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FLS struggles for traction as UK banks shun secured funding

The Funding for Lending Scheme has provided banks with a cheap and easy way of funding themselves without going to the capital markets. But even without the scheme, UK banks were always likely to be parsimonious this year with their wholesale debt issuance, writes Joe McDevitt.

UK banks are in a stronger position than at any time since the 2008 financial crisis. They are increasingly well capitalised, hold ample liquid assets, have shrunk their balance sheets and are well funded. 

Creating incentives to lend is harder when banks are in such a strong position. Nevertheless, the Bank of England felt the Funding for Lending Scheme — with its cheap funding incentives — was the best way of loosening credit to the real economy. 

The Bank of England recognised when the FLS was introduced that it was likely to reduce issuance of debt into the wholesale market — and that in turn would lead to spread tightening and a further reduction in wholesale funding costs because of undersupply. 

More than one year on, there is no doubt that UK banks enjoy much lower costs of funding overall, following substantial spread tightening across all asset classes — much as the Bank of England predicted. 

 “The FLS is more about net interest margin and P&L. It has only served to reduce bank funding costs,” says Anthony Whittaker, managing director, UK and Australasian DCM at Natixis. “It’s important to recognise the FLS was patently different from emergency liquidity measures brought in at the height of the crisis. It was about stimulating lending and having the government direct where banks carry out their lending. As a liquidity measure it was, frankly, unnecessary as the market was not prohibitively expensive and all issuers had access.” 

Those lower funding costs have been passed on to borrowers, says Chris Parrish, head of treasury at Yorkshire Building Society. “The FLS has definitely had an impact, primarily on pricing. We’ve seen that in the retail market and the wholesale market, where cost of funding has dropped quite significantly.

“The reduction in wholesale issuance has shifted the pricing dynamics between investors and issuers because of the scarcity of supply. And this undersupply has also fed through to the retail market where there has been a general drop off in deposit rates.”

SME boost in doubt

Whether the FLS has worked in terms of increasing the volume of mortgage and SME lending is much less clear. In absolute terms, lending by banks that have signed up to the scheme has continued to fall. The latest data on the scheme, which goes to the end of the second quarter of 2013, showed that bank lending had shrunk by £2.3bn overall. Encouragingly, however, the second quarter saw the first increase in net lending, of around £1.6bn, which could be signs of a reversal of the continuous shrinking. 

The incentive to lend has been offset by other incentives and regulatory obligations for banks to deleverage their balance sheets. Santander UK’s net lending during the FLS stands at minus £10bn, Lloyds’s lending is at minus £5.3bn and Royal Bank of Scotland’s is at minus £6.7bn. Only Barclays has increased its net lending, by £7.4bn. 

The Bank of England would argue that lending would have fallen even further without it, and indeed forecast last year that further credit tightening was likely without the scheme.

The Bank gave the scheme a jolt in April this year when it extended the drawdown period for another year (to January 2015) and tried to skew incentives towards SME lending. For every £1 of net lending to SMEs in 2014, banks will be able to draw £5 from the scheme. 

But banks clearly have shown a preference for originating mortgages over SME loans. Lending to SMEs fell in the second quarter by another £583m, while the growth rate of lending to larger businesses over the same quarter was also negative. 

“Banks are still very cautious about which sectors they lend money to and have a strong preference for the mortgage market,” says Whittaker. “They aren’t lending to SMEs because that’s the riskier part of the economy. Now the government will fund lending to that sector 100%, but on the other hand regulators have increased the capital consumed by such lending, so the incentives are contradictory.”

The effectiveness of the scheme may have been dampened by the very low funding needs of most UK banks, which were busy in wholesale markets in 2011 and 2012. Most UK banks enjoy an excess of liquidity, which is one of the reasons Santander UK was happy to pay back £900m of its £1bn of FLS funding earlier this year. In fact, none of the major UK banks registered to the scheme — Santander UK, Lloyds, RBS and Barclays — have drawn funding from the FLS in 2013.

This makes it harder to suggest the FLS is directly responsible for the moribund secured funding market over the past year, according to one spokesperson at a UK bank treasury. “Even without the FLS, banks were likely to reduce their issuance activity,” he says.   

