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New FLS is no economic game changer but it should boost confidence
Britain's funding for lending cheap credit scheme to boost growth has garnered a degree of international acclaim in the nine months it's been running. Its “success has been noted around the world”, George Osborne claimed on Wednesday.

Mark Carney, head of the Bank of Canada and the next Bank of England Governor, made a similar observation in Washington last week.

Now the Chancellor has placed the FLS at the heart of Britain’s recovery drive – with a year’s extension to January 2015 and a big incentive to boost lending to cash-strapped small businesses. But, while already celebrated among the policymaking elite, the Treasury and the Bank are still struggling to define “success”.

On one measure, the FLS has been an abject failure. The Bank’s data show that between the scheme’s launch in August and the latest figures in February, banks and building societies reduced net lending to businesses and households by £2.74bn.

Defenders argue that such bald calculations are unfair on the grounds that lending would have contracted by even more without the FLS. Royal Bank of Scotland and Lloyds Banking Group, the UK’s two largest lenders, must reduce their loan books under state aid rules, after all.

On another measure, it has been an unqualified success. Funding costs for banks have fallen by more than a percentage point since August. As a result, mortgages for first time buyers are now about 1pc lower than in August and, the Bank estimates, borrowing costs for small and medium sized businesses are down about 0.5pc from where they would have been.

Cheaper credit is getting through to the economy, but critics question how much of that was down to the FLS. The scheme was launched just days after Mario Draghi made his famous declaration that the European Central Bank would do “whatever it takes to preserve the euro”. The ECB president’s massive bond buying pledge has done more than anything to ease credit conditions, although UK bank funding costs have fallen by more than those in the eurozone.

As the months have passed, the Bank’s ambitions for the FLS have changed. Originally, the scheme was expected to provide up to £80bn of emergency funding. Now banks can fund just as cheaply in the markets. So, instead, it is being spoken of as a “backstop” – a guarantee that banks can access cheap money for the next 22 months, come what may.

“It gives banks continued assurance against the risk that market funding rates increase, especially in light of continued uncertainty in the euro area,” outgoing Bank Governor Sir Mervyn King said in a letter to the Chancellor.

Where it has failed to have had an impact, though, is on small businesses – which employ 14m staff, half the private sector total. Lending to the sector is declining by about 3pc a year, according to the Bank, a point not lost on the politicians who hear from their angry constituents. In response, the scheme has been beefed up to encourage banks to target small companies.

The incentive under the 2014 extension of the FLS is huge. For every extra £1 lent during the rest of this year to small businesses, the bank will be eligible for £10 of cheap funding in 2014. Every £1 lent to small companies next year will qualify for another £5 of subsidised funding. By comparison, every £1 lent to mortgage borrowers or big business will be eligible for just £1 of FLS funding in 2014.

In other words, the more lending the banks do today buys them more insurance on their funding costs for an uncertain tomorrow. And small business lending buys them the most insurance of all.

The scheme has also been extended to include lending not just to households and businesses but to specialist leasing and asset based lenders, which provide £20bn of working and investment capital to small firms every year – again on a £1 to £1 basis. The arrangement means that banks can tap the FLS for unlimited funding support in 2014, so long as their net lending rises.

But will it work? Will entrepreneurs and business owners take on more debt? The argument about whether restrained demand or squeezed supply has caused small business lending to contract continues to rage, but a recent Bank report offered some anecdotal evidence that companies may respond well to cheaper credit.

“For firms reporting looser credit conditions over the past year, the effect on most factors – including orders, investment and staffing – was positive,” the report said. Those with less easy access to credit, on the other hand, decided to sit on their cash.

Bank insiders admit the enhanced FLS “is not a game changer” and will only have a marginal direct impact on the economy, but they are hoping it will boost confidence which will then release vital investment. As long as small businesses know that there is a ready supply of credit, the more likely they are to take risks.

Confidence is perhaps the most vital ingredient missing from the recovery and the FLS is an attempt to fix that. As for definitions, a confidence boost would certainly qualify as “success”.

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