Banks boosted by hopes of bailout deal

UK bank shares surged yesterday on hopes of a package to unfreeze interbank lending after the banks' meeting with the Prime Minister on Monday.

Royal Bank of Scotland was the biggest gainer, jumping 7.6 per cent, while Barclays rose 6.7 per cent. RBS and Barclays, though liquid, have been of concern to investors because of their capital positions and exposure to writedowns. Other big gainers were Bradford & Bingley and HBOS.

Last night, the Treasury denied that a deal was imminent, but the Prime Minister's reassurances to bank bosses indicated that the political will existed to unfreeze the markets and stop the lending drought from crippling the economy. The measures could involve an asset swap, with lenders offering prime mortgages to the Bank of England in return for government securities over one year or more. The lenders could then exchange those securities for cash.

The Bank of England would be likely to impose a "haircut", exchanging government securities worth less than the collateral's face value. Banks could also pay a fee and retain the credit risk for default on the loans.

Officials warned that details of a plan had not been agreed and that a number of options were still being considered.

The Bank's Governor, Mervyn King, will appear before the House of Commons Treasury Committee at the end of the month, making an announcement before then desirable but not certain. Mr King told the committee three weeks ago that he was willing to take new measures to boost liquidity as long as banks bore the risk and the support only covered loans already made.

Banks have been asking the Bank of England for months to widen the range of collateral it accepts for liquidity support and to lengthen the term of the loans. The Bank has accepted AAA-rated mortgage-backed securities in its recent three-month operations but not raw mortgages.

In September, the Bank offered to accept mortgages and corporate bonds for three-month money, but imposed a high minimum bid rate, resulting in no bidders. The central bank's £15bn auction on Tuesday was barely covered by bids, raising concerns that lenders in need of liquidity might not have enough eligible collateral to get the funding they needed.

The credit crunch is spreading from the financial markets to the real economy. The mortgage market is the most visible casualty, with lenders increasing prices or reining in their business to conserve cash. Industry sources said the funding squeeze was also hitting corporate lending, which also relies on long-term funding.

Woolwich was the latest lender to increase rates, upping its buy-to-let tracker by 60 basis points and its five-year fixed rate for landlords by half a percentage point yesterday because of huge demand. Woolwich, owned by Barclays, has also imposed a 1 per cent fee on brokers who put buy-to-let customers on to its standard variable rate.

The key three-month sterling London interbank offer rate dropped yesterday on hopes of a deal to unfreeze the market.