Response from the Court of the Bank of England to the recommendations made by the Treasury Committee and Joint Committee on the draft financial services bill on the accountability of the Bank of England

On 8 November 2011, the Treasury Select Committee of the House of Commons published a Report on the “Accountability of the Bank of England”.  On 19 December 2011, a Joint Select Committee of the Lords and Commons issued a Report on the Draft Financial Services Bill.  On 17 January 2012, the Court of the Bank issued its response to both.

Key points from the full response.

• The new responsibilities for the Bank of England in the area of financial stability will need to
  be accompanied by new accountability mechanisms. As with the mechanisms for monetary
  policy, at the centre of these should be direct accountability to parliament through the
  Treasury Committee.
• Building on the recommendations of the Treasury and Joint Committees, we propose that this
  is supplemented by establishing an Oversight Committee, with direct access to the
  policymaking processes and papers in the Bank, and formed of non-executive directors.
• The role of this Committee should be to assess whether the processes employed in making
  financial stability policy decisions have considered a full range of options and have taken
  reasonable account of the relevant information, analysis (including of the lessons from the
  past), differing views amongst policymakers, and challenges from outside the Bank.
• The Oversight Committee should also commission reviews from experts outside the Bank of
  the performance of the Bank’s financial stability policymakers. These reviews would
  recommend lessons for them. And the Oversight Committee would assess the Bank’s
  response to those recommendations.

• The Bank’s financial stability role gives it operational responsibility for managing a financial
  crisis. All decisions in a crisis involving public funds, regardless of the amount, are however,
  for the Chancellor. So the forthcoming crisis management Memorandum of Understanding
  between the Bank and the Treasury should establish a clear framework for co-ordination. It
  should also establish a power for the Chancellor, when public funds are at risk and there is a
  serious threat to financial stability, to direct the use of the Bank’s tools of crisis management.
• We support the Treasury Committee’s recommendation that future Governors of the Bank
  should be appointed for a single eight-year term.

For an update see our snippet: MPs reject Bank of England’s governance plan.

The Financial Times provides the following comment entitled:

King holds fast on Bank supervision

The governor of the Bank of England on Tuesday dismissed suggestions that its proposed new powers be subjected to internal checks and balances, in an often testy encounter with MPs.

Sir Mervyn King rejected the Treasury select committee’s proposal for a powerful supervisory board to be created within the bank, insisting such a body would damage decision-making by “second guess[ing] the decisions of policymakers”. His testimony allayed few concerns that the Bank would be insufficiently accountable once it adopted sweeping new powers over interest rates, the supply of credit and bank supervision early next year.

“This exceptionally powerful public institution needs stronger oversight,” Andrew Tyrie, Treasury committee chairman, said, adding that the Bank’s response was “still not adequate”. In November MPs demanded a powerful new supervisory board to replace the Bank’s existing 12-member court, which reviews policy and monitors Bank action on interest rates, credit and financial regulation. In October Alistair Darling, the former chancellor, described the Bank governor as a “Sun King around whom the court revolves”.

In written evidence published on Tuesday, Sir Mervyn instead proposed a new court oversight subcommittee to report occasionally – and then only on the processes by which the Bank regulates financial stability.

“It is vital that the oversight committee does not seek to second-guess the decisions of policymakers themselves,” Sir Mervyn argued. “The passing of such judgments could threaten the relationship of trust that is necessary between policymakers and the oversight committee.”

The Bank did, however, accept that future governors should be appointed to a single eight-year term rather than the current renewable five-year terms.

An external member of the Bank’s new financial stability regulator, the Financial Policy Committee, also accepted that it was difficult to balance the Bank’s powers. Michael Cohrs told MPs: “The governor is right that you don’t want to second-guess the [Bank’s rate-setting Monetary Policy Committee], but you are absolutely right that just looking at process is a bit too sterile.”

Independent corporate governance experts were critical of the Bank’s unwillingness to accept greater internal scrutiny. Bob Garratt, professor at Cass business school, said that only allowing an oversight committee to examine the process of policymaking, but not Bank policy, was “crazy”. “That is madness,” he added. “The whole point of such a committee is to help [the policymakers] make those decisions in the first place.”

The Bank’s proposed oversight committee would not have access to transcripts of policy meetings. Unlike the US Federal Reserve, which publishes its meeting transcripts with a five-year delay, Bank transcripts are destroyed once the formal minutes are agreed.

The Treasury said on Tuesday night that it had not yet decided if it would side with the Bank or MPs when it drafted Bank reform legislation due by the end of the month. But ministers are expected to back Sir Mervyn, potentially complicating the bill’s passage.

Unless Germany and the ECB move quickly, the single currency’s collapse is looming

Even as the euro zone hurtles towards a crash, most people are assuming that, in the end, European leaders will do whatever it takes to save the single currency. That is because the consequences of the euro’s destruction are so catastrophic that no sensible policymaker could stand by and let it happen.

