Bank of England gets creative

August 21, 2009

The Bank of England’s changes to the eligible collateral for repo operations announced yesterday contained a curious quirk: the Bank will now accept covered bonds backed by loans to small and medium sized enterprises.

Covered bonds are a kind of secured bank debt, backed by loans or mortgages. If the bank can’t repay the debt, bondholders can liquidate the collateral to get their money back.

Why are the Bank’s new rules interesting? For the simple reason that, to my knowledge, there is no such thing as an SME covered bond — yet.

What is the bank playing at? Clearly UK lenders are under pressure to boost lending to small companies; allowing them to pledge SME loans as collateral may help open up a new funding channel and get some funds flowing to UK businesses. Perhaps it knows that some banks are getting ready to launch the first such deals and wants to give them every chance of succeeding.

SME covered bonds won’t help borrowers that much on their own, since covered bonds are guaranteed by the issuer and don’t allow banks to free up any capital for new lending. That’s why we also need the securitisation market to get back on its feet too. (In a securitisation the bank sells assets or transfers their economic risk, allowing it to recycle capital and make new loans).

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