Markets are awaiting details of new measures promised by the Bank of England to ease banks’ difficulties obtaining longer-term funding, particularly to finance mortgage lending. What form could they take?

In principle, the Bank can offer relief in three main ways:

1. Increase the average term of its lending to the banking system.
2. Widen the definition of eligible collateral against which loans are made.
3. Increase the total volume of lending.

Under 1, the Bank has already moved a long way. Longer-term lending (i.e. for three months or longer, including the loan to Northern Rock) now accounts for an estimated 80% of funds advanced to the banking system, up from 30% in September last year. A further increase is possible but is unlikely to have a significant beneficial impact.

Under 2, the Bank has allowed some widening but continues to operate stricter rules than the Fed and ECB. It still requires government collateral for its normal weekly operations and a portion of its longer-term lending. Banks have been allowed to use AAA-rated asset-backed securities in special auctions of three-month funds in December and January, which have been rolled over and expanded in March and April. Last September, the Bank offered to auction three-month funds against a broad range of collateral including mortgages and corporate bonds as well as ABS but imposed a high minimum bid rate, resulting in no take-up. Applying this broad collateral definition to all longer-term lending, without enforcing a penal rate, would be helpful in both widening access to official funds and allowing liquidity-short banks to borrow in greater amounts.

A significant improvement in funding conditions is, however, also likely to require measure 3 – an increase in aggregate lending to the banking system. This presents a technical issue: any such expansion requires offsetting sterilisation measures to prevent banks’ reserve balances with the Bank rising above target. (An overshoot of reserve balances would result in very short-term interest rates falling below Bank rate, undermining MPC policy.) Two possible measures for achieving a rise in lending without boosting banks’ reserves are as follows. First, the Bank could ask the Debt Management Office to repay immediately the government’s remaining “ways and means” borrowing from the Bank, releasing funds for market operations. Secondly, the DMO could issue an additional quantity of Treasury bills or gilts relative to its current plans, placing the proceeds on deposit at the Bank for onward lending to the banks.

The tables below illustrate how the Bank of England’s balance sheet and the size and composition of its lending to the banking system might change if these proposals were implemented. Specifically, the following assumptions are made:

1. A further reduction of £3 billion in short-term lending in favour of longer-term loans (measure 1 above).
2. Application of the broad September definition of eligible collateral (i.e. including mortgages) in all longer-term operations (measure 2).
3. Full repayment of the remaining £7 billion “ways and means” advance to the government.
4. Placement of a £20 billion special deposit by the DMO at the Bank, financed by additional issuance of gilts and / or Treasury bills.

Changes c and d would allow an increase in the Bank’s aggregate lending to the banking system from its current level of £65 billion to £93 billion. Within this total, changes a and b would permit new longer-term lending of £38 billion against mortgage collateral. This is a significant sum in the context of the overall mortgage market – sufficient to finance five months worth of net lending at its recent pace.

In addition to these measures, the authorities should also consider emulating the Federal Reserve’s “term securities lending facility”, under which banks are able to swap mortgage-backed securities for Treasuries held on the Fed’s balance sheet, with the Treasuries then used as collateral to obtain funds in the market. The Bank of England holds few gilts on its balance sheet so such a facility would require the DMO to create extra gilts specifically for this purpose.

The purchasing managers’ surveys are reasonable coincident indicators of economic activity. The charts below show quarterly GDP growth together with a weighted average of PMI new business indices covering the manufacturing and services sectors for the US, Eurozone, UK and Spain.

Somewhat surprisingly, the UK PMI indicator has held up best in early 2008, suggesting growth of about 2% annualised. The Eurozone indicator has also been relatively resilient, while US surveys look consistent with a flat economy, supporting other evidence that a fall in GDP may have been avoided in the first quarter.

The stand-out, however, is the collapse in the Spanish PMI indicator. The government plans significant fiscal stimulus but can the ECB continue to ignore a developing recession in the Eurozone’s key locomotive economy of recent years?

Three-month sterling LIBOR eased to 5.95% at its fixing yesterday but remains detached from Bank rate at 5.25%. As well as the appropriate level of official rates, the MPC ought to discuss ways of closing this gap at its meeting this week.

The Bank of England’s money market operations are no longer a technical adjunct of the policy process but have become central to achieving the MPC’s aims. Mervyn King has promised new facilities to ease banks' longer-term funding difficulties. The form and scope of such measures should be discussed and decided upon by the full MPC, not a select group of Bank officials. To emphasise its increased focus on market rates, the MPC could communicate its plans for narrowing LIBOR / Bank rate spreads along with its rate decision at midday on Thursday.

My MPC-ometer suggested financial market pressures warranted a cut in Bank rate last month. It has stuck to its guns this month, forecasting a 6-3 vote for a quarter-point ease. Interestingly, the Sunday Times Shadow MPC also voted 6-3 for a reduction, with one member seeking a half-point move.

Claims have recently been made that a 10% fall in house prices would plunge three million households into negative equity.

In the early 1990s housing market downturn, when house prices on the Halifax measure fell by 13% from peak to trough, negative equity is estimated to have affected about 1.5 million households. Loan to value ratios in the 1980s housing boom were higher than in recent years.

A 10% fall in house prices would return them to their level in spring 2006. Four million new mortgages – both loans for house purchase and remortgages – have been extended since March 2006. Fewer than one million of these mortgages will be on an original loan-to-value ratio of more than 90%. (Even Northern Rock kept the share of 90%+ LTV loans below a quarter in 2006 and 2007.) A significant proportion of this one million would remain in positive equity even if prices fell 10% (e.g. borrowers who purchased or remortgaged in 2006 on LTVs close to 90%).

In a recent speech, MPC member Kate Barker referred to Bank of England calculations indicating 5% of mortgagors would be in negative equity in the event of a 15% fall in house prices. (The analysis is based on the 2007 NMG Research survey of household finances.) With 11.8 million mortgages outstanding at the end of 2007, this implies about 600,000 households. With a 10% decline, the figure would be less than half a million.