UK Special Liquidity Scheme

Governor King said the SLS was intended to help banks support the real economy. He denied that it was intended to “bail out” banks or revitalize the mortgage market directly. “If the scheme works, then it will have an effect on the mortgage market indirectly, but it was not designed to intervene directly into the mortgage market” (King 2008).

The BoE had already tried to use the Sterling Monetary Framework (SMF), its traditional monetary policy implementation tool, to restore liquidity to the financial sector. The SMF had capacity to provide a certain amount of liquidity to the financial sector, but the market demand for liquidity quickly outpaced its capacity. Despite extending SMF operations and “undertaking a number of extraordinary longer-term open market operations against a broader range of collateral,” the steep increase in liquidity demand could not be met by SMF. To satiate this demand, the SLS was created (John, Roberts, and Weeken 2012).

A fixed six-month period from the date of the SLS announcement was set for eligible institutions to enter into the collateral swap agreements with the BoE. This time period was called the “drawdown window.” The six-month period was chosen “to be long enough to allow banks to package up portfolios of legacy loans into a form that would be accepted in the SLS” (John, Roberts, and Weeken 2012). The participants in the SLS were able to access the SLS repeatedly during the nine-month drawdown window, and no new drawings could be undertaken once the drawdown window closed (John, Roberts, and Weeken 2012).

The original six-month time period, from April 21, 2008, to October 21, 2008, was extended by an additional three months. On September 17, 2008, the BoE announced that the program would remain open until January 30, 2009. The announcement cited “the current disorderly market conditions” that had resulted from the September 15, 2008, bankruptcy of Lehman Brothers (John, Roberts, and Weeken 2012).

Participants were required to sign the pro forma documentation prepared by the BoE. The documentation was available on request to those institutions eligible to participate. Once the legal documentation was signed and following prepositioning of eligible securities with the BoE, authorized drawdown requests were made to the BoE’s Sterling Markets Desk in order to conduct a transaction (BoE 2008a).

The Treasury indemnified the Bank of England against any net loss it incurred. The Treasury would be exposed to loss only if a counterparty defaulted, the value of the collateral provided by the counterparty fell by more than the size of the haircuts, and the remaining exposure exceeded any retained SLS fee income (John, Roberts, and Weeken 2012).

Institutions eligible to sign up to the BoE’s existing bilateral Standing Facilities were all banks and building societies that were required under the Bank of England Act 1998 to place cash ratio deposits at the BoE (BoE 2008a). Cash ratio deposits are non-interest-bearing deposits lodged with the BoE by eligible institutions (i.e., banks and building societies) that have reported average eligible liabilities of more than £600 million over a calculation period (FAQ).

King explained that the reason for this design was to ensure that the SLS could operate within the BoE’s normal market operations. Under the SLS, about one-half of building societies in the UK were eligible; the others did not meet the minimum liability size requirement. King justified this design feature with two reasons. First, by tradition, the smaller building societies had been able to access liquidity from larger building societies and banks. Second, the smaller building societies had not been involved in securitizing mortgages and were not facing the same potential losses as the larger building societies and banks eligible for SLS (King 2008).

In addition to citing fees, King stated that by imposing haircuts on the assets being swapped, the BoE ensured that the credit risk on these assets stayed with the banks and prevented any moral hazard concerns (King 2008). Haircuts were also intended to protect the BoE against loss in the event that a bank participating in SLS defaulted (John, Roberts, and Weeken 2012). Eligible securities were valued by the BoE using observed market prices that were independent and routinely publicly available. The BoE reserved the right to use its own calculated prices. If an independent market price was unavailable, the BoE used its own calculated price and applied a higher haircut. The BoE’s valuation was binding (BoE 2008a).

The total haircut applied to an eligible security comprised two elements: (1) a standard base haircut for that asset type and (2) haircut add-ons to protect against additional risk specific to that security (John, Roberts, and Weeken 2012).

As shown in Figure 4, the daily mark-to-market value of securities ensured that, “if the value of the assets pledged fell, after adjusting for haircut, below the value of the Treasury bills lent, banks either had to provide more assets to the BoE or return some of the Treasury bills borrowed” (John, Roberts, and Weeken 2012).

In an information document published along with the press release announcing the SLS, the BoE outlined the timing of the swaps as follows: “To provide banks with the certainty about liquidity that is needed to boost confidence, assets will, unless they mature within one year, be swapped for one year and banks will have the opportunity, at the discretion of the Bank of England, to renew these transactions for a total of up to three years” (BoE 2008c).

