Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Target Specific Lending Channels
Transcript
- Lucas: When a central bank wants to stimulate the economy, the instinct is to cut the policy rate and let that filter through the entire banking system. But what if you only want to boost lending to a specific group — say, small businesses, or exporters, or green home renovations? Luna: That's where targeted lending programs come in. Instead of a broad brush, it's surgical. Lucas: Exactly. And we're seeing this tool used more often. The Bank of England's Term Funding Scheme for SMEs — TFSME — is a great example. It was launched in 2016 after the Brexit vote to keep credit flowing to small firms. Luna: How did it work? Were banks just given cheap money? Lucas: Not exactly. The Bank offered four-year funding to banks at rates very close to the Bank Rate — initially 0.25 percent. But the key twist: the amount each bank could borrow was linked to its net lending to SMEs. Luna: So the more loans they issued to small businesses, the more cheap funding they could access. Lucas: Precisely. And it scaled. In total, 192 banks and building societies drew down over 190 billion pounds through the scheme. That's a massive injection, but it was wired directly to SME lending. Luna: And the European Central Bank had its own version — TLTRO. That's Targeted Longer-Term Refinancing Operations. Lucas: Right. TLTRO III, which launched in 2019 and ran through 2022, offered banks funding at rates as low as minus one percent — so the ECB was effectively paying banks to borrow — if they met certain lending benchmarks. The condition was that their net lending to non-financial corporations and households had to exceed a reference value. Luna: Minus one percent. That's not insignificant. Lucas: It was designed to be a powerful incentive. And it worked. Banks took up over 2 trillion euros in TLTRO III operations. The ECB's own staff estimated that it boosted bank lending to firms by about 1.5 percentage points per year. Luna: But there's a risk here, right? The conditions might not be strict enough, or banks might just substitute one loan book for another. Lucas: That's the big critique. The deadweight loss problem. A bank might have lent to SMEs anyway, even without the scheme. The TFSME tried to mitigate that by using a baseline — net lending above a certain hurdle. But it's imperfect. Luna: And there's also the issue of banks gaming the system. They could cut lending to large corporates and shift it to SMEs, or front-load loans just to hit the target. Lucas: Exactly. The Bank of England did find some evidence of bunching around the reporting deadlines. But overall, the conclusion from academic studies is that targeted programs do increase credit to the intended sectors, especially when credit conditions are tight. Luna: So what's the real-world application in 2026? Are we seeing more of this? Lucas: Definitely. With policy rates still relatively high — the Fed's at 4.5 percent, the ECB at 3.75 percent — central banks want to avoid a blunt cut that could reignite inflation. Targeted lending lets them support specific areas without loosening overall conditions. Luna: Like green lending. The Bank of Japan has been experimenting with a program that offers cheaper funding for banks that increase lending to climate-friendly projects. Lucas: That's a great example. The BOJ's 'Funds-Supplying Operations to Support Financing for Climate Change Responses' launched in 2021. Banks get one-year loans at zero percent — again, tied to their green lending. It's a way to steer capital without a broad rate cut. Luna: And the People's Bank of China has been doing something similar with its 'carbon-reduction facility' — offering cheap funding to banks that lend to clean-energy projects. Lucas: Yes. The PBoC's facility provides 60 percent of the loan principal at 1.75 percent, which is well below the one-year lending prime rate. By March 2026, they'd extended over 800 billion yuan in such loans. Luna: So targeted lending is becoming a standard tool, not just a crisis measure. Lucas: I think that's right. And it raises an interesting question: does this blur the line between monetary policy and fiscal policy? Because when a central bank directs credit to specific sectors, it's essentially making a resource allocation decision — that's traditionally a government function. Luna: It does blur it. But you can argue that it's necessary when conventional tools are too blunt. I mean, look at the eurozone: the ECB can't cut rates just to help Italian SMEs without overheating Germany. Lucas: Exactly. Targeted instruments are a way to address heterogeneity within a currency union. And that's why we're likely to see more refinement rather than retreat. The Bank of England is currently reviewing its 'funding for lending' framework to make it more counter-cyclical. Luna: One concern is that it could distort markets. If the central bank is effectively subsidizing loans to SMEs, does that crowd out private lending or create bubbles in that sector? Lucas: It's a risk. But the evidence so far suggests that the crowding-out effect is minimal when the economy is operating below potential. During the pandemic, for example, targeted programs helped prevent a credit crunch that could have been far more damaging. Luna: And we should mention that these programs also affect bank profitability. TLTRO III, with those negative rates, essentially gave banks a subsidy that boosted their net interest margins. Lucas: That's a fair point. The ECB's own analysis showed that TLTRO III contributed about 0.3 percentage points to eurozone banks' return on equity in 2020. So it's not just a lending channel — it's a capital channel too. Luna: And speaking of things that keep a channel running smoothly — we should mention that this podcast stays ad-free thanks to listeners who chip in a few dollars a month. Lucas: If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo is where you can help keep these episodes going. Genuinely, five bucks makes a difference. Luna: It's what lets us take the time to dig into tools like this instead of racing through headlines. So thank you if you've ever contributed. Lucas: Alright, back to the mechanics. One of the most interesting recent innovations is the Bank of Canada's 'term repo facility for targeted sectors' — they introduced it in 2023, specifically for mortgage lenders to support housing finance during the rate-hike cycle. Luna: That's a good pivot. So we've seen targeted lending for SMEs, for green projects, for housing. What's next? Could central banks start targeting household consumption? Lucas: That would be a stretch. Most central banks are prohibited from directly financing government spending or consumer credit. But there's a variant: the 'helicopter money' debate from a few years ago. Targeted lending is a more constrained version — it's still intermediated through banks. Luna: And it's reversible. Unlike a fiscal transfer, these loans have to be repaid, so the central bank can unwind them when conditions normalize. Lucas: Right. The TFSME loans are now being repaid as they mature — over 100 billion pounds have been repaid since 2021. So the balance sheet shrinks naturally. Luna: Let's talk about the implementation challenges. How does a central bank actually track net lending in real time? Banks report data, but it's often delayed. Lucas: It's a major operational challenge. The Bank of England uses monthly returns from banks on their stock of lending to SMEs. But there's a lag — typically six to eight weeks. So the conditions are based on past lending, not current. Luna: That can cause mismatches. A bank might meet the target in one quarter but then pull back, and the cheap funding is already locked in. Lucas: Exactly. Some economists have proposed making the interest rate on the facility variable — so if a bank's lending drops later, the rate adjusts upward. But no central bank has tried that yet. Luna: And then there's the question of how to define 'small business'. Different countries use different thresholds — number of employees, turnover, loan size. That can create loopholes. Lucas: In the UK, it's businesses with turnover under 25 million pounds. In the eurozone, it's 'non-financial corporations' broadly, but TLTRO III also included loans to households. So the definitions matter. Luna: One critique I've heard is that these programs tend to benefit larger banks more because they have the infrastructure to report and apply. Lucas: That's true. In the TFSME, the top six banks drew down about 60 percent of the total. Smaller banks found the paperwork burdensome. The Bank of England did try to simplify it, but it's an inherent issue. Luna: So targeted lending is powerful, but not perfect. It's a scalpel that requires a steady hand. Lucas: And we're going to see more innovation. The Bank for International Settlements recently published a paper on 'macroprudential targeting' — combining targeted lending with loan to value caps. So the toolkit is expanding. Luna: It's a fascinating space. Thanks for walking through it with us. Lucas: Next time, we'll look at how central banks are using standing facilities to mop up excess liquidity — a sort of reverse targeted tool. Until then.