Risk Reduction Initiatives

Banking Act | Special Resolution Regime | Risk Reduction Initiatives | Payment Systems Oversight | International Financial Architecture | Crisis Management

The Bank - often in conjunction with the FSA, HM Treasury and international authorities - takes actions to change the environment in which financial intermediaries operate to maintain and improve the resilience of the financial system.

These actions may involve changes to financial infrastructure. For example, the Bank introduced a Real Time Gross Settlement System in 1996 which removed the need for members of CHAPS, the high value payment system, to be exposed to one another during the business day as a result of payments transactions. Alternatively, the Bank may seek to influence the design of prudential standards for intermediaries. For example, between 1999 and 2005 the Bank played a prominent role in the design of Basel 2.

Some current structural initiatives in which the Bank is engaged are:

Liquidity Standards

Funding liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. Virtually every financial transaction or commitment has implications for a bank's liquidity. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the reliance on wholesale funding and the complexity of liquidity risk and its management.

The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector. It illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.

The Bank contributes to FSA policy initiatives to improve standards of liquidity risk management (see FSA DP07/7).

The Bank also participates actively, with the FSA, in international discussions about liquidity standards. International regulatory and supervisory standards for liquidity risk management differ. The Bank co-chairs a working group within the Basel Committee of Banking Supervisors which recently published draft standards for liquidity risk management (see below).

BCBS Principles for Sound Liquidity Risk Management and Supervision (June 2008)

BCBS Liquidity risk: Management and Supervisory Challenges (February 2008)

CEBS second part of technical advice to the European Commission on liquidity risk management (June 2008)

FSA DP07/7: Review of the liquidity requirements for banks and building societies (December 2007)

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Solvency standards - Basel 2

Basel 2 determines the minimum amount of capital that all EU banks must hold against their exposures (eg loans to customers, commitments entered into in derivatives contracts) in order to protect depositors. It made capital rules more risk-sensitive than in the past, so that for example the amount of extra capital required for risky, unsecured loans relative to loans to highly creditworthy customers with good collateral increased.

Risk-sensitivity means that regulatory rules provide an incentive to banks to hold an amount of capital appropriate to their risk-profile. However, under Basel 2 macroeconomic conditions could affect the amount of capital that banks are required to hold, creating so-called "procyclicality": capital could be run down in good times as requirements fall encouraging lending and in a recessionary period increased capital requirements could unduly constrain lending.

The Bank has contributed to international efforts to establish the extent to which Basel 2 could create problematic procyclicality and has conducted research on the effects of bank capital on loan supply.

Working with the FSA, the Bank is monitoring the impact of Basel 2 on intermediaries and will be vigilant for any signs of procyclicality or other potential systemic risks.

Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version
Basel Committee on Banking Supervision. BIS - June 2006.

Monitoring Basel 2/CRD capital requirements
Financial Services Authority.
Paper to the Credit Risk Standing Group - March 2007. (42k)

Monitoring Cyclicality of Basel II Capital Requirements
James Benford and Erlend Nier. Bank of England
Financial Stability Paper No 3 - December 2007. (561k)

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Payment system liquidity and collateral management

Banks’ capacity to meet their financial obligations as they fall due is ultimately determined by the efficiency with which liquidity flows within and between payment systems. The Bank, therefore, seeks to identify barriers to the smooth flow of liquidity and, where appropriate, considers intervention to improve infrastructural arrangements or to influence system participants’ incentives.

With internationally-active banks increasingly managing liquidity centrally, barriers to the within-group flow of liquidity can have implications for the inter-bank flow. In this regard, the Bank has recently examined the flow of liquidity within cross-border banking groups.

Banks can access liquidity by providing good quality collateral to central banks and other market counterparties. The ability of international groups to make use of collateral held in one country to access liquidity in another can significantly reduce the risk of a bank being forced to delay settlement of payment obligations while it seeks alternative sources of liquidity. This delay can disrupt the flow of liquidity in the payment system.

As part of wider work on mitigating liquidity risk, the Bank contributed to a report by the G10 Committee on Payment and Settlement Systems (CPSS), 'Cross-border collateral arrangements', published in January 2006. The group is considering practical ways to strengthen cross-border collateral arrangements, including greater information-sharing and enhancing operational coordination among central banks.