A euro break-up would cause a global bust worse even than the one in 2008-09. The world’s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls (see article). The euro zone could shatter into different pieces, or a large block in the north and a fragmented south. Amid the recriminations and broken treaties after the failure of the European Union’s biggest economic project, wild currency swings between those in the core and those in the periphery would almost certainly bring the single market to a shuddering halt. The survival of the EU itself would be in doubt.

Yet the threat of a disaster does not always stop it from happening. The chances of the euro zone being smashed apart have risen alarmingly, thanks to financial panic, a rapidly weakening economic outlook and pigheaded brinkmanship. The odds of a safe landing are dwindling fast.

Markets, manias and panics

Investors’ growing fears of a euro break-up have fed a run from the assets of weaker economies, a stampede that even strong actions by their governments cannot seem to stop. The latest example is Spain. Despite a sweeping election victory on November 20th for the People’s Party, committed to reform and austerity, the country’s borrowing costs have surged again. The government has just had to pay a 5.1% yield on three-month paper, more than twice as much as a month ago. Yields on ten-year bonds are above 6.5%. Italy’s new technocratic government under Mario Monti has not seen any relief either: ten-year yields remain well above 6%. Belgian and French borrowing costs are rising. And this week, an auction of German government Bunds flopped.

The panic engulfing Europe’s banks is no less alarming. Their access to wholesale funding markets has dried up, and the interbank market is increasingly stressed, as banks refuse to lend to each other. Firms are pulling deposits from peripheral countries’ banks. This backdoor run is forcing banks to sell assets and squeeze lending; the credit crunch could be deeper than the one Europe suffered after Lehman Brothers collapsed.

Add the ever greater fiscal austerity being imposed across Europe and a collapse in business and consumer confidence, and there is little doubt that the euro zone will see a deep recession in 2012—with a fall in output of perhaps as much as 2%. That will lead to a vicious feedback loop in which recession widens budget deficits, swells government debts and feeds popular opposition to austerity and reform. Fear of the consequences will then drive investors even faster towards the exits.

Past financial crises show that this downward spiral can be arrested only by bold policies to regain market confidence. But Europe’s policymakers seem unable or unwilling to be bold enough. The much-ballyhooed leveraging of the euro-zone rescue fund agreed on in October is going nowhere. Euro-zone leaders have become adept at talking up grand long-term plans to safeguard their currency—more intrusive fiscal supervision, new treaties to advance political integration. But they offer almost no ideas for containing today’s conflagration.

Germany’s cautious chancellor, Angela Merkel, can be ruthlessly efficient in politics: witness the way she helped to pull the rug from under Silvio Berlusconi. A credit crunch is harder to manipulate. Along with leaders of other creditor countries, she refuses to acknowledge the extent of the markets’ panic (see article). The European Central Bank (ECB) rejects the idea of acting as a lender of last resort to embattled, but solvent, governments. The fear of creating moral hazard, under which the offer of help eases the pressure on debtor countries to embrace reform, is seemingly enough to stop all rescue plans in their tracks. Yet that only reinforces investors’ nervousness about all euro-zone bonds, even Germany’s, and makes an eventual collapse of the currency more likely.

This cannot go on for much longer. Without a dramatic change of heart by the ECB and by European leaders, the single currency could break up within weeks. Any number of events, from the failure of a big bank to the collapse of a government to more dud bond auctions, could cause its demise. In the last week of January, Italy must refinance more than €30 billion ($40 billion) of bonds. If the markets balk, and the ECB refuses to blink, the world’s third-biggest sovereign borrower could be pushed into default.

The perils of brinkmanship

Can anything be done to avert disaster? The answer is still yes, but the scale of action needed is growing even as the time to act is running out. The only institution that can provide immediate relief is the ECB. As the lender of last resort, it must do more to save the banks by offering unlimited liquidity for longer duration against a broader range of collateral. Even if the ECB rejects this logic for governments—wrongly, in our view—large-scale bond-buying is surely now justified by the ECB’s own narrow interpretation of prudent central banking. That is because much looser monetary policy is necessary to stave off recession and deflation in the euro zone. If the ECB is to fulfil its mandate of price stability, it must prevent prices falling. That means cutting short-term rates and embarking on “quantitative easing” (buying government bonds) on a large scale. And since conditions are tightest in the peripheral economies, the ECB will have to buy their bonds disproportionately.

Vast monetary loosening should cushion the recession and buy time. Yet reviving confidence and luring investors back into sovereign bonds now needs more than ECB support, restructuring Greece’s debt and reforming Italy and Spain—ambitious though all this is. It also means creating a debt instrument that investors can believe in. And that requires a political bargain: financial support that peripheral countries need in exchange for rule changes that Germany and others demand.

