Wholesale funding by UK financial institutions is expected to decline because of the attractive costs of a government Funding for Lending Scheme, according to market participants, with spreads on covered bonds and RMBS expected to tighten as a result.

The Funding for Lending Scheme (FLS) was launched on 13 July by HM Treasury and the Bank of England (BoE) and went live on Wednesday of last week (1 August). It is intended to boost lending to the real economy – UK households and non-financial companies – and allows UK banks and building societies to borrow, at a fee, UK Treasury Bills in exchange for collateral during an 18 month drawdown window from 1 August to 31 January 2014. The T-Bills will be lent for up to four years, with a fee of 0.25% over the Treasury bill repo rate charged per year for institutions maintaining or expanding their net lending between 30 June 2012 and the end of 2013. Banks whose lending declines will be charged an additional fee of 0.25% for each 1% fall in lending, up to a maximum fee of 1.5% for those that contract their stock of lending by 5% or more.

Loans can also be drawn down for up to 5% of a financial institution’s current stock of loans to households and businesses, estimated to amount to £80bn across the industry.

Based on a bank rate of 0.5%, this means that funding costs under the FLS can range from 0.75% to 2%, which market participants said compares favourably with market rates for wholesale funding, at least for those banks that are maintaining or growing their lending.

“The base rate plus 25bp as a funding cost is quite attractive,” said a DCM banker, “more so than any other source, certainly in the wholesale market.

“If you’re shrinking your balance sheet the 150bp over base rate looks less obvious, or requires more thought.”

UBS bankers said the outlook for sterling covered bond issuance in the second half of the year will remain subdued, “not least” because of the FLS, with a more active prime RMBS market recently having already given UK issuers cause to not tap the longer dated sterling covered bond market.

UniCredit analysts believe the FLS will have an impact on UK covered bond issuance activity given the four year time span of the scheme and the “extremely” attractive cost of borrowing under it.

They noted that 22% of benchmark covered bonds issued in the UK during 2011 and 2012 year-to-date had a three year maturity and 49% a five year maturity, and said that the FLS could have an impact on future issuance activity, especially up to five years.

However, add the UniCredit analysts, euro benchmark covered bonds will probably not dry up but shift to longer maturities (five years-plus), thereby limiting the effect of the FLS, with the impact on covered bond issuance in sterling and/or with maturities up to five years likely to be more pronounced.

Philip Walsh, head of business & relationship management for EMEA structured finance at Fitch, examined the impact of the FLS on UK RMBS issuance, noting that market participants expect it to be significant, even though the scheme is directed at mortgage and other retail lending as well as lending to corporates, especially small and medium sized enterprises (SMEs). He said this is because the lower end of the borrowing range under the FLS, even after taking into account haircuts on nominal asset values of the collateral submitted, will be considerably cheaper than current RMBS pricing, and that some lenders have already reduced mortgage lending rates accordingly.

According to Fitch, AAA rated RMBS are typically priced at around 1.5% over Libor, compared with all-in funding costs of 0.75%-2% under the FLS.

The rating agency said that the exact impact on RMBS issuance volumes is difficult to estimate but that it expects regular issuers will continue to issue, albeit in lower volume, with issuance otherwise opportunistic.

But while the cost of funding under the FLS may on the face of it appear attractive, market participants note that other variables will also influence UK financial institutions’ decision as to whether or not to tap the scheme, or to what extent, and how any use will affect their funding plans.

“It’s thrown up a lot of questions,” said the DCM banker. “Some funding officials’ views on wholesale funding programmes have been knocked for six and people have to sit down with a fresh bit of paper and work with senior management to figure things out.”

Related issues that need to be considered, he suggested, include whether to use the scheme at all, to what extent any borrowing under it replaces wholesale and/or retail funding, and how funding-efficient the scheme is for institutions in light of the amount of collateral they have and any internal encumbrance limits.

“If you are far away from internal encumbrance limits then you may not worry about efficiency so much,” he said. “It depends on how constrained you are from a collateral standpoint.”

Collateral eligible for the FLS is the same as that eligible for the Bank of England’s Discount Window Facility (DWF), according to the UK central bank, with haircuts under the Sterling Monetary Framework (SMF) applicable.

Other considerations that were cited as influencing the extent to which UK financial institutions access the FLS included the value of maintaining relations with investors by continuing to access the debt capital markets, with UniCredit analysts noting that issuers have an interest in maintaining regular covered bond issuance and that this could lessen a potential “FLS effect” on supply volumes.

Market participants also noted that many UK financial institutions had already flagged reduced funding needs. Lloyds TSB, for example, said on the occasion of its half year results that its public term funding requirement for 2013 is expected to be less than £10bn, down from £19.5bn of wholesale term issuance in the first half of 2012. The banking group said that the FLS will help it “support economic growth”, for example by increasing its SME Charter commitment by £1bn in response to the scheme. HSBC, meanwhile, has said it will not access the FLS because it is predominantly funded by customer deposits and has a very solid funding position.

Besides UK financial institutions themselves making public their plans to tap the FLS or not, information about use of the scheme will be forthcoming when the Bank of England on a quarterly basis publishes the size of participants’ outstanding drawings, in addition to FLS group base stock and net lending figures.

An outcome of the FLS on which there appears to be more certainty, however, is spread tightening.

“I don’t think it will lead to anything but spread compression for UK banks,” said the DCM banker, “because they have this alternative source of funding that on the face of it has attractive terms.”

UK covered bond issuance in euros has already been scarce this year-to-date, accounting for around 4% of total euro benchmark supply, according to RBS analysts, with the sterling market accounting for 63% and US dollars the remainder.

Fitch’s Walsh also notes that secondary market prices for UK RMBS are expected to tighten, if issuance falls and overall stock in the market shrinks as a result, exacerbated by a heavy flow of redemptions.

“But will they tighten sufficiently to make new issuance competitive?” he said. “Let’s wait and see….”