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The Bank of England special liquidity scheme in detail

Under the Bank of England scheme, announced on 21 April, to ease the credit crisis, 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 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.

The scheme has three key features:
1. The asset swaps will be for long terms. Each swap will be for a period of one year and may be renewed for a total of up to three years.

2. The risk of losses on their loans remains with the banks.

3. The swaps are available only for assets existing at the end of 2007 and cannot be used to finance new lending.

Mervyn King, governor of the Bank of England, said “The Bank of England’s special liquidity scheme is designed to improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks.”
Banks will be able to enter into new asset swaps at any point during a six-month window, starting on 21 April. Those swaps will be for a term of one year. Banks will be able, at the discretion of the Bank of England, to renew them each year for, at most, a total of three years. After that, the scheme will close.

The length of these transactions is designed to provide banks with the certainty about liquidity that is needed to boost confidence. During the lifetime of an asset swap, banks will be required to pay a fee based on the three-month London interbank interest rate (Libor).

The Debt Management Office will supply the Bank of England with the necessary Treasury bills. Banks will be able to swap for those bills a range of high-quality assets, including AAA-rated securities backed by UK and European residential mortgages. But to prevent banks relying on the scheme to finance new lending, they will be able to swap securities formed only from loans that were already on their balance sheets at the end of 2007.

The scheme is indemnified by the Treasury, but is designed to avoid the public sector taking on the risk of potential losses. Banks will need, at all times, to provide the Bank of England with assets of significantly greater value than the Treasury bills they have received. If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury bills. And if their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets.

The scheme will be ring-fenced and independent of the Bank of England’s regular money market operations so it will not interfere with the Bank’s ability to implement monetary policy.

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 three- month lending operations to include mortgage-backed securities. The stock of outstanding lending against that wider range of collateral is £25bn.

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