For its own part, the Bank currently accepts high-quality euro-denominated securities on a routine basis and has also established a bilateral arrangement with the Federal Reserve Bank of New York to take delivery of US Treasuries in exceptional circumstances.

Cross-border collateral arrangements
G10 Committee on Payment and Settlement Systems (401k)

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Payment system interdependencies

The Bank is working closely with authorities in other jurisdictions to assess key interdependencies within and between systems, and continues to seek ways to encourage banks to join systems - eg Continuous Linked Settlement and CHAPS - which reduce or eliminate direct credit exposures between member banks during the working day.

In this context, the Bank has contributed to two initiatives by the G10 Committee on Payment and Settlement Systems. Published in May 2008, the report on Foreign Exchange Settlement Risk provides an update on efforts to reduce foreign exchange settlement risk. The report makes recommendations regarding risk management by individual institutions. It further recommends that central banks and banking supervisors continue to support and promote initiatives to reduce foreign exchange settlement risk.

Progress in reducing foreign exchange settlement risk
CPSS Publications No 83 - May 2008

A second CPSS report published in June 2008, focuses on interdependencies of payment and settlement and the risks arising from increased relationships between system operators, financial institutions and service providers. The report underlines the need for risk management practices to acknowledge the growing importance of these interdependencies.

The interdependencies of payment and settlement systems
CPSS Publications No 84 - June 2008

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Payment systems research

The Bank also supports research into payment system economics. Amongst other things, this work aims to improve our understanding of systemic risk in interbank payment systems, and how both participant behaviour and system design can influence this risk. Published work can be found on the Bank's Publications page. In addition, the Bank's researchers regularly participate in international payment economics conferences. In November 2007, the Bank and the ECB jointly organised a conference on payments, and monetary and financial stability.

Joint Bank of England/ECB Conference on 'Payments and monetary and financial stability'
ECB, Frankfurt, 12-13 November 2007 (63k)

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Linkages between firms

Financial firms are highly interconnected, including through direct financial exposures to one another resulting from day-to-day liquidity management, in counterparty and market exposures arising from trading activity and through common membership of crucial payment systems.  This creates a risk that problems at one firm could be rapidly transmitted to others.

In many of the world's payment and settlement systems, banks lacking direct access to the system rely on system members to act on their behalf. This can result in bilateral credit exposures. Perhaps even more importantly, member banks which act on behalf of many non-members may come to resemble market infrastructures themselves, thereby creating potential 'single points of failure' for the network of firms dependent on them. Furthermore, disruption to one of the major non-system banks might spill over to disrupt the 'infrastructure' bank and its other customers.

The Bank has taken steps to reduce these risks. In 2003, for example, it helped create the Continuous Linked Settlement (CLS) system, which removes direct credit risk from foreign exchange transactions.

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Responding to innovations in payments

The rapid evolution of financial markets and the safety and efficiency of the supporting payment and settlement infrastructure have a strong bearing on one another: innovations in infrastructural arrangements can stimulate the growth and development of underlying markets; equally, frictions in the infrastructure can retard activity and undermine liquidity and stability.

For instance, developments in the supporting post-trade infrastructure have not kept pace with the rapid growth of the over-the-counter (OTC) derivatives markets in recent years. This has prompted public authorities to intervene to coordinate action amongst market participants. Further improvements in the post-trade infrastructure could enhance stability by improving data integrity and agents' risk management capabilities, and potentially also foster further growth and liquidity in the OTC markets.

The Bank has contributed to a report by the G10 Committee for Payment and Settlement Systems (CPSS) on this topic and supports its recommendations. The report promotes expanded use of new automated systems for post-trade processing of OTC derivatives, argues strongly in favour of open access to, and interoperability between such systems, and encourages policy makers to review the case for applying internationally agreed operational standards to such facilities. The report also suggests that the industry consider ways to mitigate the potential for market disruption in the event of a close-out event.

New developments in clearing and settlement arrangements for OTC derivatives
G10 Committee on Payment and Settlement Systems (326k)

New markets and new demands: challenges for central banks in the wholesale market infrastructure
Speech by Nigel Jenkinson, Executive Director, Financial Stability (115k)

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