The term of the Treasury bills being swapped for the illiquid assets was nine months; therefore, the Treasury bills had to be exchanged regularly during the life of the swap under the SLS. To enable such rollovers, participants holding soon-to-mature Treasury bills had to return these to the BoE once the residual maturities of the bills were between 10 and 20 days. The BoE would then return these old Treasury bills to the Debt Management Office in exchange for new nine-month Treasury bills, which the BoE would in turn pass back to the participant on the same day (John, Roberts, and Weeken 2012).

Participating institutions were allowed to “mature, or partially mature” the collateral pledged at the SLS before their contractual maturity dates, “against surrender of the Treasury bills” (BoE 2008a).

As shown in the top line of Figure 5 below, “almost all of the £185 billion of Treasury bills borrowed in the SLS were contractually due to be returned to the BoE in the nine months to end-January 2012, with almost £70 billion due to be returned in the final month” (John, Roberts, and Weeken 2012). The BoE wanted a more gradual end to the SLS so there were not market disruptions with an abrupt end.

The problem with a significant concentration of maturities in the last few months of the SLS was that, “the market could have found it difficult to absorb this issuance, which in turn, may have pushed up the overall funding costs of banks” (John, Roberts, and Weeken 2012).

Knowing that this would be an issue, the BoE, in late 2009 and early 2010, began discussing with the major participants how to ensure that the size of the SLS tapered more smoothly as it approached the January 2012 end date. “Following those discussions, banks were asked to submit individual voluntary repayment schedules consistent with what they considered to be credible funding plans” (John, Roberts, and Weeken 2012). These plans, in aggregate, can be seen in the middle line of Figure 5.

As seen in the bottom line of Figure 5, the actual, realized taper was even smoother than the voluntary plans predicted. One cited reason was “the relatively favourable conditions in long-term funding markets in the second half of 2010 and first half of 2011” (John, Roberts, and Weeken 2012).

The BoE did not attach any conditions, such as dividend restrictions on shareholders or compensation limits on management. This was typical of crisis-era market liquidity programs; such conditions became common later in the crisis as governments introduced programs that posed greater risks to taxpayers, such as credit guarantees and capital injections. In response to a question in Parliament, King said that “this was a central banking operation which I think would have failed if it had been thought that there were hidden political agendas attached to it.” He noted that the SLS program was “similar in kind” to the US Federal Reserve’s Term Securities Lending Facility and Primary Dealer Credit Facility, announced shortly before the SLS, and that these programs also had attached no nonfinancial conditions (King 2008).

In testimony to Parliament a week following the announcement of SLS, then–BoE Governor King stated that the fee was one of the intentional design principles to protect against moral hazard (King 2008). Per the Market Notice that accompanied the SLS announcement, “[t]he fee payable on borrowings of Treasury bills was the spread between 3-month LIBOR and 3-month general collateral gilt repo rate, as observed by the BoE, subject to a floor of 20 bps. The fee also was to vary at the BoE’s discretion” (BoE 2008a).

The fee structure was specifically designed to “reduce over reliance … Higher fees [were charged] for higher levels of usage relative to the size of each institution’s balance sheet” (John, Roberts, and Weeken 2012).

The reason for the use of the general collateral (GC) gilt repo rate was that if SLS participants wanted to obtain cash, they had to repo the Treasury bills; this would have cost banks approximately the GC gilt repo rate. Moreover, the floor of 20 bps was higher than the spread between LIBOR and general collateral gilt repo rate prior to the financial crisis and designed to make SLS relatively unattractive if market interest rates fell to precrisis levels, incentivizing the banks to exit SLS. The floor also ensured that the BoE’s administrative costs were covered, including the fee paid to the Debt Management Office for borrowing the Treasury bills (John, Roberts, and Weeken 2012).

In order to, “reduce incentives for banks to time their drawings under SLS according to prevailing market interest rates,” the “spread was fixed on the date of a drawdown and was refixed thereafter every 3 months” (John, Roberts, and Weeken 2012). The fee was based on the mark-to-market value of the Treasury bills at the closing Debt Management Office reference prices (BoE 2008a).

The fee was paid every three months at the end of the refix period, or upon termination (BoE 2008a). “Because the fee was payable in arrears, it resulted in the haircut-adjusted market value of collateral to being greater than the sum of the market value of Treasury bills and the fee owed to the BoE” (John, Roberts, and Weeken 2012).

Moreover, the BoE charged back to the participants specific legal costs associated with checking the eligibility of collateral, as discussed below. Custody fees incurred by the BoE in holding eligible collateral, including where securities had been prepositioned with the BoE, were charged back to participants (BoE 2008a).

SLS was set up to provide liquidity for temporarily illiquid legacy assets (BoE 2008b). The BoE required each participant to certify compliance with criteria set forth below and reserved the right to seek independent verification of compliance, at the cost of the participant. The BoE also reserved the right to reject any security offered for any reason (BoE 2008a).