This instrument must involve some joint liability for government debts. Unlimited Eurobonds have been ruled out by Mrs Merkel; they would probably fall foul of Germany’s constitutional court. But compromises exist, as suggested this week by the European Commission (see Charlemagne). One promising idea, from Germany’s Council of Economic Experts, is to mutualise all euro-zone debt above 60% of each country’s GDP, and to set aside a tranche of tax revenue to pay it off over the next 25 years. Yet Germany, still fretful about turning a currency union into a transfer union in which it forever supports the weaker members, has dismissed the idea.

This attitude has to change, or the euro will break up. Fears of moral hazard mean less now that all peripheral-country governments are committed to austerity and reform. Debt mutualisation can be devised to stop short of a permanent transfer union. Mrs Merkel and the ECB cannot continue to threaten feckless economies with exclusion from the euro in one breath and reassure markets by promising the euro’s salvation with the next. Unless she chooses soon, Germany’s chancellor will find that the choice has been made for her.

Source: The Economist

2011 IMF Annual Research Conference, Washington DC, November

The global financial crisis gave economists pause for thought about what should be the future of macroeconomic policy. We have devoted much of our thinking to this issue these past three years, including how the many policy instruments work together.

The interactions between monetary and macroprudential policies, in particular, remain hotly debated. And this year’s IMF Annual Research Conference is an important opportunity to take that debate another step forward.

Looking back, it is striking how many papers from last year’s conference—on post-crisis macroeconomic and financial policies—have been so immediately relevant to events on the ground. Just to give you an example: the paper on fiscal space is obviously front and center in the policy debate on the European sovereign crisis, the United States’ budget, and challenges faced by advanced country governments more generally.

This year’s topic—monetary and macroprudential policies—is equally relevant. It goes to the core of central banks’ mandates, and their role in achieving macroeconomic and financial stability. The financial crisis triggered a fundamental rethinking of these issues, but much research, both conceptual and empirical, remains to be done. The conference provides an excellent opportunity to engage with prominent academics, policymakers and private sector practitioners. I hope the conference will contribute to expanding the frontier of knowledge on this topic.

The conference program lays the ground for an exciting debate.

Professor Hyun Song Shin of Princeton University will give the keynote Mundell-Fleming address. He will talk about the role of international factors in determining domestic financial conditions. We saw a good illustration of this in the run-up to the recent financial crisis, when European global banks intermediating U.S. dollar funds eased credit conditions in the United States. Clearly, such international linkages need to be taken into account when choosing an appropriate mix of monetary and macroprudential policies.

Eleven other papers we have on the program each touch on a critical aspect of the intersection between monetary and macroprudential policies. Just to give you a flavor of what to expect, here are some of the questions we will be discussing:

• Should monetary policy lean against credit and asset price bubbles, or should this task be delegated squarely to macroprudential policy?
• What if macroprudential policy is only partially effective because it encourages regulatory arbitrage and other “leakages”? Does this imply that monetary policy should weigh in, too?
• What if the government does not have full information on the riskiness of new financial instruments? Will it be able to set macroprudential policies at the levels that will ensure lasting financial stability?
• How can policymakers guard against the possibility that monetary tightening may encourage excessive risk-taking by financial institutions that find themselves in distress at higher interest rates?
• How should macroprudential policies be coordinated internationally if they have cross-border repercussions?

In addition to the Mundell-Fleming Lecture, the conference will feature three other policy-oriented events. David Lipton, the IMF’s First Deputy Managing Director, will open the conference. The luncheon speech, by Jean-Pierre Landau, Second Deputy Governor of the Banque de France, will be an opportunity to reflect with a central bank insider on the role of central banks in maintaining financial stability and how that role is set to evolve in light of the lessons from the crisis.

And we will conclude the conference with an Economic Forum on “Monetary and Macroprudential Policies: Challenges and Solutions.” A panel of experts—including Lewis Alexander (Nomura), Joe Gagnon (Peterson Institute of International Economics), Andrew Lo (MIT), and John Williams (Federal Reserve Bank of San Francisco)—will discuss how synergies between monetary and macroprudential policies can be best achieved to reduce the risks of future financial crises, without imposing undue costs on the economy.

I would like to take this opportunity to thank the Conference Organizing Committeeand the Editor of the IMF Economic Review, Pierre-Olivier Gourinchas, for drawing up such an outstanding program. Some of the conference papers will be featured in theIMF Economic Review, which is becoming a required reading for everyone interested in questions related to global economic policies, open economy macroeconomics, and international finance and trade.

As always, the IMF’s Annual Research Conference is intended to be a forum for discussing innovative research, and facilitating an exchange of views among researchers and policymakers. Like in the past, we hope that research presented at this conference will contribute to new policy thinking both here at the IMF, and among economists and policymakers more broadly.

Read the papers posted online, and see the video of the Economic Forum

Financial Policy Committee statement from its policy meeting, 20 September 2011.

The Financial Policy Committee held its second formal meeting on 20 September. Since its previous meeting there had been severe strains in financial markets, which stemmed in large part from continuing concerns about the sustainability of external and internal debt positions of some countries, especially in the euro area. Anxiety about the consequences of these issues for banks had increased materially and, in turn, the perceived vulnerabilities of banks were adding to strains in financial markets.

The Committee recognised that dealing with the problems facing the international financial system as a whole would require long-term reforms to tackle unsustainable debt positions and the cumulative and persistent loss of competitiveness in a number of euro-area countries. But given the scale of current risks, the Committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system.

UK banks had made progress over the past two years in building up their capital and liquidity, which had placed them in a somewhat stronger position to withstand adverse developments whilst maintaining the supply of credit to the economy. The Committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term.

The Committee therefore recommended that banks should take any opportunity they had to strengthen their levels of capital and liquidity so as to increase their capacity to absorb flexibly any future shocks, without constraining lending to the wider economy. This could include raising long-term funding whenever possible and ensuring that discretionary distributions reflected any reduction in profits.

The Committee also advised the FSA to encourage banks, via its supervisory dialogue, to manage their balance sheets in such a way that would not exacerbate market or economic fragility. For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided.

Moreover, the Committee recognised that, in the event that severe risks crystallised, it would be natural for banks’ capital and liquidity ratios to be run down to ensure that lending to the non-financial economy was not impaired.

In addition to identifying, and advising on measures to mitigate, risks to the financial system, the Committee’s terms of reference – set out in the Government’s February 2011 consultation document – required it to carry out preparatory work and analysis in advance of the legislation to put the Committee on a statutory basis coming into effect. This included assessing and advising on potential macroprudential instruments. The Committee devoted part of its meeting in September to an initial discussion of this issue.

The role of the Committee was to identify and take action to mitigate risks that built up within the financial system as a whole. In order to fulfil that role, the Committee judged that, alongside its broader scope to make recommendations, it would need to have directive powers over three broad categories of policy tool affecting:

i) the balance sheets of financial institutions (including non-banks);

ii) the terms and conditions of transactions in particular financial markets; and

iii) market structures.

The Committee considered a variety of potential tools within each category. Under the first, it considered instruments targeted at capital and liquidity, such as maximum leverage ratios, countercyclical capital and liquidity buffers, variable risk weights and provisioning practices. Under the second category, examples included limits on loan to value ratios and margining requirements. Under the third category, it discussed, among others, disclosure requirements, obligations to conduct financial trading via organised platforms and/or cleared via central counterparties, and adjusting risk weights to reflect the degree of interconnectedness of institutions within the financial system. But there would need to be further debate about which precise tools the Committee would advise HM Treasury to include in the initial set of instruments over which it had directive powers. There was time for such further debate before that advice was due in the first half of 2012.

The Committee recognised that its understanding of how such instruments were likely to work would improve with experience. As such it was minded to recommend a relatively narrow initial set, which could then evolve. Furthermore, innovation and change within the financial system would give rise in due course to new risks to which the Committee would need to respond. For these reasons, it was highly likely that the list of instruments over which the Committee had power of direction would need to be refreshed from time to time. So the procedure laid out by HM Treasury and Parliament by which this would happen would need to be expeditious.

Finally, the Committee urged HM Treasury to continue its efforts to ensure that developments in European legislation did not provide an impediment to the ability of the Committee to use macroprudential policy instruments in the interests of financial stability in the United Kingdom, as envisaged in the consultation documents proposing the establishment of the Financial Policy Committee.

Further details of the Committee’s discussions is published in the Record of the Committee’s Meeting.

The FPC will hold its final meeting of 2011 on 23 November. The Financial Stability Report (FSR) will be published on Thursday 1 December at a press conference led by the Governor. Among other things, it will contain the Committee’s agreed policy recommendations, and an explanation of why it came to those decisions. The record of the meeting will not be published at the same time, instead it will be released on 6 December. This is a slight modification to the process adopted in June whereby the FPC published the FSR and the record of the meeting simultaneously.

Source: Bank of England

Constraints on Central Banks Leave Markets Adrift

They called it the “Greenspan put,” and it reassured a generation of traders. If economic storms were gathering, the top central banks — most important the Federal Reserve, then led by Alan Greenspan — could and would step in to prevent disaster.

Because the traders effectively had a put option, they could safely bet that the markets would survive even the worst crisis.

This year, volatility has soared and share prices have fallen sharply, in part because few think there is a Bernanke put, or, for that matter, a Trichet put. It is far from clear that the authorities could stem a new panic, and even less clear that many would be willing to try.

