|Cross-border bank credit and global financial stability (109KB)
By Bob Hills and Glenn Hoggarth of the Bank’s International Finance Division.
This article looks in detail at one aspect of global liquidity: cross-border credit provided by banks. Cross-border banking can potentially have considerable benefits, especially by diversifying the available sources of lending and borrowing, and by increasing banking competition. But such flows can also amplify risks in times of stress. As this article sets out, cross-border bank lending contributed to the build-up in vulnerabilities before the recent crisis, and exacerbated the bust once the crisis hit. The article then considers possible policy responses, arguing in particular that policymakers need to ensure that they can properly monitor these flows, from the point of view of recipient countries and the global system as a whole.
Central counterparties: what are they, why do they matter and how does the Bank supervise them? (85KB)
By Amandeep Rehlon of the Bank’s Market Infrastructure Division and Dan Nixon of the Bank’s Media and Publications Division.
The Government introduced major changes to the system of financial regulation in the United Kingdom in April 2013, including creating the Financial Policy Committee and transferring significant new supervisory responsibilities to the Bank. As part of this, the Bank is now responsible for the supervision of central counterparties, or CCPs. This article explains what CCPs are, setting out their importance for the financial system — including the benefits they bring and some of the risks they could present if not properly managed. It also summarises the Bank’s approach to supervising CCPs and describes some of the key priorities the Bank will be pursuing.
||Changes to the Bank of England (80k)|
By Emma Murphy of the Bank’s Macroprudential Strategy Division and Stephen Senior of the Bank’s PRA Transition Unit.
The Bank of England is currently experiencing its most important institutional and functional changes in a generation. Failings in pre-crisis arrangements have prompted the Government to introduce wholesale changes to the UK regulatory landscape which come into force in April 2013. This regulatory reform has resulted in the Bank gaining significant new responsibilities, including for: microprudential regulation of insurers, deposit-takers and major investment firms, through the creation of the Prudential Regulation Authority; macroprudential regulation of the financial system as a whole, through the creation of the Financial Policy Committee; and supervision of some critical post-trade financial market infrastructure providers. This article summarises the main changes to the Bank arising from these reforms, including those already put in place in anticipation of the reforms, as well as the new governance arrangements that are being introduced, as part of the Bank’s accountability to Parliament and the public.
Private equity and financial stability (96k)
By David Gregory of the Bank’s Markets, Sectors and Interlinkages Division.
In the mid-2000s, there was a dramatic increase in acquisitions of UK companies by private equity funds. The leverage on these buyouts, especially the larger ones, was high. The resulting increase in indebtedness makes those companies more susceptible to default, exposing their lenders to potential losses. This risk is compounded by the need for companies to refinance a cluster of buyout debt maturing over the next few years in an environment of much tighter credit conditions. From a macroprudential policy perspective it will be important to monitor the use of debt in acquisitions in future episodes of exuberance. But there is also a potential role for private equity to play in promoting recovery in a downswing, in particular at the current juncture, by restructuring companies in difficulty.
Commercial property and financial stability (112k)
By James Benford and Oliver Burrows of the Bank’s Financial Stability Directorate.
Commercial property played a key role in the recent financial crisis in the United Kingdom. A rapid build-up of debt tied to commercial property investments pre-crisis supported a boom in prices. The consequent bust led to a sharp rise in non-performing loans. This episode has many precedents in the United Kingdom and parallels across countries. The structure of the commercial property market, and in particular the role of leveraged investors with significant maturity mismatches on their balance sheets, is important in understanding the market’s dynamics and the risks it can pose. The new Financial Policy Committee will be alert to these risks and deploy tools to counteract them where necessary to protect financial stability.
||The role of designated market makers in the new trading landscape (119k)|
By Evangelos Benos and Anne Wetherilt of the Bank’s Payments and Infrastructure Division.
Designated market makers (DMMs) have traditionally been a source of liquidity for exchange-traded securities and financial contracts. Recent regulatory and technological developments, however, have changed the environment in which DMMs operate, raising questions about their place in the new trading landscape. This article discusses the role and challenges of DMMs in today’s trading venues.
By Andrew Bailey, Executive Director of the Bank of England and Managing Director of the Financial Services Authority’s Prudential Business Unit, and Sarah Breeden and Gregory Stevens of the Bank’s PRA Transition Unit.