The eligible securities comprised:

1. UK and European Economic Area (EEA)^FNThe EEA includes European Union member nations and several non-EU member nations. covered bonds rated AAA, including those issued by the institution, or entities in the same group as the institution, entering into the transaction. The underlying assets of these covered bonds had to be either mortgages or public sector debt.
2. AAA-rated tranches of UK and EEA residential mortgage-backed securities (RMBS) backed by UK and EEA mortgages. The underlying assets were not allowed to be synthetic (i.e., not derivatives). RMBS backed by mortgages originated by the institution, or entities in the same group as the institution, entering into the transaction were permitted.
3. AAA-rated tranches of UK, US, and EEA asset-backed securities backed by credit cards, including those originated by the institution, or entities in the same group as the institution, entering into the transaction. The underlying assets could not be synthetic (i.e., not derivatives).
4. Debt issued by Group of 10 (G-10) sovereigns rated Aa3 or higher, excluding securities eligible in the BoE’s normal open market operations, subject to any settlement constraints.
5. Debt issued by G-10 government agencies explicitly guaranteed by national governments, rated AAA; and
6. Conventional debt issued by the US government-sponsored enterprises, or GSEs (Freddie Mac, Fannie Mae, and the Federal Home Loans Banks), rated AAA (BoE 2008a).

Additionally, the collateral that was previously eligible in the BoE’s open market operations (UK and German government debt) was also eligible for SLS (John, Roberts, and Weeken 2012). On October 8, 2008, in support of the government’s actions to recapitalize the UK banking system, the BoE announced that UK government-guaranteed bank debt would also be considered eligible securities (BoE 2008f).

Eligible securities were denominated in sterling, euros, US dollars, Australian dollars, Canadian dollars, Swedish kronor, or Swiss francs, or, in the case of Japanese government bonds, only yen. Credit ratings were provided by two or more of Fitch, Moody’s, and Standard and Poor’s (BoE 2008a). However, the ratings requirement was used as a “broad indicator of standards of credit quality expected, but the BoE exercised its own discretion, avoiding any mechanical reaction to changes in external ratings” (John, Roberts, and Weeken 2012).

In an answer to concerns about failings of rating agencies revealed during the crisis, King said that the real weaknesses with the ratings applied less to the standard instruments eligible for SLS and more to the very complex products like collateralized debt obligations (CDOs) that bundled the riskier tranches of US mortgage-backed securities. He said there was not much loss in confidence regarding ratings of the standard instruments that were used by all central banks in their market operations (King 2008).

US MBS—including MBS guaranteed by the GSEs and private-label MBS issued by the private sector—were not eligible.

Securities eligible for the SLS had to be held on the participant’s balance sheet as of December 31, 2007. The purpose of the SLS was to “deal with the overhang of existing assets on banks’ balance sheets, not to finance new lending directly” (John, Roberts, and Weeken 2012).

There was one exception to the December 31, 2007, cutoff rule. Certain securities “were issued from revolving structures, meaning that the underlying pools of loans backing the securities accepted as collateral (mostly covered bonds and some RMBS) could be topped up by loans originated after December 31, 2007” (John, Roberts, and Weeken 2012). The BoE did not disqualify this collateral from the SLS, but rather “decided to limit the value of such securities that could be delivered into the SLS by a single institution” (John, Roberts, and Weeken 2012).

Over the three-year life of SLS, the BoE set forth “amortization limits.” For RMBS issued through a master trust where the pool of assets included mortgages originated after December 31, 2007, 100% of the level of such securities or underlying loans outstanding on the balance sheet as of December 31, 2007, were considered eligible in the first year of SLS. In the second year, two-thirds of those securities were eligible. In the third year, one-third of those securities were eligible (BoE 2008a; John, Roberts, and Weeken 2012).

Eligible securities were to be deliverable via: (1) Euroclear or Clearstream, for instruments issued directly into the International Central Securities Depositories; (2) international links maintained by Euroclear; or (3) such other delivery mechanism as the BoE specified. Eligible securities had to be prepositioned with the BoE in advance of a drawdown (BoE 2008a).

Substitutions of collateral were permitted even after the end of the drawdown period. If the substitution made after the drawdown period “had a shorter maturity than the underlying collateral swap, the term of the collateral swap was similarly reduced” (BoE 2008a).

Stigma was a key concern for the BoE. For this reason, individual institutions were subject to strict confidentiality clauses under the terms of the program. The Bank also persuaded the largest banks to participate so that if there were any accidental disclosures of individual participation, the market would not take usage of the program as a weakness (Winters 2012).