Others to blame

The FLS should not be viewed in isolation. It was preceded, for instance, by two rounds of European Central Bank long term refinancing operation liquidity provision, which provided Europe’s banks with cheap funding for three years. UK banks took €22bn of LTRO funding in the second round in February 2012 alone. Appetite for cheap central bank funding was largely satiated before the FLS was introduced. 

Moving forward, new Bank of England governor Mark Carney announced at the end of August that once the main UK lenders had met the minimum 7% capital requirements against their risk-weighted assets, they would be allowed to reduce holdings of highly liquid assets to 80% of the Basel Committee’s Liquidity Coverage Ratio. This frees up the equivalent of around £90bn that could be lent to the economy. On the other hand, it gives banks even less need to fund themselves in the capital markets.   

In the covered bond sector, a UK bank has not issued a benchmark deal since May 2012. UK RMBS issuance has also dropped off drastically. This year to date there have only been four publicly sold deals. 

The falling RMBS volumes have occurred as the sector was beginning to find its feet again. An array of UK master trust issuers, such as Lloyds, Santander UK and then Nationwide, had familiarised themselves with the US investor base. Barclays, HSBC and RBS had managed the same feat for their credit card securitization programmes. 

There is a danger that with such a long gap between dollar denominated issuance that familiarity will be lost. “The UK banks had a growing US investor base for securitized products, but now I am not sure you’re not going to see a lot of new players come in,” says Robert Plehn, head of asset backed solutions at Lloyds. “Given the lack of supply, the US investors with European arms will stay involved but there is a risk the pure US investor base could drop away.”

The lack of supply has seen UK RMBS spreads tighten from around 145bp-165bp over three month Libor (depending on the programme) for three year paper in the first half of 2012 to around 40bp-70bp over in the secondary markets of late. 

But the spread contraction has also brought new asset classes into play. “Certain investors are not buying prime RMBS paper because spreads have come in so much and instead are switching into higher yielding paper such as CLOs and CMBS,” says Plehn. 

“So, in a way, alongside its clear benefit to homeowners and businesses, the FLS has also benefitted those less vanilla asset classes. The spread tightening has certainly helped make the returns for CLO equity players work better. The FLS hasn’t necessarily shut down the asset-backed market, but in the UK it has moved the issuance away from bank issuers to non-bank issuers and in general away from the UK to continental Europe with a greater proportion of deals from continental Europe, in particular in ABS versus RMBS product.” 

Low supply tightens spreads

The spread tightening has also put senior unsecured funding, which was too expensive for some UK banks to use, back in banks’ armouries. This is not, however, simply a result of the FLS, says Olly Burrows, senior banking analyst at Rabobank. 

“Senior unsecured debt has seen a tightening bias since last summer. Spreads have returned to some semblance of normality, in terms of level and volatility,” he says. “Key to this has been reduced supply, despite some qualms over banking regulation, for instance with the new resolution regime. That’s not to suggest that spreads will return to pre-crisis levels any time soon. Nevertheless, healthy investor demand does and should persist for this perennial asset class. The FLS may be a contributing factor in this spread tightening trend for UK banks, but not a significant factor.”  

When the FLS was introduced, many observers predicted it would be particularly beneficial for challenger banks — new institutions looking to increase market share, and building societies. “For banks like Virgin Money, Tesco or Metro that are in an aggressive growth mode and trying to expand their balance sheets the FLS suits them because there is no risk of them triggering the higher rates,” says Natixis’s Whittaker.  

But aside from Nationwide Building Society, which has drawn down £2.5bn and increased lending by £7bn, the other larger building societies have been restrained with their FLS usage. Yorkshire Building Society (YBS) has drawn £450m, Skipton has drawn £410m, Leeds has drawn £250m and Coventry has drawn £500m. This is partly because the larger builders have seen strong retail inflows that reduce their funding needs. 

“From our own perspective, we’ve been overshooting on our retail funding,” says Chris Parrish at YBS. “As a mutual we are intentionally slower to react to lower rates to protect our savers, but that leads to more retail inflow. We planned to draw on the FLS sooner and in greater volume, but we haven’t needed to because our retail is outperforming.”

The smaller building societies have been even more abstemious with their drawings. Nine builders that signed up to the scheme, for instance, have not used it at all. 

“The small building societies have actually taken very little and this may be because pledging collateral to the FLS is not straightforward if you don’t have the systems and manpower to package up securitized collateral,” says Whittaker. “Committing a pool of whole mortgage loans is not that economic either after the haircut is taken into account.”

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