UK: Thoughts on the SLS and EUR/GBP

• The Bank of England's Special Liquidity Scheme has allowed UK banks to swap illiquid assets for treasury bills since April. The SLS has been enormously popular among UK banks as this has given them funding in return for illiquid mortgage-backed securities.
• The SLS should have come to an end on 20 October 2008 but due to 'disorderly market conditions' the BoE yesterday announced an extension to 30 January 2009. That was to provide additional time for banks to plan their access to the scheme in 'an orderly fashion'.
• We argue that an end of SLS could generate temporary demand for sterling relative to the euro, all other things being equal. There are, however, several caveats to this.

Any link between SLS and EUR/GBP?

The UK covered bond market has been hit harder than other European covered bond markets because of greater exposure to structured credit products at UK banks than at other European banks. UK banks have relied heavily on wholesale funding, especially residential mortgage-backed securities (RMBS), and the financial crisis has caused a dry-up in liquidity in this market. As a reaction to the low level of liquidity and dislocated wholesale markets, the Bank of England (BoE) announced its Special Liquidity Scheme (SLS) in April 2008.

The SLS allows UK banks to swap illiquid assets (e.g. high-quality mortgage-backed assets) for treasury bills. Swaps have been available only for assets on the balance sheet of the participating banks by the end of 2007 and have not been used to finance new lending. Hair cuts in the SLS have been quite severe - a 12% hair cut has been applied for triple-AAA covered bonds plus additional 5% for bonds without an observable market. SLS has therefore been less attractive for banks with the opportunity of using the lending facilities at the ECB, where hair cuts until last week have been substantially lower. These have, however, been tightened recently.

The SLS has been a remarkable success. Estimates vary, but the SLS is thought to have provided close to GBP200bn to British banks. An exact figure on the funding provided by the BoE is not available until September 24.

The real funding need of UK banks has in fact been much larger - British banks have also used the facilities at the ECB in order to get the required funding. The ECB has lent banks close to EUR500bn and much of it is thought to have gone to UK institutions.

The SLS should have ended on 20 October 2008. But in the past couple of weeks speculation has been that shutdown would create a funding gap and eventually push British banks into insolvency. Pressure has therefore risen on the BoE to prolong the SLS in order to prevent such events.

On 17 September, the BoE issued the following statement:

"In view of the current disorderly market conditions, the Bank of England is today announcing an extension of the drawdown period for its Special Liquidity Scheme to provide additional time for banks to plan their access to the scheme in an orderly fashion. The drawdown period will now end on 30 January 2009. The Bank will publish its consultation document on proposals for permanent reforms of its market operations at a later date."

The BoE added that the features of SLS and the terms offered remain unchanged.

For now, an unnecessary escalation of the turmoil appears to have been avoided by the BoE's actions. That might also rely on two important factors: First, the asset swaps involved in the SLS are up to three years, meaning that there will be no immediate refinancing shock on the participants in October or soon thereafter. Second, and perhaps most important, UK financial institutions have shown signs of 'overprotecting' - i.e. exploited SLS to its maximum. This means, that the immediate need for swapping might be limited in the shorter run as UK banks have already lent more than they needed for shorter-term purposes.

Nevertheless, the problem lies in front of us rather than behind. The BoE cannot accept illiquid assets forever and the question is, if those it has already accepted will ever become valuable again.

Are there any FX implications? At present, the answer is no. Since SLS is extended British banks will continue to get funding at the BoE. Beyond 30 January 2009, the answer might be trickier. If the SLS is shut down and if the exploitation of the SLS until now represents a real funding need for UK institutions, or the 'overprotection' continues unabated beyond 30 January 2009, it will generate demand for sterling at the expense of the euro. That is because UK banks need to go to the ECB and buy euro denominated treasury bills instead. But since they need sterling funding they will have to sell these against sterling-denominated treasury bills. And here is where the demand for sterling on behalf of the euro arises. Further ahead, the opposite pattern will naturally occur as the British banks need to buy euro-denominated treasury bills back, but as this can be up to three years ahead, we will not focus on that effect in the following.

Can the potential effect on EUR/GBP in 2009 be quantified? Probably not, due to too many unknowns. We have little knowledge on British banks' exact funding needs - perhaps the BoE will replace SLS with something more permanent beyond 30 January 2009 and we don't know the timing of the possible sterling demand vs the euro. If SLS has provided around GBP200bn to UK banks, it corresponds to the total daily EUR/GBP turnover for three whole days. Needless to say, that is a good deal. Still, we can only conclude that this might will have a temporary downward effect on EUR/GBP but we cannot quantify this effect - i.e. by what percentage EUR/GBP would fall, or even estimate the timing, since we know little on the reaction function of UK institutions. Our best guess is, all other things being equal, that isolated this will push EUR/GBP a few percentage points lower, but probably not much further, as other factors are pulling in the opposite direction.

Danske Bank
http://www.danskebank.com/danskeresearch

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