The Prudential Regulation Authority (PRA), as part of the Bank of England, will become the United Kingdom’s prudential regulator for banks, building societies and credit unions (collectively deposit-takers), insurers and major investment firms in 2013. This is part of a wider reform of the UK regulatory framework, which will also see the creation of a Financial Policy Committee within the Bank, and a new conduct regulator, the Financial Conduct Authority. This article provides a brief description of the PRA’s role and its intended supervisory approach. It summarises some of the key themes of the two more detailed documents about the PRA’s intended approach that were published jointly by the Bank and the Financial Services Authority in October 2012.
||RAMSI: a top-down stress-testing model developed at the Bank of England (72k)|
By Oliver Burrows, David Learmonth, Jack McKeown and Richard Williams of the bank's Risk Assessment Division.
Top-down stress testing is one way of assessing the resilience of the financial system to the risks it might face now or in the future. The Risk Assessment Model of Systemic Institutions (RAMSI) developed at the Bank of England is an example of a top-down stress-testing model and is part of the Bank’s risk assessment toolkit. This article offers an overview of RAMSI and illustrates its use in the stress tests carried out during the IMF’s 2011 UK Financial Stability Assessment Program.
||Considering the continuity of payments for customers in a bank’s recovery or resolution (54k)|
By Emma Carter of the Bank’s Customer Banking Division.
The robustness of payments infrastructure, and the associated ability of payments to flow seamlessly, is an important contributor to financial stability. The United Kingdom’s payments infrastructure has historically proved to be efficient and robust. But, in a situation where a bank is in difficulty or fails, the need to ensure that customers can continue to make and receive payments may become challenging. This article draws together and discusses some of the issues in the way that UK payments and payment schemes work in stressed scenarios. It highlights some possible enhancements which could help to achieve minimal disruption to payment flows in the event that a bank gets into difficulty or fails — a subject the authorities, payment schemes and banks have been addressing in recent months. It looks at elements of recovery and resolution planning from the specific perspective of retail payments.
|The Bank of England’s Special Liquidity Scheme
By Sarah John, Matt Roberts and Olaf Weeken of the Bank’s Sterling Markets Division.
The Bank of England introduced the Special Liquidity Scheme (SLS) in April 2008 to improve the liquidity position of the UK banking system. It did so by helping banks finance assets that had got stuck on their balance sheets following the closure of some asset-backed securities markets from 2007 onwards. The Scheme was, from the outset, intended as a temporary measure, to give banks time to strengthen their balance sheets and diversify their funding sources. The last of the SLS transactions expired in January 2012, at which point the SLS terminated. During the period in which the SLS was in operation, the Bank undertook a fundamental review of its framework for sterling market operations and developed a new set of facilities to provide ongoing liquidity insurance to the banking system. This article explains the design and operation of the SLS and describes how that experience has influenced the design of the Bank’s permanent liquidity insurance facilities.
Bank resolution and safeguarding the creditors left behind (88k)
Developments in the global securities lending market (111k)
By Geoffrey Davies and Marc Dobler of the Bank’s Special Resolution Unit.
Not for the first time, the global banking crisis illustrated the vulnerability of banks to a loss of confidence by their depositors, other creditors and counterparties. The experience highlighted the need to have special arrangements for dealing with failing banks — a ‘special resolution regime’ — that provides the authorities with the tools necessary to reduce the systemic risks arising from a bank’s failure while at the same time limiting the taxpayers’ exposure to the costs. The United Kingdom’s own Special Resolution Regime for dealing with failing banks and building societies was borne out of the difficulties in dealing with the failure of Northern Rock in the autumn of 2007.
By Matthew Dive of the Bank’s Payments and Infrastructure Division, Ronan Hodge and Catrin Jones of the Bank’s Financial Institutions Division and James Purchase of the Bank’s Sterling Markets Division.
Securities lending plays an important role in supporting financial markets. For example, it can improve market liquidity, potentially reducing the cost of trading and increasing market efficiency. But by increasing the interconnections between institutions it can pose potential risks to financial stability, which are exacerbated by a lack of transparency in the securities lending market. Since the onset of the financial crisis, market participants have attempted to address some of these risks, and fundamental changes to market infrastructure are being discussed, such as the use of central counterparties. New regulations under way to improve the resilience of the financial system may also impact both the risks to financial stability from securities lending and its benefits.
||The Bank’s money market framework (84k) |
By Roger Clews, Chris Salmon and Olaf Weeken of the Bank’s Sterling Markets Division.
