Explainer: Special liquidity scheme

Explainer: Special liquidity scheme

The market seizure caused by the near-collapse of Bear Stearns, America's fifth-largest investment bank, forced Bank of England governor Mervyn King to announce the special liquidity scheme on April 21.

It was intended to encourage banks and building societies to lend to each other, which they had been reluctant to do as a result of the run on Northern Rock a year ago. The problem was that big financial groups had lost their ability to raise funds by packaging up mortgages into bonds. These became toxic in the US sub-prime mortgage crisis that started last summer and forced Northern Rock to its knees.

Through the SLS, banks and building societies were able to swap mortgage-backed bonds and other unwanted assets for attractive government paper (nine-month Treasury bills). The idea was to inject more liquidity into financial markets and encourage banks to do business with each other.

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King said the scheme would run until October 21, but assets that had been used in the scheme could be swapped for three years in total. Some banks lobbied hard for the scheme to be extended and for more assets to be included to obtain the government paper. The banks will be keen to see the suggestions in the consultation paper that King said would be issued next week.

Many argue the SLS, which investment bank UBS has calculated may have poured £200bn of liquidity into the system, has not fulfilled its purpose. Libor, the rate at which big banks lend to each other, is more than 70 basis points above the 5% base rate - it was 10 points before the credit crunch. As long as that gap remains, any interest rate cuts are unlikely to be passed on to would-be homeowners.

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