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Why do the banks need so much money from the Bank of England's special liquidity scheme? Are they suffering from financial instability? Evan Owen, The IFA Defence Union, Gwynedd

Mervyn King, Bank of England, London

Dear Evan,

With markets for many securities currently closed, banks have on their balance sheets an overhang of high quality mortgage-backed assets that they cannot sell or pledge as security to raise funds.

Their financial position has been stretched by this overhang so banks have been reluctant to make new loans, even to each other. Under the special liquidity scheme, banks can for a period swap illiquid assets of sufficiently high quality for Treasury bills. Responsibility for losses on their loans, however, stays with the banks. By tackling decisively the overhang of assets in this way, the scheme aims to improve the liquidity position of the banking system and increase confidence in financial markets.

Banks will need, at all times, to provide the Bank of England with assets of significantly greater value than the Treasury bills they have received. If the value of those assets were to fall, the banks would need to provide more assets, or return some of the Treasury bills. If their assets pledged as security were to be down-rated, the banks would need to replace them with alternative highly-rated assets.

Sarah Robson, Council of Mortgage Lenders, London

Dear Evan,

The special liquidity scheme is not targeted at financial instability but is intended to inject liquidity into the banking system and increase confidence in financial markets. There is no limit on the size of the scheme. Its usage will depend on the banks and building societies' appetites but this is not a reflection of their stability.

Peter Williams, Intermediary Mortgage Lenders Association, London

Dear Evan,

The short answer is because with the markets for the sale of securities and inter-bank lending effectively closed banks have had difficulty raising the funds they need to support everyday transactions. The special liquidity scheme was put in place to allow banks to raise funds on securities, many of them long-term, that would normally have been sold on the market.

Banks raise money in different ways, retail deposits is an obvious one and rates have gone up to draw funds in but it is a slow business. They can securitise assets and slow lending. They can undertake rights issues. If one bank was short it could borrow from others but all are facing the same problem and doing the same things to recover the position. Moreover, given the loss of confidence in both the assets banks are trying to sell and in the banks themselves following Bear Sterns and Northern Rock, banks are not lending to each other. The scheme is designed to help ease current funding pressures. Despite comments to the contrary by ministers it is not aimed directly at helping the mortgage market though this might be a by product.

For six months selected lenders (firms with deposits greater than £500m) can access the scheme and they can swap their illiquid assets including mortgage backed securities for Treasury bills for up to three years. An initial £50bn has been made available but this is open ended and demand might take this up to £80bn. There will be no details until the scheme closes in October.

Will it help? The evidence as measured by the spread between the Libor rate and the Bank rate is not good and further measures may yet be needed. The scheme is for assets in place before 31 December last year so it will not help new business or non deposit taking lenders. It was a bold move by the Bank of England given its cautious behaviour and reflects its desire to improve the liquidity position of the banking system and raise confidence in financial markets while ensuring that the risk of losses on the loans they have made remains with the banks.

As this suggests the whole system has been under considerable strain. There will be moves to require greater liquidity in the system and the FSA has been pressing lenders to increase their reserves and to improve liquidity. As this suggests we have the Bank pumping money into the system while the FSA is encouraging banks to hold more themselves. Both reflect the real tensions around solvency and liquidity. The Treasury through the Crosby review will also get in on the act so this is far from over.

Simon Hills, British Bankers' Association, London

Dear Evan,

The issue is not one of financial stability but one of liquidity – that is to say it is about financing short-term borrowing between banks, not supporting any bank's capital base. Liquidity has been in short supply during the recent market instability - this has been largely down to market sentiment rather than fundamental weakness. Remember the banks are only borrowing this money and not on the most favourable terms.

The banks temporarily swap their major assets for government-backed bills. The risk remains with the banks and repayment is required with interest in one year (though it may be renewed for up to three years). The Bank's plan will not stop the crystal ball gazers from continuing to foretell our economic doom. But it will provide the world's stock markets with the assurance they need that the UK stands alongside them in using every tool at its disposal to head off the global credit crunch.

Make no mistake, this is a worldwide phenomenon. The European Central Bank and the US Federal Reserve responded to it some time ago by allowing a wider range of bank assets to be held as collateral against their borrowing. The Bank of England is now following suit with a package designed to safeguard taxpayers' funds and to encourage banks to return to the commercial money markets.