The Bank of England implements the policy stance of the Monetary Policy Committee through its operations in the sterling money markets. It also uses these operations to reduce the costs of disruption to the liquidity and payment services supplied by banks. In order to ensure their continued effectiveness, it was necessary to adapt the framework for these operations in response to the significant changes to financial and monetary conditions that occurred during the recent financial crisis. This article describes how central banks can use their money market operations to implement monetary policy and provide liquidity support to banks and some of the issues that can arise when undertaking operations to achieve these two objectives. The article goes on to explain the Bank’s choices about its own operating framework, including how its thinking has been influenced by the lessons learned during the financial crisis.
||Evolution of the UK banking system (112k) |
By Richard Davies and Peter Richardson of the Bank's Financial Institutions Division and Vaiva Katinaite and Mark Manning of the Bank's Prudential Policy Division.
The financial system provides three key services: payment services, intermediation between savers and borrowers, and insurance against risk. These services support the allocation of capital, and the production and exchange of goods and services, all of which are essential to a well-functioning economy. While the basic financial services are relatively timeless, the characteristics of the system providing them change continuously, in response to both economic and regulatory developments. This article tracks the evolution of a core component of the financial system in the United Kingdom, the banking sector, describing how technology has transformed the economics of banking, and how deregulation in the 1970s and 1980s freed banks to take advantage of new opportunities through globalisation and financial innovation. The result has been the emergence of large, functionally and geographically diverse banking groups. Post-crisis, public-policy attention has been focused on the costs of a banking sector dominated by large and complex institutions that are seen as too important to fail.
||Collateral risk management at the Bank of England (384k) |
By Sarah Breeden, Head of the Bank's Risk Management Division and Richard Whisker of the Risk Management Division.
In response to the financial crisis the Bank of England has expanded the range of collateral accepted in its market operations to include private sector assets, notably asset-backed securities and covered bonds. Such assets have different risk characteristics to the forms of collateral previously accepted, presenting new risk management challenges. This article sets out how the Bank of England undertakes collateral risk management, highlighting in particular the significant degree of protection taken by the Bank in its operations.
||The Bank's balance sheet during the crisis (421k) |
By Michael Cross of the Bank's Foreign Exchange Division, Paul Fisher, Executive Director Markets and Olaf Weeken of the Bank's Sterling Markets Division.
This article sets out how monetary policy implementation and liquidity provision during the financial crisis have affected the size and composition of the Bank of England's balance sheet. It extends and updates a recent speech by Paul Fisher, Executive Director Markets, and describes the main components of the Bank's balance sheet prior to and during the crisis.
||Bank of England Systemic Risk Survey (489k)|
By Sarah Burls of the Bank's Risk Assessment Division.
Earlier this year, the Bank introduced a formal Systemic Risk Survey to supplement its regular dialogue with market participants. The survey is intended to elicit market participants' views about the prospects for financial stability in the United Kingdom. This article introduces the survey and reports the key results, following the summary published in the June 2009 Financial Stability Report.
||The economics and estimation of negative equity (432k) |
By Tomas Hellebrandt of the Bank's Monetary Assessment and Strategy Division, Sandhya Kawar of the Bank's Systemic Risk Assessment Division and Matt Waldron of the Bank's Structural Economic Analysis Division.
Negative equity occurs when the market value of a house is below the outstanding mortgage secured on it. As house prices fall, the number of households in negative equity tends to rise. Between the Autumn of 2007 and the Spring of 2009, nominal house prices fell by around 20% in the United Kingdom . There are no data which accurately measure the scale of negative equity. Three estimates presented in this article suggest that around 7%-11% of UK owner-occupier mortgagors were in negative equity in the Spring of 2009, although for most of those households, the total value of negative equity was relatively small. The effects of negative equity can be painful for those households concerned. Negative equity can also have implications for both monetary policy and financial stability, which are discussed in this article. These effects are likely to depend on developments elsewhere in the macroeconomy and financial system.
Capital inflows into EMEs since the millennium: risks and the potential impact of a reversal (651k)
Recent developments in portfolio insurance (2.2mb)
By Guillermo Felices, Glenn Hoggarth and Vasileios Madouros of the Bank's International Finance Division.
