The Bank of England's Funding for Lending Scheme (FLS) is like a "pretty bandaid" for the banking sector, one economist told CNBC on Wednesday after the central bank expanded the program.
The BoE announced on Wednesday that it would extend FLS by one year till January 2015 and allow co-operatives and leasing organizations to also access the funding. The news came as Barclays reported weakened earnings and followed a week of gloomy economic news for the U.K. economy.
"This is like a pretty bandaid, the lending program is a bandaid," Erik Nielsen, global chief economist at UniCredit told CNBC. "There is not a lot of demand for credit because ultimately businesses borrow money when they see demand for their products. Lending to the corporate sector lags GDP and you can't put the cart in front of the horse here."
"It's a fundamental problem with demand for credit and it's a fundamental problem that banks are being hammered so they are not particularly willing to take new risks. I bet you today that the number one risk on European banks' balance sheets is not derivatives or funny stuff, it's exposure to small and medium-sized enterprises, unfortunately, and that's because of the macro economics, " Nielsen added.
U.K. banks, operating in a tighter regulatory environment since the financial crisis, have been pressured to continue lending to small and medium-sized business but data from the BoE released in its quarterly report in April showed that the annual rate of lending had stalled and even contracted.
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"The annual rate of growth in the stock of lending to U.K. businesses was negative in the three months to February. The stock of lending to both small and medium-sized enterprises and large businesses also contracted over this period. The annual rate of growth in the stock of secured lending to individuals was broadly unchanged," the BoE said in its quarterly report.
The data follows a trend set last summer. Data from the bank showed that although 14 billion pounds was taken from the FLS scheme by British banks between August and December in 2012, the participating banks made fewer loans in the period.
To avoid such a scenario, the BoE on Wednesday said banks that lend one pound to small and medium enterprises (SMEs), would get up to 10 pounds of funding in 2013.
"Basically they [the BoE] have incentivized the banks on a ten to one basis on net SME lending," Cormac Leech, bank equity researcher at Liberum Capital told CNBC on Wednesday. "[Bank executives] now have a big incentive to basically tell all their credit officers to take the rest of the year off and just shovel money out the door to SMEs."
Sector Under Stress
The announcement from the BoE on Wednesday morning came as Lloyds Banking Group said its plan to sell 632 branches had collapsed after the Co-op banking group which had planned to buy them pulled out, citing the economic downturn and a tougher regulatory environment.
Meanwhile, Barclays announced that its first quarter profit had fallen 25 percent to 1.78 billion pounds, down from 2.4 billion pounds a year ago. Under Basel III rules, banks now have to hold more capital and Barclays' core tier-one capital ratio strengthened to 11 percent.
The bank said it would take another 500 million pound restructuring charge as the new CEO tries to remake the bank. Investors have so far cheered the turnaround with Barclays shares rising 46 percent over the last 12 months. On Wednesday the shares were down 0.54 percent.
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Joshua Raymond, chief market strategist at City Index, said the British banking industry was under stress and as such, Lloyds' and Barclays' announcements were not a surprise.
"It's not too much of a surprise given the economic headwinds in the U.K. and looking at the regulatory limits that are in place too, so it makes it more difficult for these branches to be sold off to Co-op," Raymond told CNBC Europe's "Squawk Box."
Nielson agreed that the banking sector was under severe stress from new regulatory requirements brought in since the financial crisis hit.
"This is a sector that is under so much stress, the regulatory tsunami that is coming at the banking system, the fear of the financial transactions tax is taxing senior management's time to a very large degree now. You have to delever, but how do you raise capital when you cannot show good earnings results?" Nielsen said.
"The key issue is that we have to delever, we all know that, you can do that by raising capital and to do that you have to promise investors a good return or you do it on your asset side and you contain your loan book," he said. "It's a sector being completely hammered by policymakers right now."
- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt