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Bank of England Announces Swap Plan

On 21 April 2008, the Bank of England launched a plan “to allow banks to swap temporarily their high quality mortgage-backed and other securities for UK Treasury Bills.”  

Due to distressed financial times, many securities’ markets have closed, creating an “overhang” of these assets on their balance sheets, leaving them without means to raise funds. Consequently, banks have not been making new loans, even to other banks.

Within this plan, banks will be able to exchange high quality illiquid assets for Treasury Bills. Although this scheme has the potential to help the banks, it is not a bailing out. The responsibility for any losses on the loans is still with the bank, and they will be charged a fee.

The three main features of the scheme are that: 1) each exchange is valid for one year, with the option to renew for a total of three years, 2) the banks remain responsible for the risk of losses on their loans, and 3) the swaps cannot be used for new lending, applying only to assets from the end of 2007.

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.”  If confidence is strengthened, it is likely that commercial banks will then pass on the BoE’s recent cuts on a key interest rate to debtors.

Beginning yesterday, the banks are eligible to enter into new asset exchanges during a six-month window. These exchanges will be valid over a period of one year. The Bank of England will then decide which banks may renew the exchanges, on a year by year basis, for up to three years. After which time, the scheme closes. The duration of these exchanges has been determined as sufficient to give banks a much needed boost of confidence. Banks will pay a fee for this plan, which is based on the 3-month Libor.

Because this scheme is only available for loans that were already made by the end of 2007, this exchange will not apply to new lending. The Debt Management Office will supply the Treasury Bills to the Bank of England in exchange for already made “high-quality assets, including AAA-rated securities backed by UK and European residential mortgages” (not any backed by the U.S.).

The plan is to begin with around £50bn, all the while being dependent upon current market conditions.