Will Bank of England's rescue plan work?

By Stephanie Flanders Economics editor, BBC News

When the Bank of England launched its Special Liquidity Scheme, the Bank and the government had rather different ideas about what would count as a success.

Four weeks on, the Bank thinks the £50bn-plus official bank lending scheme has done what it was asked to do, though it is still early days.

The government is less enthused. I'm told that Number 10 advisors have been calling in City experts to explain why the programme has not had more impact.

So who is right? Has the scheme worked - or not?

Sweet dreams

The answer really does depend on how much you expected the new swap facility to achieve, in a market where banks just do not want to lend as much as they did.

Mervyn King, the Bank's Governor, said he would consider it a success when one morning he'd wake up and realise he had not been worrying about the health of the banking system for two months.

In his press conference on 14 May he said he had not got to that point yet, but things had definitely got better.

High hopes

The Bank's key goal was to rule out the possibility that a major bank would go under due to a simple lack of cash.

What's happening now is that the market is adjusting; margins are being rebuilt to a more sustainable level Mervyn King, Bank of England governor Q&A: Bank of England plan to help UK banks

Most in the City would say that has been achieved.

By and large, the cost of insuring against a major bank failure in the UK has fallen appreciably.

As far as we can tell, demand for the scheme has been fairly brisk.

Incredibly, we will have little idea how much has actually been borrowed under the new facility until it is closed.

But the betting in the City is that banks may use it to swap as much as £90bn in mortgage-backed assets for special Treasury bills in its first few months.

Unfortunately, government ministers were hoping to get more bang for their many billions of bucks.

They wanted to see inter-bank lending rates come down sharply - and cuts in ordinary mortgage rates as well.

Other forces

This was always optimistic. The Libor rate - the rate at which banks lend to each other - has come down by about a quarter of a percentage point relative to expected official rates since the plan started.

Banks only need a small buffer of liquidity when markets are calm and credit is always available Huw van Steenis, Morgan Stanley.

As the above chart shows, the gap that had opened up between UK (Sterling) Libor rates and those of other currencies has also fallen.

But US (dollar) spreads have also fallen, so we probably cannot credit the Special Liquidity Scheme for all of the decline in UK rates.

And as the chart also shows, these rates are still extremely high relative to where they were before the credit crunch got going in August.

Mortgage mystery

And of course, the average interest rate on new fixed rate mortgages has not budged. If anything, it has gone up.

The Bank of England wants more from the City

This creates a puzzle.

If banks have indeed been using (or preparing to use) the facility to the tune of tens of billions of pounds, that should have increased liquidity in the market.

How come Libor is still so high?

The answer is that in the current environment, banks have an almost limitless desire for liquid assets. Slaking that thirst does not make them any more willing to lend to anyone else.

"Banks only need a small buffer of liquidity when markets are calm and credit is always available", says Huw van Steenis, head of banks and financials research at Morgan Stanley.

"But in a market like today, when credit is erratic and now always available, banks want to be safer.

"If everyone wants to be safer, demand for liquidity stays high and so do rates."

Sustainable level

The credit crunch has clearly made everyone in the City a lot less keen on unsecured lending - lending not backed by solid collateral.

In the same press conference on 14 May, Mr King said this might lead to a permanently higher spread between Libor and expected official rates, since the Libor market is unsecured.

Where does all of this leave mortgage rates?

The answer is: wherever banks and other lenders want them to be.

But do not expect them to come down any time soon.

When the Monetary Policy Committee raised rates five times in the year before last August, mortgage rates did not rise to the same extent because the banks were squeezing their margins in their desperate desire to lend.

Now the same is happening in reverse.

Lenders want to rebuild their profit margins by increasing the gap between their mortgage rates and official rates. And the Bank Governor, for one, is not perturbed.

"What's happening now is that the market is adjusting; margins are being rebuilt to a more sustainable level," Mr King said.

"I don't think that's very surprising."

The dearth of cheap mortgage deals on the market may not be very surprising for government ministers either.

That does not make it any more welcome.

But if they were expecting housing market salvation to come from the Old Lady of Threadneedle Street they were backing the wrong horse.