Capital inflows into emerging market economies (EMEs) were at a record level in 2007 and higher than prior to the East Asian and Russian crises a decade earlier. These inflows largely reflect improvements in EMEs' economic and financial strength in recent years. But some EMEs, especially in Central and Eastern Europe, may be vulnerable to a reversal of capital flows if the global credit squeeze is prolonged or global GDP growth falls sharply. This could adversely affect both EMEs and foreign investors.
By Darren Pain of the Bank's Foreign Exchange Division and Jonathan Rand of the Bank's Sterling Markets Division.
The aim of this article is to describe how portfolio insurance works, the main strategies employed and how these have evolved over recent years, and the possible links between their use and financial market stability. The key benefit of portfolio insurance is that it enables financial risk to be distributed among those agents most willing to absorb it. The downside is that it can possibly create conditions for greater fragility in financial markets and leaves issuers of portfolio insurance exposed to potential unexpectedly high losses. It seems unlikely that portfolio insurance-related investments contributed significantly to the financial market volatility that began in Summer 2007. Nonetheless, it is important to keep alert to situations when portfolio insurance could potentially work to amplify financial market instability.
||Costs of sovereign default (506k)|
By Bianca De Paoli of the Bank's Monetary Instruments and Markets Division, Glenn Hoggarth of the Bank's International Finance Division and Victoria Saporta of the Bank's Systemic Risk Reduction Division.
Over the past quarter of a century, emerging market economies (EMEs) have defaulted on their sovereign debts frequently. This article assesses the size and types of costs that have been associated with these defaults. It emphasises that costs, measured by the fall in output, are particularly large when default is combined with banking and/or currency crises. Output losses also seem to increase the longer that countries stay in arrears or take to restructure their debts. The paper concludes with a number of policy suggestions to improve debt crisis prevention and management and the role played by the IMF.
||Financial stability, monetary stability and public policy (151k)|
By Chay Fisher, System Stability Department, Reserve Bank of Australia and Prasanna Gai of the Bank’s Systemic Risk Assessment Division.
The interplay between financial and monetary stability has received considerable attention in recent times, from policymakers and academics alike. This article reviews the broad themes that have emerged in the recent literature and highlights several key issues that merit attention by researchers. In particular, the optimal combination of instruments designed to achieve these twin goals of policy simultaneously remains a relatively underexplored area of research.
||The determination of UK corporate capital gearing (440k)|
By Peter Brierley of the Bank’s Financial Stability area and Philip Bunn of the Bank’s MacroPrudential Risks Division.
This article seeks to explain the high current level of UK corporate capital gearing. It also explores the empirical relationship between gearing and a range of financial characteristics. Analysis of aggregate data suggests that the sharp rise in gearing between 1999 and 2002 cannot all be explained by an increase in its long-run equilibrium level, according to a model where that equilibrium is determined by the trade-off between the tax benefits of debt and the risks of financial distress. There are a number of factors not captured by that model that could have contributed to a sustainable increase in gearing. But on balance it seems that gearing has been above a sustainable level, causing firms to adjust their balance sheets by paying lower dividends and issuing more equity and perhaps by investing less than they otherwise would have done. Analysis of company accounts data suggests that gearing levels are persistent, positively related to company size and negatively correlated with growth opportunities and the importance of intangible assets. In the past, highly profitable companies had low gearing, but this relationship has broken down since 1995 as more profitable firms have increased their debt.
||Perfect partners or uncomfortable bedfellows? On the nature of the relationship between monetary policy and financial stability |
By Chay Fisher of the Bank's Financial Stability Assessment Division and Melanie Lund of the Bank's Centre for Central Banking Studies.
The first annual Chief Economist Workshop, organised by the Bank of England's Centre for Central Banking Studies (CCBS), brought together economists from over 30 central banks. It marked a changing path for the CCBS as it increases its role in providing a forum where central bankers and academics can exchange views on central bank policies and share specialist technical knowledge. The topic for the inaugural meeting was the interplay between monetary policy and financial stability, an issue that has risen to prominence in international debate in recent years.
||The relationship between the overnight interbank unsecured loan market and the CHAPS Sterling system (77k)|
By Stephen Millard and Marco Polenghi of the Bank's Market Infrastructure Division.
