4 March 2013 Last updated at 08:36 ET

Funding for Lending: How does it work?

Banks have said they intend to increase mortgage lending "significantly" in early 2013

Funding for Lending (FLS), the Bank of England and Treasury scheme to boost bank lending to households and companies, opened for business at the beginning of August 2012.

The aim of the scheme is to increase bank lending by roughly £60bn.

The hope is that this will help keep the economy out of recession, by halting the downward spiral of lending and borrowing that the UK has experienced in the past few years, since the onset of the credit crunch and international banking crisis.

Banks and building societies will be able to access the funds until the end of January 2015, after the scheme was extended for a year by the government.

How does it work?

In essence, the Bank of England is letting commercial banks borrow funds from it cheaply, so that the banks then pass this on in the form of cheap loans to households and firms.

What is the point?

The point is to encourage the UK's commercial banks to borrow more money, and more cheaply than at present, so they can then in turn lend it to people and companies who wish to borrow.

What can go wrong?

It may turn out that individuals and firms do not want to borrow much more at the moment, as the CBI business organisation has warned.

What has happened so far?

In its first report on FLS, at the start of December 2012, the Bank said that in the third quarter of the year, just six banks or building societies had actually used the scheme. Together they had borrowed £4.4bn, and in fact this had boosted their net lending by only £496m.

But on June 3rd 2013, the Bank reported that 40 banks were taking part in the scheme, and together they had drawn down £16.5bn under the scheme. Net borrowing fell by £300m in the first quarter of 2013, a big improvement on the fall of £2.4bn in the fourth quarter of 2012, suggesting the scheme is taking time to take effect.

The Bank of England says it will take longer for new loans to filter through to the business sector, because of the time it takes to get a loan approved. It also said many banks had cut back on loans to commercial property companies.

So this is all about mortgages?

It is not supposed to be, but mortgage lending is where the first effects have been seen. More money is available to house buyers, at lower interest rates than before, although so far the banks are still being very fussy about to whom they will lend.

As a result, most deals still require a deposit of 20% or more. Deals for those with smaller deposits are on offer as before, but banks have much less money to grant to those with down-payments of just 5%, 10% or 15%.

What about savers?

They have suffered an unforeseen knock-on effect of FLS. They are now being offered even less interest on their savings accounts than before. The availability of cheap funds from the Bank means that lenders do not need to try so hard to attract funds from the general public, to then lend on to borrowers. That is why it is now almost impossible to find a savings account offering more than 3% interest.

So what are the mechanics of FLS?

Banks and other lenders approach the Bank of England, if they want. They swap assets they already have, such as loans, with the Bank. It in turn provides them with pieces of paper known as Treasury bills, for a four-year period.

The commercial banks are then able to use these bits of paper as top quality backing with which to borrow cash in the wholesale financial markets, from other lenders. With the Treasury's backing, the idea is that they will be able to borrow funds at very cheap rates.

How will the Bank of England measure the performance of the banks that participate in FLS?

The banks will initially be able to access Treasury bills of a value of up to 5% of the funds they currently lend. They will be charged just 0.25% interest, much less than the going rate.

If a bank subsequently increases its overall lending, they can borrow more than 5%. If it decreases its lending levels, then the interest rate it has to pay on the Treasury bills rises to 1.5%.

How will the taxpayer be protected in this arrangement?

Here we will see the return of the banking concept known as the "haircut". The collateral pledged by commercial banks will have to be worth more than the high-grade paper being offered by the Bank of England. So, for every £1 of Treasury bills they borrow, the assets being pledged will have to be worth, say, £1.10 or £1.20. Thus if the value of that asset subsequently falls, the Bank of England will not suffer from the top slice of any loss.