By Steven Black
The Bank of England with the approval of HM Government has launched the Funding for Lending Scheme. Its intent is to provide the means whereby banks and building societies can increase their lending to UK households and businesses. The FLS seeks to give credit to banks making new loans. This puts arranging and fronting banks at an advantage because they can take the credit for the initial advances made and pass on credit risk to syndicating banks.
Banks and building societies are to be allowed to borrow gilts issued by the Bank of England (BoE) for the initial fee of 25pbs subject to receipt of acceptable collateral. The initial borrowing limit for any such bank or building society will be 5% of the total quantity of sterling loans held by them as at 30 June 2012 and made available to UK resident households and private (ie exclude public corporations – owned by central or local government) non-financial corporations (“PNFCs”). This limit may be increased by the relevant bank or building society making new sterling lending available to UK resident households and PNFCs. Each pound of new lending entails a corresponding increase in the limit.
The fee payable for borrowing from the BoE under the FLS is 25bps if the relevant participant increases or maintains its sterling lending position to UK resident households and PNFCs. It its net lending position should fall below the amount drawn under the FLS in any quarter then this shortfall shall attract an extra fee of 125bps on top of the 25bps already charged for the drawing.
Base lending and loan transfers
As mentioned above the loans made available by a bank or building society as at 30 June 2012 go toward their borrowing allowance under the FLS. This total of lending is adjusted to take into account loan purchases and sales before 30 June 2012 with purchases increasing the allowance and sales decreasing it. However, loan transfers after 30 June 2012 are excluded and only new lending is allowed to increase a bank or building society’s borrowing allowance. This will stop double counting where a participant in the FLS makes a loan and claims this as an increase in its lending and then sells the loan onto a third party. Without the exclusion, the third party as a participant in the FLS, could claim the loan purchase constitutes an increase in lending on its behalf. This would appear a sensible precaution. However, what about syndications? Often the primary round of syndication is affected by way of loan transfers to the original banks. By using the loan transfers as a way of entering the syndicate these initial banks could very well exclude themselves from having their lending count toward the borrowing allowance calculated under the FLS. An arranging bank which provides the full amount to the borrower before syndicating down promptly after closing will be able to claim such amount toward its borrowing allowance despite only holding the debt for a matter of days.
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Collateral and Pre-positioning
The Bank of England will require collateral for its loans of gilts. The eligible collateral will be the same as already required for the Discount Window Facility (“DWF”) and so may be familiar to many UK banks and building societies.
Portfolios of loans are eligible provided they meet the criteria, for instance subordinated and revolving loans are excluded. The eligible portfolio are then “pre-positioned” with the BoE.
The pre-positioning process has four elements:
(a) A review of the participant’s lending practices and policies including a site visit. BOE is looking here for assurance on the quality of the loan origination and servicing processes. Underwriting and risk management practices and quality of management information.
(b) A legal review of the loans, including a legal sampling exercise. The purpose of this is to ensure the loans can be effectively transferred to BoE and to identify any legal risks associated with transfer and ownership by BoE. Typical sample size will be 75 loans and given many loan documents going back over ten years have been prepared with transfers to special purpose vehicles and funds this should not prove to be a difficult hurdle.
(c) A loan level data tape in the form of a spread-sheet containing information necessary for BoE to stress test the portfolio. This information is to be updated monthly whilst the balance of the portfolio given in the tape is to be updated weekly.
(d) An independent data audit will be required by 14 March 2014 on the initial lending position of each participant under the FLS. In addition, the BoE reserves the right to require independent audits of any data provided to it.
Part (a) must be completed for each new participant or business line from which loans are pre-positioned. Parts (b)-(d) are required for each additional portfolio of loans or when then there is substantial increase in the number of loans in a pool.
The time taken for pre-positioning on loans depends on the complexity of the assets. For standard form residential mortgages it should take only four weeks but for more complex assets such as lending to large corporations or to commercial property developers it can take up to three months.
The value applied to loans as collateral for the FLS will be adjusted by BoE on the basis of the pre-positioning procedures. BoE’s valuation is binding but we are assured the process it will use to reach its value will be broadly in line with the methodology applied to securities backed by equivalent collateral.
Securities can also constitute collateral for the purposes of the FLS. The securities will be transferable ones and so much of the due diligence is not required. In addition, valuations on the securities can be conducted by the BoE using observed market prices which are independently and publicly available. However, once again the BoE will have discretion where it feels the independent price is unavailable and their decision is binding.
The main costs a participant in the FLS will incur are in the accumulation of data to ensure BoE monitoring requirements are met and in legal fees. It is understood the participant will be responsible for both its own and BoE’s legal fees.
HM Government and BoE have put a great of publicity into the FLS and are confident it will strengthen bank lending in the UK. Indeed fronting and arranging banks may be delighted to see all of an advance they make count as new lending particularly when through a syndication sell down they quickly pass on the credit risk. The syndicating banks may not be so pleased and may conclude the FLS does not give them sufficient credit. This in turn could deter them from entering the market and thereby have the opposite effect as is intended for the FLS.
Steven Black is a consultant to the debt and capital markets practice at law firm Osborne Clarke