This article uses data on CHAPS Sterling transactions to describe the segment of the unsecured overnight loan market that settles within CHAPS. It assesses the size, timing and importance of these transactions for the underlying payments infrastructure. Advances and repayments of overnight loans are estimated to have accounted for around 20% of CHAPS Sterling activity by value over our sample period; four CHAPS Sterling members send and receive virtually all payments corresponding to these loans; and, finally, the value of CHAPS Sterling payments associated with this market rises towards the end of the CHAPS day.
||The macroeconomic impact of revitalising the Japanese banking sector (185k)|
By Katie Farrant and Bojan Markovic of the Bank's International Economic Analysis Division and Gabriel Sterne of the Bank's Monetary Assessment and Strategy Division.
In this article we assess the possible macroeconomic effects of proposals to revitalise the banking system in Japan. Our analysis is supported by a theoretical model that incorporates various interactions between the banking sector and the wider economy. In the long run, a planned reduction in the ratio of non-performing loans (NPLs) to total loans and the intended fall in the risk premium faced by Japanese banks may help to boost the level of investment. Achieving a revitalised banking system cannot be done costlessly, however, and our model suggests that there may be some negative short-run macroeconomic impact as credit growth is reduced.
Financial stability and the United Kingdom's external balance sheet (170k)
By Mhairi Burnett of the Bank's Monetary and Financial Statistics Division and Mark Manning of the Bank's Domestic Finance Division.
This article, one in an annual series, examines the United Kingdom's financial transactions with the rest of the world, paying particular attention to the implications for financial stability. In recent years, the United Kingdom's stocks of external assets and liabilities have increased considerably, and each now exceeds £3.5 trillion. This is three times UK GDP and around a third of the United Kingdom's total financial assets. The monetary financial institutions (MFI) sector accounts for approximately half of the external balance sheet, reflecting both the international orientation of UK-owned banks and the cross-border activities of foreign-owned UK-resident banks. The article begins with a conceptual discussion of how external positions might affect financial stability, before turning to recent developments. The principal focus is on the MFI and private non-financial corporate (PNFC) sectors, in which the largest external positions exist. The discussion draws upon data from a variety of sources, including the Pink Book, sectoral financial balance sheets, the Bank of England and the IMF.
||Balance sheet adjustment by UK companies (104k)|
By Philip Bunn and Garry Young of the Bank's Domestic Finance Division.
Corporate debt levels in the United Kingdom are currently at an historically high level in relation to the market value of corporate capital. Empirical evidence discussed in this article suggests that this is unlikely to be an equilibrium position and that companies will continue to act so as to strengthen their balance sheets. Much of this adjustment is likely to occur through financial channels, such as reduced dividend payments or increased new equity issues, but it could also occur through more restrained capital investment. Illustrative simulations presented in the article suggest that adjustment tends to be gradual and that it may take several years for balance sheets to return to equilibrium.
||A review of the work of the London Foreign Exchange Joint Standing Committee in 2002 (50k)|
This note reviews the work undertaken by the London Foreign Exchange Joint Standing Committee during 2002.
||Financial pressures in the UK household sector: evidence from the British Household Panel Survey (85k)|
By Pru Cox, John Whitley and Peter Brierley of the Bank's Domestic Finance Division.
Household indebtedness has risen rapidly in relation to incomes in recent years. But aggregate data cannot indicate which types of households-by age, income or wealth-have accumulated the most debts. This article uses information from the latest British Household Panel Survey (for the year 2000) to provide some evidence on that issue. The survey suggests that debt-to-income ratios vary widely across households. The youngest and lowest - income households increased their debt-to-income ratios by most-and from the highest levels - between 1995 and 2000. But the households with the highest absolute levels of debts tended also to have the highest incomes and net wealth in both years. A large proportion of this wealth was held in housing assets. Such households did not, however, hold substantially more liquid assets than less indebted households. Although households were relatively sanguine about their higher levels of debt, that confidence could be eroded if circumstances deteriorated. Overall, changes in the distribution of household debt in recent years suggest that the household sector may be somewhat more vulnerable to an adverse shock than the aggregate measures indicate.
The external balance sheet of the United Kingdom: recent developments (98k)
By Robert Westwood of the Bank's Monetary and Financial Statistics Division and John Young of the Bank's Domestic Finance Division.