In other words, the slogan for markets as the International Monetary Fund and World Bank meet this week in Washington could well be, “You’re on your own. Don’t count on anybody to bail you out.”

The situation is thus drastically different from that of three years ago, when I.M.F.-World Bank meetings served as a forum to find joint strategies to ameliorate the financial crisis that had followed the collapse of Lehman Brothers.

Now there appears to be division and disarray within Europe and the United States. Central bank efforts to help the economy have become politically controversial, and there has been infighting at both the European Central Bank and the Federal Reserve.

At the European Central Bank, the departing president, Jean-Claude Trichet, has faced sniping from Germany and the resignation of Jürgen Stark, a German member of the bank’s executive board. Mr. Stark cited personal reasons, but his departure was widely interpreted as a repudiation of the bank’s purchases of bonds issued by troubled European nations.

At the Fed, Ben S. Bernanke, the chairman who succeeded Mr. Greenspan, has faced dissents within the central bank on recent efforts to stimulate the economy.

There was a long-lived bipartisan consensus in the United States — it lasted at least from 1992, when Mr. Greenspan helped banks recover from bad loans to Latin American nations, through 2008 — that the Fed was expected to steer the economy and would be treated gently by politicians.

Presidents tended to reappoint Fed chairmen, even those appointed by predecessors of the other political party, in part because of fear that markets would be outraged by any effort to politicize monetary policy. There have been six presidents since Paul A. Volcker took over at the Fed in 1979, but Mr. Bernanke is just the third chairman.

That consensus seems to have vanished, with candidates for the Republican presidential nomination vying with one another to show their hostility to Mr. Bernanke, even though he is a Republican who previously served as the chief economic adviser to President George W. Bush.

One candidate, Mitt Romney, has said he would ask Mr. Bernanke to resign. Another, Rick Perry, the governor of Texas, suggested that Mr. Bernanke might be trying to stimulate the economy to aid President Obama’s re-election campaign. On Tuesday , Republican Congressional leaders took the extraordinary step of publicly calling for the Fed to do no more.

That did not stop the Fed from announcing some initiatives on Thursday, but they were relatively small and disappointing to investors. Share prices fell sharply after the announcement.

The political challenges may make it harder for the Fed to do much more over the next year, even if the economy is weaker than expected. Similarly, Mario Draghi, the Italian central banker who will take over from Mr. Trichet on Nov. 1, will be under great pressure from Germany to avoid actions that might increase inflation, even if they may be needed to prevent a new financial collapse.

At the same time, European governments have found it hard to agree on effective action. A July 21 agreement, which was supposed to provide money for Greece while limiting the losses for banks, has yet to be put in place, and markets seem convinced that a Greek default is inevitable. Italy is the latest country to find bond markets hesitant to provide funds.

European banks, many of which were slower than American ones to raise capital when investors grew more friendly in 2010, may need to be rescued again precisely because of fears that the rescuers of 2008 — national governments — may not be able to meet their obligations.

At a meeting of European finance ministers last week, Timothy F. Geithner, the United States Treasury secretary, pleaded for coordinated action. “Governments and central banks need to take out the catastrophic risk to markets,” he said. After he left, Austria’s finance minister said Americans should stop lecturing Europe.

Those countries that can borrow money easily and cheaply — most important, Germany and the United States — are reluctant to do so, even with the threat of a new recession seeming to grow. The Germans argue that other European nations must cut back spending to regain competitiveness, that there is no gain without pain. Mr. Obama has proposed a new stimulus program, but it faces uncertain political prospects only weeks after the two parties agreed to seek consensus on ways to reduce government spending.

Large banks around the world have seized on the disarray of governments to begin campaigns to reduce regulation, complaining that new rules adopted after the 2008 debacle threaten growth. They want capital rules eased and hope that few will remember it was their excessive risk-taking, relative to the capital they had, that helped to create the 2008 disaster and that threatens a new one.

Some politicians join in that complaint, saying current problems stem from excessive government interference in the economy, particularly in free markets.

Those who remember the “Greenspan put” may find that argument odd. It is the fear that governments may not ride to the rescue that seems to have unnerved markets.

Perhaps it is the low expectations that provide the best hope for some kind of success at the meetings of the I.M.F. and the World Bank. Three years ago, it was widely expected that governments and central banks could act cooperatively and effectively. Now any indication they can still do so would come as a pleasant surprise.

Source: New York Times

This paper identifies and discusses some of the more difficult and contentious issues relating to macroprudential policy.

Published jointly by the Group of 30 and the Bank of England, co-authored by Alastair Clark – External Member of the Financial Policy Committee and Senior Adviser for Financial Stability at HM Treasury – and Sir Andrew Large – Former Deputy Governor of the Bank of England.

