October 2011, all assets will have been returned to the banks, all Treasury Bills to the Bank of England, and the Scheme will close. The Scheme is a one-off operation to deal with the existing overhang of assets held by banks.