The external balance sheet (or international investment position) gives the most complete picture of the stock position of a country in its financial transactions with the rest of the world. The very breadth of coverage of the data leads inevitably to problems of measurement and valuation. Nevertheless, subject to certain qualifications, the data can throw some light on macroeconomic and financial stability issues related to the United Kingdom's cross-border financial links. This article, one in an annual series, discusses the recent evolution of the United Kingdom's external balance sheet, reviewing along the way some of the main methodological issues that impinge on an interpretation of the data. It concludes that, despite a persistent current account deficit, the balance of probability is that the United Kingdom still has net external assets, or at least the capacity to generate net investment income from overseas. There are also some grounds for optimism that the structure of its assets and liabilities has left the United Kingdom in a fairly strong position to withstand financial shocks.
||The balance-sheet information content of UK company profit warnings (67k)|
By Allan Kearns and John Whitley of the Bank's Domestic Finance Division.
This article looks at the information content of profit warnings issued by UK private non-financial companies over the period 1997-2001 in relation to measures of their profitability and balance-sheet strength. It finds that profit warnings are associated with a persistent fall in profit margins and that this decline in margins is larger than for companies who do not issue warnings. The article also finds that profit warnings contain incremental information for other balance-sheet variables: those firms who issue warnings are also more likely to see their gearing levels rise, and investment and dividends fall, than other firms whose profit margins also fall but who do not issue a warning.
Money and credit in an inflation-targeting regime (85k)
By Andrew Hauser and Andrew Brigden of the Bank's Monetary Assessment and Strategy Division.
This article is one of a series on the UK monetary policy process. It discusses how the assessment of money and credit data fits into the Bank's quarterly forecast round. Monetary statistics are available more rapidly than most other economic data and provide early information on the near-term economic outlook. The analysis on money and credit might be used to adjust some output of the Bank's macroeconometric model. It could also help the MPC to assess the risks around its central projections, reflected in the inflation and GDP fan charts.
International Financial Architecture: the Central Bank Governors' Symposium 2002 (63k)
The Central Bank Governors' Symposium 2002 examined the architecture of the world's financial system. Horst Koehler, Managing Director of the IMF, and the Bank of England's two Deputy Governors at the time, David Clementi and Mervyn King, gave the main addresses. This article summarises what they said. It also gives a precis of eight background papers provided for the occasion. Taken together, these eleven contributions explore general aspects of the international financial architecture, as well as discussing how financial crises may be contained or prevented, and best resolved when they do occur.
||Credit channel effects in the monetary transmission mechanism (97k)|
By Simon Hall of the Bank's International Finance Division.
Economic models often assume for simplicity that the impact on the wider economy of changes in financial conditions can be summarised by a relatively limited set of financial variables, such as short-term risk-free interest rates and long-term government bond rates. However, financial developments can, at times, have important effects on the economy, which these variables would not necessarily indicate. For example, following the suspension of debt payments by Russia in the summer of 1998 and the emergence shortly afterwards of problems at the hedge fund Long Term Capital Management (LTCM), interest rates on corporate debt rose relative to rates on government debt, and a number of central banks reduced official interest rates to mitigate possible effects on spending in the wider economy. In practice, policy-makers take account of a wide range of information on conditions in financial markets to monitor, and potentially respond to, these sorts of developments.
This article reviews potential theoretical explanations for two features of finance provision—the apparent preference by many borrowers to finance spending using own funds, and for many of those who do borrow, to rely on bank rather than capital market finance. These so-called 'credit channel' models help to explain why borrowers' financial positions might affect their spending, and why shocks to banks can have a marked impact on borrowers that are particularly dependent on bank finance. As such, these models illustrate some important interactions between the monetary and financial stability objectives of central banks and highlight the need for policy-makers to monitor a wide range of financial indicators.
In practice, banking system distress and significant disruptions to bank loan supply are relatively rare in developed banking sectors, as in the United Kingdom. As such, bank lending credit channel effects may be relatively infrequent. Balance sheet credit channel effects probably play a more continuous role in the economy, but they too will likely vary in strength over time, reflecting structural changes in the financial system and cyclical fluctuations in borrower financial health. This article focuses on a representative model of balance sheet effects. Two other articles in this Bulletin use the framework of this model to show how credit channel effects may affect spending in the UK corporate and household sectors.
||Bank capital standards: the new Basel Accord (78k) |
By Patricia Jackson of the Bank's Financial Industry and Regulation Divison.
The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.