While the recent emphasis on macroprudential policy reflects the inadequacies of traditional approaches to macroeconomic policy and financial regulation revealed by the financial crisis, the paper points out that there is as yet no clear consensus on the scope or precise targets of macroprudential policy. The paper identifies, however, two key elements: monitoring, analysing and seeking to mitigate emerging “conjunctural” risks (e.g., an excessive build-up of leverage or debt); and enhancing the resilience of the financial system in the face of these risks.

At the same time, the paper recognises the need for balance with other policy objectives: “A regulatory regime which requires, for example, excessive levels of capital may ensure systemic stability but at the same time may unnecessarily inhibit the growth and risk-handling capacity of the economy.” The challenge, Clark and Large say, is to capture such trade-offs without losing the focus on systemic stability.

The authors highlight the overlaps with fiscal, monetary and other policies and the difficulty of identifying a distinct set of macroprudential instruments. Indeed they suggest that the designation “macroprudential instrument” may be unhelpful; rather there are instruments which are relevant to macroprudential objectives but often to other objectives as well. These overlaps complicate the decision-making process.

They also consider which indicators best identify potential sources of systemic vulnerability, for example, unsustainable trends in financial aggregates over time and unstable patterns of financial exposures as well as structural weaknesses. When determining which data are more useful for macroprudential analysis, they emphasise the need first to define a clear objective and call for a balance between the collection of “ideal” data and the costs (for financial firms) of producing it and the costs (for the authorities) of analysing it. In the background they note the question of whether or how any macroprudential policy framework should be reflected in statute. The authors believe that such statutory backing can be helpful, particularly in signalling the importance of this area of policy, but suggest a “gradualist approach” focussing first on those aspects about which there is already a reasonable level of confidence.

Should the finance ministry, the central bank or the regulators take the lead on macroprudential matters? The paper argues that this is bound to be influenced by national circumstances but that in “peacetime” there is a good case for the function to be anchored at the central bank. In contrast, however, the authors suggest that in a crisis the finance ministry should be in overall charge, partly because, in a crisis, there is likely to be a key question about whether and if so how fiscal resources should be used but also because the response to any significant financial disruption could involve difficult political judgements. Central banks and regulators are nevertheless likely to have a dominant role in the operational response to a crisis, subject to the finance ministry’s ultimate power of decision. Such arrangements imply the need for a process to switch from peacetime to crisis; the macroprudential authority might have responsibility for triggering this transition.

Finally, the authors consider the constraints on developing a national as opposed to an international approach to macroprudential policy and the challenges in achieving convergence between the two. They argue that, given fiscal capacity and legal frameworks are predominantly national, there are limits on how far international bodies can assume an operational role in crisis management. However, the authors emphasise the valuable part international authorities like the IMF and FSB can play in setting standards for macroprudential policy frameworks. The paper concludes that the highly interconnected nature of the financial system means that it will be increasingly important for national authorities to coordinate their actions.

Download the full paper: Macroprudential Policy: Addressing the Things We Don’t Know

The Central Banking ON AIR debate:

Tomorrow at 08:30 BST (London), 03:30 EST (New York).

In association with: BNP Paribas.

Free Registration.

Date: Thursday, 8 September, 2011

Time: 8:30am GMT (London)

The financial crisis has challenged ideas of what roles a central bank should play in an economy and markets.

It has reopened questions that the profession thought had been settled.

The forthcoming Central Banking ON AIR debate, sponsored by BNP Paribas Securities Services, will discuss the key policy and institutional debates facing central bankers today.

The panel will consider:

• Whether inflation targeting can continue in its current format;

• What is meant by the macroprudential mandate;

• What role if any central banks should play in regulation;

• How governance structures need to be changed;

• Whether central banks will continue to be “independent”

This Central Banking ON AIR debate will be shown, free to view, on September 8th 2011.

Bernanke hints at more Fed support

Ben Bernanke has hinted that the US Federal Reserve will do more to support the stalling US economy, saying that the central bank “is prepared to employ its tools as appropriate to promote a stronger recovery” and will extend its September monetary policy meeting “to allow a fuller discussion”.

But in his annual speech to a Fed gathering in Jackson Hole, Wyoming, Mr Bernanke avoided the emphatic language he used in a similar speech last year and offered no detailed discussion of the Fed’s easing options. That suggests the Fed is unlikely to launch a third round of quantitative easing – nicknamed QE3 – unless the economic situation gets substantially worse.

“The Federal Reserve has a range of tools that could be used to provide additional monetary stimulus,” Mr Bernanke said. “We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September.”

Investors initially reacted poorly to the speech but took heart at the possibility of further Fed action, with the S&P 500 index rallying to trade up 1.2 per cent by midday. “There’s still some pricing in of more monetary policy action in the near term,” said Ian Lyngen, senior government bond analyst at CRT Capital. “Markets seem to be thinking there will be no ‘QE’ today, but perhaps there will be after the extended meeting in September.”

In a further sign of US economic weakness, estimates of second quarter growth were revised down from an annualised rate of 1.3 per cent to 1 per cent.

Mr Bernanke also expressed alarm about long-term unemployment, saying that it could leave a “major scar” on the US economy. He also criticised fiscal policymakers, suggesting that their arguments about the debt ceiling had probably harmed growth. “Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank,” he said.

Markets are now focusing on the economic policy speech that President Barack Obama is due to make after the US Labor Day holiday in September. “Mr Bernanke surprised markets when he threw the ball into the president and Congress’s laps,” said Kenneth Polcari, managing director at Icap and a NYSE floor trader. “He set the president up for a huge speech, and no one’s going to make a big move until that,”

Mr Bernanke said that recent data suggested first-half growth was slower than expected, noting that “temporary factors can account for only a portion of the economic weakness that we have observed”. He added that the Fed had cut its growth forecasts and expected inflation to settle at or below the Fed’s target.

He also clarified the Fed’s recent guidance that short-term interest rates are likely to remain exceptionally low until mid-2013, saying that it is the most likely outcome rather than a certainty. “In what the committee judges to be the most likely scenarios for resource utilisation and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years,” Mr Bernanke said.

“The quality of economic policymaking in the United States will heavily influence the nation’s longer-term prospects. To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies.”

Source: Financial Times

If the first fear is global recession, the second is that central banks have run out of fixes

They do have means to respond, but only with radical and possibly dangerous policies whose efficacy is dubious. These nuclear monetary weapons might be better kept locked away.

Printing money — or quantitative easing — has always been seen as the last resort. Now, it seems to be the only option. It has various manifestations, and recent weeks have shown some of its limitations.

The Swiss National Bank and the Bank of Japan tried to reverse the appreciation of their respective currencies by increasing liquidity to banks and striving for still lower short-term interest rates. Japan also intervened directly in the currency market by selling yen. But it remains close to its peak, and the Swiss franc has pushed on to new highs. This type of involvement has not proved effective.

The European Central Bank has shunned Q.E. outright. Being bold has meant buying euro zone government debt in the secondary market, while neutralizing the monetary effect by sucking in bank deposits. This big gun has worked. Yields on 10-year Italian and Spanish government debt have tumbled by over one percentage point.

The question for the central bank is whether it should go further by buying large amounts of euro zone sovereign debt without any offsetting moves that take money out of the system. This might seem an easy solution to the region’s debt crisis. But the risk is that the central bank becomes a holder of debt that requires restructuring — as is probably the case now with Greece.

The central bank then faces real losses that it must pass on to European governments. Again, it could just print more money to fill the hole, monetizing the debt, as economists say. Numerous irresponsible central banks in Latin America and elsewhere have done so in the past. But the usual result has been high inflation. Germany, which remembers Weimar, sees this as the ultimate risk.

The Bank of England has so far taken a conservative Q.E. course — buying £200 billion of British government bonds. Growth there remains weak. The bank may well decide in coming months to start a second round of Q.E. But it’s doubtful how effective more gilt purchases would be. The bank might be tempted to be bolder and buy corporate bonds. The risk is that this is like pushing on a piece of string, as the real problem is a lack of demand in the real economy.

By far the boldest exponent of Q.E. has been the Federal Reserve. Its second round of money printing financed purchases of $600 billion of Treasuries. The question is how much QE2 has achieved and, as markets panic, if QE3 will soon be required. But when the yield on the American 10-year note is already hovering around 2.4 percent, would more Treasury purchases be useful?

Ben S. Bernanke, the Fed chairman, has said that more radical options are available. Cooperation between monetary and fiscal authorities, he wrote in 2002, could permit a “money-financed tax cut” equivalent to a “helicopter drop” of money, to use a phrase from the economist Milton Friedman. Politicians would certainly balk at that — as would most Fed governors, three of whom have rejected the bank’s new commitment to keep rates low till 2013.

Congress sought to tie the government’s hands on conventionally financed spending, and is politically miles away from using printed money to finance looser fiscal policy.

The reality is that bolder Q.E. would bring risks for the dollar and for inflation worldwide. QE2 coincided with a surge in global commodity prices, increasing inflation in emerging economies and, now, in America to 3.6 percent. Gasoline prices are up 36 percent in the last year. Consumer purchasing power has been harmed. If more Q.E. means higher prices, the policy risks obstructing growth.

But if recession returns to the United States, the world economy slows and the markets’ worst fears are realized, then the Fed and other central banks would have no other option. The world isn’t desperate yet, even though America’s recovery is slow. Central banks do have an arsenal. They just should not rush to use it.

Source: New York Times

Press conference: Opening Remarks by the Governor

Let me welcome you all to the first press conference for the Financial Stability Report published under the auspices of the Bank’s new Financial Policy Committee (FPC). With this press conference and the publication today of both the Stability Report and the Record of the FPC’s meeting, we are making an important step towards improving the openness and transparency of financial stability policy in this country.

The purpose of the FPC is to act as the guardian of the resilience of the UK financial system. Although it is not yet on a statutory footing, the FPC is charged with identifying and monitoring systemic risks, and making recommendations to regulators and financial institutions to mitigate them. In today’s Report the FPC is publishing six recommendations. They relate to areas of the financial system in which we are concerned that risk is increasing.

The most serious and immediate risk to the UK financial system stems from the worsening sovereign debt crisis in several euro-area countries. As the Report makes clear, direct UK bank exposures to those economies are limited. But experience has shown that contagion can spread through financial markets especially when there is uncertainty about the precise location of exposures. A UK bank could have lent to a bank that itself had lent to a bank that in turn was exposed to sovereign risk. The Committee therefore judged that greater clarity about the extent of these exposures would help to limit the transmission of problems to UK banks, and that this extra transparency should be a permanent part of major banks’ reporting.

So, in its first recommendation (shown on page 1 of the Record of last week’s meeting):

The Committee advises the FSA to ensure that improved disclosure of sovereign and banking sector exposures by major UK banks becomes a permanent part of their reporting framework, and to work with the FPC to consider further extensions of disclosure in the future.

There is no evidence that the euro area sovereign and banking sector exposures of smaller UK banks are significant. But to dispel any doubts on this point, in its second recommendation:

The Committee advises the FSA to compile data on the current sovereign and banking sector exposures of other UK banks not subject to the EBA stress tests. If these exposures are significant, then the FSA should publish an aggregate estimate.

Another risk identified in the Report concerns the adequacy of provisioning. When lenders choose not to take action against borrowers who are in arrears or in breach of covenants (known as loan forbearance), it is important that adequate provisions are set aside for prospective losses. This is not to suggest that forbearance is wrong; it may well make sense for both parties to a loan. But if provisioning is inadequate, banks’ reported profits and levels of capital may provide a misleading picture of their financial health. The FSA has done some initial work in this area, but without further information it is difficult for the FPC to be confident in its overall assessment. And so in a third recommendation:

The Committee advises the FSA to extend its review of forbearance and associated provisioning practices across UK banks’ household and corporate sector exposures on a global basis.

Since the end of 2007 the major UK banks have reduced leverage and increased their capital by £117bn. But in the light of the uncertainties in the world economy, there is a strong case for banks to build up their capital levels further when the opportunity arises, for example when earnings are relatively strong. Such “opportunistic capital building” is the Committee’s fourth recommendation:

The Committee advises UK banks that, during the transition to the new Basel III capital requirements, they should take the opportunity of periods of strong earnings to build capital so that credit availability is not constrained in periods of stress.

In good times banks should retain more of those earnings, rather than distribute them to shareholders or as compensation. The Committee is clear that the purpose of building capital in this way is to improve resilience without jeopardising credit availability. It is not to accelerate the transition to the new Basel III capital requirements. Rather, it is to build up the buffer of capital over and above the minimum required level of capital in good times, in order to run down the buffer in less good times.

To make this effective, in its fifth recommendation:

The Committee advises the FSA, as part of its regular supervisory dialogue with banks, to ensure that the proportion of earnings retained is consistent with the FPC’s advice on capital.

The Committee is also monitoring risks at the level of the financial system as a whole over the longer term. Of particular concern is any increase in financial system interconnectedness and opacity, since the use of complex and opaque funding structures can disguise the build-up of risk. Exchange-traded funds (ETFs) provide one example of a contributory factor to this tangled web. For good and proper reasons, these funds have grown rapidly in recent years, with the size of the European ETF market now estimated to exceed $300bn. But complexity has begun to creep in, especially through so-called synthetic ETFs. And the assets of ETFs are increasingly being used as a source of funding for some banks, through collateral swaps and similar transactions. So in its sixth recommendation:

The Committee advises the FSA that its bank supervisors should monitor closely the risks associated with opaque funding structures, such as collateral swaps or similar transactions employed by exchange-traded funds.

Focusing – as the FPC must – on risks to the financial system can leave one feeling rather depressed. We cannot hope to prevent financial crises from happening. But we can build institutions that help to ensure that our financial system is more resilient in future. Today marks the start of that process, and I hope you will watch the evolution of the FPC with interest.

Our new Committee will have a team of 11 voting members when it is fully up and running. Today you see on the platform the five-a-side version, who now stand ready to answer your questions.

View the webcast or download the transcript.

Available BoE Financial Stability downloads