Talk given by Donald Kohn, External Member of the Financial Policy Committee, Bank of England, at the US Department of the Treasury Conference, December 2011.
An important and interesting aspect of my post-Federal Reserve life has been my membership as an “external” on the interim Financial Policy Committee at the Bank of England. And I thought this audience might find it interesting to hear a little about the implementation of macroprudential policy in the United Kingdom. We issued our third set of recommendations just yesterday, so this is a good time to discuss our efforts to identify and deal with threats to financial and economic stability.
The Financial Policy Committee.
I’ll begin with some background on the establishment of the interim Financial Policy Committee. As in many places, the elected officials in the UK saw room for improvement in the performance of the various authorities responsible for financial stability, both in the build up of vulnerabilities and the response to the subsequent crisis. And they saw the shortfall as partly reflecting structural issues. In particular, the separation of bank supervision from the central bank, which occurred in 1997 when the Bank of England was given a clear price stability mandate and a greater degree of independence, seemed to impede the efficacy of supervision and of crisis response. The Bank retained generalized responsibility for financial stability and it published a much admired Financial Stability Report, but it did not directly participate in formulating and implementing the supervisory policies to establish and protect financial stability, and so did not itself have the levers to carry out its role effectively. The most obvious failing of the UK system, however, was that no single institution had the responsibility, authority, or powers to monitor the system as a whole, identify potentially destabilizing trends and respond to them with concerted action.
Shortly after the new government took office in the spring of 2010 it published a discussion draft of a new structure that moved the regulation and supervision of individual firms back into the Bank of England. Meanwhile the regulation of conduct within the financial system – including the conduct of firms towards their retail customers and the conduct of participants in wholesale financial markets – is to be carried out by a separate, dedicated, specialist body. To focus responsibility and accountability the Government has proposed a new subsidiary of the Bank – the Prudential Regulatory Authority – that will concentrate on microprudential oversight, while a new Financial Policy Committee will provide for the dedicated macroprudential overlay. The law to implement this new structure is still under discussion, but in the meantime the government has established an “Interim” Financial Policy Committee and given it two charges: First, identify risks to financial stability in the UK and make recommendations to deal with those risks; most of the recommendations are to financial institutions and Financial Services Authority, the FSA, which still has the responsibility for oversight of financial institutions. Both the risk identification and the recommendations are included in the Financial Stability Report, which is now the responsibility of the FPC.
Second, we are to make recommendations to the government about what tools we will need in the new law to do our job. Ultimately, we are to have two kinds of powers with respect to tools. First to make recommendations to the authorities where the FPC believes that specific regulatory actions are required in order to protect financial stability. These recommendations are subject to consideration by the relevant authority and then to the usual rulemaking process if the authority decides to go forward. Second, if we see the threat to stability as being immediate and serious, we will be able to issue directives to the microprudential authorities on regulatory tools that should be deployed in the pursuit of macroprudential policy.
The interim FPC has 11 members, including four externals serving on a part-time basis, and it is chaired by the Governor; an observer from the Treasury also attends. The discussions have been vigorous and good – a wide range of views are solicited and expressed about the risks to the financial system and what can be done to ameliorate them. Meetings tend to focus on narrowing the number of issues and identifying the most effective responses. We greatly benefit from the range of backgrounds members bring to the task. Two members come from the FSA and are responsible for microprudential regulation and for implementing many of our recommendations; several are from the financial stability side of the Bank with their macro-financial perspective; several are macroeconomists who have dealt primarily with monetary policy issues and see the relationships between developments in the financial sector and the real economy; and importantly two of my fellow externals have quite extensive experience in the London financial markets, which they have utilized to bring issues to our attention and to inform many of the rest of us without such experience how our concerns are playing out in the “real world”.
I am going to concentrate on the leg of our mandate that asks us to identify risks and make recommendations to preserve financial stability.
Risk Identification
Unfortunately, in one sense this hasn’t been difficult. The UK is part of Europe, even if it’s not part of the euro area, and its banks and businesses are exposed to developments in the ongoing saga of the fiscal, banking and business stresses so evident there. As a consequence, each time we met, we identified exposure to these developments as the primary systemic risk to the U.K. financial system.
We are also building on a risk-identification structure already in place at the Bank of England. Staff provide extensive briefings to FPC members in advance of our meetings. This includes information and analysis on the macrofinancial environment and short- and medium-term risks to financial stability – both in the UK and abroad in those markets in which UK banks are active. A key aspect of that analysis is the ability of the UK banks to withstand potential adverse developments. We review many different metrics and model outputs within this process. In addition, the Bank has an active market intelligence function that produces reports on what is going on in markets and the views of market participants about emerging risks. But of particular value is that members bring their own knowledge and understanding of the UK financial and economic system to the meetings. For myself, I make it a practice to talk to people in the financial sector on my visits to London so I can learn first-hand what stability issues are on their minds.
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