On 16 January 2001 the Basel Committee released a consultation package setting out the details of the new Accord. The Bank of England and Financial Services Authority jointly represent the United Kingdom on the Basel Committee. Comments are requested by the end of May and the Committee is expecting to release the final version of the Accord by end-2001 for implementation in 2004. A parallel consultative process is also operating at the EU level. A directive to implement the Basel proposals in the EU, which will cover both banks and investment firms, is also due to take effect from 2004.
The 1988 Accord was based on broad credit risk requirements, although it was amended in 1996 to introduce trading-book requirements as well. The proposed new Accord has three pillars: Pillar 1 will set new capital requirements for credit risk and an operational risk charge; Pillar 2 will require supervisors to take action if a bank's risk profile is high relative to capital held; and Pillar 3 will require greater disclosure from banks than hitherto to enhance market discipline.
The new credit risk requirements will be much more closely tied to the riskiness of particular exposures. In order to set such risk-based requirements the Committee had to consider a wide range of issues regarding the determinants of credit risk. This article sets out the background to the proposed changes and some of the issues that arise.
International financial crises and public policy: some welfare analysis (64k)
By Michael Chui, Prasanna Gai and Andy Haldane of the Bank's International Finance Division.
During the 1990s, a number of emerging market economies experienced well-publicised financial crises: Mexico in 1994/95; South East Asia during 1997; Russia in 1998; and, most recently, Brazil in 1999. On some estimates, the frequency of financial crisis has increased since the 1980s. For example, the World Bank documents 69 instances of 'systemic' crisis since the late 1970s. These crises have afflicted developed and developing countries alike.
There have been a number of recent attempts to measure the output costs of these crises—either the direct fiscal costs (such as the cost of recapitalising banks), or the indirect opportunity costs (of below-trend growth) associated with crisis. These cost estimates are large, often lying between 10% and 20% of annual pre-crisis GDP. The GDP contractions are also often protracted, averaging—on some estimates—more than four years for industrial countries and around three years for emerging economies.
The cost and frequency of financial crises suggests that crisis prevention and crisis resolution are major international public policy concerns. In recent years, this has been reflected in a debate on what has become known as the reform of the 'international financial architecture'. There are many facets of this debate. What are the causes of financial crisis? What public policy measures best address these frictions? And what are the welfare implications of crisis and of different approaches to dealing with them?
This article describes a model of financial crisis and explores its implications for public policy. The framework nests the key features of earlier models but is better able to address international architecture questions in a welfare setting. In particular, this framework is used to assess the welfare costs of creditor coordination failure and several recent public policy proposals on reforming the international financial architecture. The costs of creditor coordination failures are found to be high. But policies that improve sovereign liquidity management or that stall creditor runs—such as payments standstills—can mitigate these costs.
Analytical models can be useful in assessing public policy means of preventing and resolving crisis. They allow quantified, welfare-based policy analysis. This article has outlined one particular model of crisis and used it to explore the welfare costs of crisis and the implications of certain policy measures to resolve crisis. Future research might usefully consider relaxing some of the more restrictive assumptions in the model. First, we assume that the quantum of debt and the form of the debt contract is fixed in advance. Debt size and debt structure might be affected importantly by some of the public policy measures considered here. Second, the model uses a simple measure of welfare and side-steps difficult issues about the distribution of gains and losses between different parties. Third, only a sub-set of the myriad policy proposals currently on the table are considered here. It would be useful to explore these and other extensions in a quantitative, welfare-theoretic, setting.
Central banks and financial stability (64k)
Safeguarding financial stability is a core function of the modern central bank, no less than market operations and the conduct of monetary policy. This is evident from the detailed survey of central banks, drawn from a wide variety of industrial, transition and developing countries. For those central banks that have never acted as regulator or supervisor of financial institutions, and for those that have recently shed these roles, financial stability responsibilities may be shared with other agencies, but the central bank is still very much in the game. This is particularly true in circumstances where bank failure would pose systemic risk. Threats to financial stability may arise from many sources, including excessive competition or overcrowding in the banking sector, misguided or misapplied regulation or lending to troubled institutions, undue forbearance, and currency crises. Financial stability impinges upon monetary policy and reacts to it. There are therefore powerful arguments for retaining responsibility for both within the central bank.
By P J N Sinclair, Director, Centre for Central Banking Studies.
