Will the government’s new lending scheme work?

The government is to throw another £120bn at the banks to persuade them to lend to businesses. Matthew Partridge examines whether this latest scheme will work.

The government has outlined a new plan to try to boost bank lending to businesses.

This two-pronged scheme will involve the Bank of England (BoE) injecting £5bn of liquidity into the banking system each month. Banks will also be able to borrow from the BoE against a wider range of collateral, provided they increase lending.

Overall, both schemes are expected to result in up to £120bn of new funds being made available to the economy. While it will not lend directly, the Treasury will underwrite any losses.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The news has been received positively by the market overall. However, others have attacked the scheme as a gimmick.

Indeed, the shadow chancellor, Ed Balls, has accused the Bank of England of repeating the mistakes of the 1930s. "Simply giving the banks billions of pounds doesn't translate into loans to business. If business is not investing and creating jobs and if our economy is not growing, that's the fundamental problem."

Of course, Balls would say that that's the nature of politics. But does he have a point? Will this move have much impact on Britain's economic prospects?

The new scheme will boost bank profits, but not lending

One of the best takes on this comes from James Ferguson, chief strategist at Westhouse Securities, and a regular MoneyWeek contributor. He points out that the three main UK banks have a funding gap of £250bn. This means that they still have more loans than they have deposits to back them.

This leaves them vulnerable to a disruption in the money market (a large funding gap' was what ended up bringing Northern Rock down). So the banks have been trying to close this gap by cutting lending.

So James thinks that what will happen is that "banks will do their best" to switch to this BoE funding for half of the gap, and continue to shrink the other half.

As a result, the new loans will "merely slow the rate of loan contraction", rather than boost overall lending. If you assume a 3% spread between the cost of the liquidity provided by the BoE, and the market rate the bank will write the loans at, the main effect will be to boost profits by up to £3.6bn.

Of course, the Bank of England will hope that much of these profits will be retained to help banks deal with the remaining bad loans (the more profits they retain, the more bad debt they can afford to write off).

However, Ferguson believes that there is no evidence to suggest that they will do this. Indeed, he suggests that most of it will simply leak into staff compensation.

More QE is almost certain

The fact is, this particular scheme shows why the BoE has been doing quantitative easing (QE) instead of fiddling about with the mechanics of lending.

Whatever you think of QE, it's the tool that the world's central banks have chosen to deal with the banking crisis. And as Ferguson has pointed out in MoneyWeek in the past, it may be the only thing that prevented the UK from ending up in the same position as Ireland.

The main way it did that was by preventing the money supply from collapsing. As we've mentioned before, for strong growth to take place, experts think that the money supply should be grow by around 7% a year.

However, the latest figures show that M4 ex-OFC(the BoE's preferred measure) is only up 3.5% on the same time last year (and growing by 3.4% on a six month annualized terms).

So chances are that we'll see more QE alongside this new loan scheme particularly with recent UK economic data turning out to be somewhat disappointing.

Jamie Dannhauser of Lombard Street Research thinks predicts that "another £50bn could be announced as soon as the July MPC meeting". Capital Economics agrees. Indeed, it points out that, in his speech outlining the scheme, "Mervyn King indicated that the MPC is also ready to undertake a further easing of monetary policy".

Like LSR, it predicts that the asset purchases will take place at the next meeting. "It looks like the upcoming July meeting is the most likely bet for a QE extension". That points to a weaker pound, and possibly even resurgent concerns about inflation, once the latest bout of panic over Europe is over.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri