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Mervyn King insures the banks

• Robert Peston
• 11 Sep 08, 11:11 AM

There is a very strong hint this morning from Mervyn King that the Bank of England will continue to allow banks to swap mortgages for cash (or more precisely, to swap mortgage-backed securities for Treasury Bills) after the closes on October 21.

That was expected by the chief executives of those running our capital-constrained banks, but the confirmation will still come as a relief - and should at least prevent any further tightening of conditions in money markets and reduce the risk of any further reduction in the volume of mortgage finance offered by banks.

King hasn't divulged the detail of what he calls a new "liquidity insurance facility".

But, in evidence to the , he outlined what he would want to achieve with this facility - from which a good deal can be extrapolated of some significance for most of us (so please read on, even if some of the technical detail seems baffling).

Perhaps the most important implication of what he said is that the Bank of England will swap liquid government paper for securitised mortgages only for short periods - which is the equivalent of providing loans to the banks for just a few weeks at a time, rather than for the three-year term of the Special Liquidity Scheme.

His reason for the switch to short-term funding from long-term funding is that he wants to insure the banks against disaster and collapse that could stem from a sudden unexpected withdrawal of cash or liquidity.

But he doesn't want the Bank to be influencing the banks' commercial lending decisions by becoming a permanent regular funding source for them. Or to put it another way - and don't groan if you've just been refused a mortgage by a bank - he doesn't want to do anything that would encourage the banks to lend more than the diminished sums they are currently lending.

That said, my understanding is that banks will be able to swap new mortgages for cashable government securities in the revised liquidity insurance arrangements that will shortly be announced. That's a big change from the Special Liquidity Scheme (SLS), which would only take as collateral those mortgages that had been signed off by the end of last year.

It means that even those banks that have taken full advantage of the SLS, and have already dumped all or most of their older mortgages assets on the Bank of England, should be able to continue lending to home buyers.

Mervyn King said his primary aim is to "smooth the adjustment of financial institutions hit by financial shocks" - or to give them confidence that if they can't raise cash from their assets in the normal way by tapping commercial, wholesale sources, the Bank stands willing and able to fill the breach.

What's being proposed might not have been sufficient to have prevented the collapse of a bank like Northern Rock, which was probably over-dependent on unreliable wholesale funding. But it should mean that henceforth most banks won't be able to fail purely because of an inability to acquire short-term funding to meet immediate and pressing needs.

But perhaps more important and more resonant is the following statement from King:

"It is not the purpose of central bank liquidity insurance to provide a source of long-term funding to the financial system - indeed it cannot do that. Only private savers or taxpayers via the government can provide such funds.

"So I hope everyone will understand that the proposals to be published next week, important though they are, will not and cannot solve the shortage of funding to finance bank lending, including mortgage lending."

Or to put it another way, King has passed the buck back to the Treasury to decide whether further measures are required to revive the flat-as-a-pancake mortgage market.

And as I've pointed out here before, King has made it crystal clear that he believes it would be wholly inappropriate for taxpayers' money to be used to suck substantial funding back into the mortgage market.

Which presents something of a dilemma to a government fearful of being seen to do nothing to address the credit drought that, as King admits, is one of the main causes of the painful economic slowdown we're experiencing.

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