Participating institutions will initially be able to borrow the equivalent of 5% of the amount they currently lend but if they increase their lending, they will be able to borrow more.
Commenting on the launch of the scheme, the Governor of the Bank of England, Mervyn King, said: "This joint action by the Bank and the Treasury creates strong incentives for banks to expand their lending to the real economy.
"The more banks expand lending, the more they can use the Scheme. That will encourage banks to make loans to families and businesses both cheaper and more easily available."
Chancellor of the Exchequer George Osborne added: "The Funding for Lending Scheme will provide welcome support to households and businesses at a challenging time for the UK economy.
"The UK is recovering from a long and deep recession in the face of ongoing uncertainty in the eurozone, which is having a negative impact on growth and investment across the world. This uncertainty is contributing to increased funding costs for UK banks, and tighter credit conditions for households and businesses."
