The objective of the Funding for Lending Scheme was laudable enough: improving the flow of funds to the real economy. But the way the UK government went about this leaves a lot to be desired, particularly with covered bonds at the ready. Credit Suisse head of covered bond origination Richard Kemmish suggests allowing SME collateral as an alternative, in the first of a new series of opinion pieces.

UK Chancellor George Osborne

By providing heavily subsidised funding directly to UK banks at a uniform rate way below market levels via the Funding for Lending Scheme (FLS), the UK government has certainly provided a great incentive for banks to lend.

But the price equation is the same for the riskiest and the least risky banks. Indeed it gets cheaper the more you lend – which presumably means the further down the credit curve you go. That’s pretty obvious moral hazard with the UK taxpayer standing behind the risk.

It also circumvents the capital markets at precisely the wrong time.

In the covered bond world in particular British banks were starting to finally trade at sensible levels – I even heard a German trader refer to “core jurisdictions like the UK”. Never heard that one before.

At the same time the market – in both sterling and euros – is increasingly desperate for top quality private sector assets, and if they are less correlated to the euro-zone or to public sector risk so much the better. The IMF has already highlighted the shortage of top quality securities, whether it be for bank treasury liquidity needs, for posting as collateral for derivatives (private or centrally cleared) or simply for the better spread/capital trade-off for UK insurers under Solvency 2.

And then the UK government goes and turns off the supply of covered bonds.

Wouldn’t it have been a whole lot easier if the government had just amended the UK covered bond law to allow SME loans to be eligible collateral?

Risk would have been correctly priced – lower risk banks would have been more, not less incentivised to expand their loan books and lock in a positive net interest margin. There would have been a much needed healthy supply of top quality triple-A bonds, with a low correlation to government risk for investors.

And of course banks could have chosen a sensible term funding structure, rather than looking at a concentration of maturities in four years’ time.

What a wasted opportunity.

If you would like to discuss contributing an opinion piece to The Covered Bond Report, please e-mail Neil Day, nday@coveredbondreport.com or call on +44 20 7428 9575. We are keen to hear well-argued opinions addressing topical themes in either a positive or negative light. Also, feel free to share any thoughts on the FLS using the comment function below.