LONDON (Reuters) - A flagship British scheme to get banks lending is likely to prove underwhelming unless the benefits spread beyond the mortgage market and into small business investment.
Bank of England Governor Mervyn King and Chancellor George Osborne announced the Funding for Lending Scheme (FLS) last June, in a bid to revive an economy that is still smaller than it was before the 2008-09 financial crisis.
It allows banks and building societies to access more than 80 billion pounds in cheap finance if they maintain or increase net lending to households and businesses.
The scheme's success is important for both men. For King, it is an alternative to a government bond purchase programme that may be losing its ability to boost growth. For Osborne it is a way to help the economy that requires little public money at a time of government austerity.
But mortgage lending, not business investment has been the winner so far.
Only 4.36 billion pounds was drawn down in the FLS's first two months of operation in August and September, and economists estimate a further 8-10 billion pounds may have been taken in the three months to December.
This has led to a sharp fall in the interest rates banks pay to raise funds from markets, and to a moderate increase in the number of mortgages approved.
But there has been little tangible extra lending so far - and there is a debate over why.
The banks say they are ready to lend but that companies are over-cautious. Many companies, by contrast, reckon the banks are only willing to lend to larger firms.
"(Banks) want their horse to be 10 lengths ahead before they put a bet on it. They want a proven winner," said Michael Morris, business development manager for Chirton Engineering, a small manufacturer that makes precision components, mostly for the oil and gas industry.
Chirton itself says it has little trouble getting competitive finance, but that its experience is not typical of other manufacturing firms based near it in North Shields, an industrial town in northeast England.
"I think we're an exception," Morris said. A strong track record of meeting profit targets helped, as did the fact that Chirton was seeking lending secured on machinery, rather than a more general overdraft facility to fund working capital.
More typical may be a specialist contractor in the construction industry, based in central England but working nationwide, which did not want to be named because of the sensitivity of its banking relationship.
The company, with annual sales of around 8 million pounds, returned to profit last year and was seeking to expand its 100,000 pound overdraft. Instead, it said bank lowered it.
"Over the last 12 months there has been very much a hardening of attitudes and a robust application of terms and conditions," the company's managing director said.
"(Banks) are interested in what charges they can levy - so short-term profit - and also what level of security they can force people into."
LACK OF DEMAND?
Net lending to households and businesses was growing by more than 10 percent a year before the financial crisis, but since 2009 the rate has been close to or just below zero.
Banks such as RBS (RBS.L) insist that they are keen to lend to solid businesses, and that the problem is that firms lack confidence to invest at a time when there is ongoing weakness in the euro zone, Britain's main export market.
"The overriding issue out there is that people are still nervous about the environment," said Chris Sullivan, head of RBS's corporate lending division.
"In a difficult environment, cash is king. It gives you flexibility. I would like to lend more ... substantially more, but what I'm finding is these companies want to lend their money to us," he continued, explaining that business deposits with RBS were at a record level.
To an extent, data from the Bank of England backs this up. A recent survey showed that banks' willingness to lend hit the highest level since records began in 2007 during the final three months of 2012 - though banks' enthusiasm dropped off when they were asked specifically about smaller firms. Businesses' demand for loans was little changed.
Nonetheless, the FLS is meant to go some way to solving this problem. It allows banks and building societies to use illiquid collateral - such as bundles of business loans or mortgages - to access finance at a rate of about 1.25 percent.
This is much cheaper than banks could find on the open market before the FLS started, and has led to a fall in mortgage rates - and those paid to savers - as well as more loans available to home-buyers with small deposits.
However, small business lending is still falling. The key question is whether this is simply a matter of time - as business loans take longer to set up than consumer mortgages - or if it reflects other factors that may hit the long-term success of the FLS.
Senior Bank of England official Paul Fisher, who is closely involved in the scheme, openly admitted that this was uncertain.
"If people really don't want to borrow, then the FLS might not deliver an increase in net lending. But the opportunity is there. To the extent that the elevated funding costs of the banking system were constraining the supply of credit, we've lifted that constraint," he said.
Economists such as BNP Paribas's David Tinsley say it may need a stronger economy to take off.
"In any reasonable recovery, you wouldn't first expect businesses to rush out and invest. There is a lot of extra output they can attain by working their existing assets harder," Tinsley said.
The FLS could have been better designed by distinguishing between business lending and mortgages - which offer less of a boost to the economy, Tinsley said. And the FLS's January 2014 closing date for new business might mean it is over before demand for business investment really gets going, he added.
(Editing by Jeremy Gaunt.)