A Public-Private Partnership: Central Banks as a Funding Backstop

Why It Matters

The findings reveal that central‑bank funding can amplify credit availability through market‑wide effects, guiding policymakers on the design of liquidity backstops and the trade‑offs of conditionality.

Key Takeaways

• Central bank funding lowers wholesale funding costs for banks.
• Banks with high wholesale exposure cut mortgage rates after FLS.
• Conditionality reduces banks' willingness to use central funding.
• Equilibrium effect exceeds direct participation impact on credit supply.
• Unconditional funding prompts banks to originate more mortgages.

Pulse Analysis

Central banks have long used long‑term funding facilities to stabilize credit markets during downturns, but the prevailing view treats these tools as a direct substitute for private wholesale funding. Recent academic work challenges that notion, arguing that the mere availability of a public backstop can reshape market dynamics. By offering an alternative source of liquidity, central banks improve banks’ bargaining power and reduce perceived funding risk, which in turn lowers the risk premia demanded by private lenders. This complementarity framework reframes how policymakers assess the systemic impact of liquidity programs.

The Bank of England’s Funding for Lending Scheme provides a natural laboratory for testing the theory. Empirical analysis of mortgage‑originations from 2012‑2013 shows that banks with greater exposure to wholesale funding cut mortgage rates after the FLS announcement, regardless of whether they actually borrowed from the scheme. The aggregate "equilibrium effect"—the reduction in wholesale funding costs and the resulting lower loan pricing—was larger than the direct effect of FLS participation. Moreover, the impact was strongest for banks reliant on short‑term wholesale funding, indicating that the backstop primarily mitigates liquidity risk rather than simply replacing private capital.

These insights have direct policy relevance. While conditionality can steer credit toward targeted sectors, the research suggests it also dampens the equilibrium benefits of public funding, as banks may avoid using funds that carry usage constraints. Designing future liquidity facilities therefore involves balancing the desire for targeted outcomes against the need to preserve the broader market‑stabilizing effect of an unconditional backstop. As central banks contemplate new tools in the post‑COVID and climate‑finance eras, incorporating the complementarity mechanism could enhance credit flow without inflating moral‑hazard concerns.