Each year the Governors of many central banks are invited to the Bank of England for a symposium. The subject this year was financial stability. This article is based on Financial Stability and Central Banks, a written report presented to the 2000 Central Bank Governors' Symposium, which, among other things, analyses the results of a survey of central banks, outlining the scope and diversity of their financial stability activities. The article goes on to discuss financial crises and the morbidity of banks, the trade-off between competition and safety in the financial system, the international dimension to financial crises, the many links between financial stability policy and monetary policy, and the nature of the work of those charged with safeguarding financial stability.
Stock prices, stock indexes and index funds (50k)
By Richard A Brealey, special adviser to the Governor on financial stability issues.
In recent years, many UK investors have given up the quest for superior performance and have instead simply sought to match the returns on some broad market index. This has led to the suggestion that the growth in index funds has depressed the stock prices of those companies that are not represented in the index and has thereby increased their cost of capital. This effect may have been accentuated by the actions of fund managers, whose performance is compared with that of a market index and so who also have an incentive to avoid those stocks that are not included in the index. This paper argues that, in practice, these price effects are likely to be very small. In support of this view, the paper examines the price adjustments that occur when a stock is added to, or removed from, a stock market index.
Accumulating evidence that active portfolio managers do not achieve consistently superior performance has led to a rapid growth in index funds with low turnover and reduced management costs. For the most part, these funds track the performance of major market indexes and therefore tend not to be invested in the stocks of very small firms. This growth in index funds has forced active managers to hold a higher proportion of small-firm stocks than they otherwise would and, since they need to be induced to do this voluntarily, the expected return on these stocks must rise. This article argues that the portfolio adjustments forced on active managers are in practice very small and, since small-firm stocks are fairly good substitutes for large-firm stocks, the effect of index funds on required returns is likely to be no more than several basis points.
If market indexes are used as benchmarks for measuring the performance of professional active managers, then index stocks become effectively riskless for these managers and they need to be induced to hold the remaining stocks. Unlike index-fund managers, these active managers are not totally averse to holding non-index stocks, and so the incremental effect on prices of benchmarking is likely to be less than if these funds were formally indexed.
Most empirical studies of the effect on prices of index composition cannot distinguish the effect of index funds from that of benchmarking or possible information effects. One such study suggests that membership of the S&P index has had a substantial effect on prices in recent years, while another finds that flows into index funds have also had a marked cumulative price effect. However, it is difficult to reconcile these results with studies of the effect of additions or deletions to the index. In the United States these have typically found a price impact of around 3%, which would imply a shift in required returns of a few basis points. Our sample of changes to the FTSE All-Share and FTSE 100 indexes from 1994 to 1999 indicated that in both cases an addition to the index resulted in a negligible rise in price. Deletions, however, were associated with an eleven-day cumulative abnormal return of -4.5% for All-Share stocks and -2.0% for the FTSE 100 index. If permanent, these returns suggest that index deletions result in a small increase in the required return on equity for the affected firms. However, the fact that abnormal returns are observed for both indexes suggests that the effect is not simply due to the growth of index funds or performance benchmarking.
||Financial sector preparations for the Year 2000 (17k)|
By the Year 2000 team of the Bank's Market Infrastructure Division.
Since early in 1998, the Bank of England has been publishing regular progress reports on the preparations of the UK financial sector for the Year 2000. Since these reports began, awareness of the technical and business issues relating to the Year 2000 problem has grown significantly, and most technical remediation and testing work in the UK financial sector has been completed.
With much work already undertaken on planning for the Millennium weekend itself, and on contingency arrangements to ensure continued operation of the financial infrastructure in the unlikely event of any major problems, there is now a high level of confidence within the sector that it will be able to maintain 'business as usual'. But it is important not to relax efforts to plan for the Millennium, and the extent of continuing work in the sector suggests that this is well understood. All financial sector infrastructure providers and participants are, to a greater or lesser extent, dependent on the preparedness of others, both inside and outside the sector, in the United Kingdom and abroad. This is a major aspect of risk mitigation and contingency planning work, and reinforces the need for good communication between individual firms, public and private sector bodies, and the public. It is important that this work continues and that vigilance does not slip, in the knowledge of all the work that has already been done.
||Testing value-at-risk approaches to capital adequacy (643k) |
By Patricia Jackson and William Perraudin of the Bankís Regulatory Policy Division and David Maude of the Bank's Monetary Assessment and Strategy Division.
This article looks at the nature of whole-book value-at-risk models, and describes how the Bank of England set out in 1995 to assess their performance in accurately predicting risk and in providing a basis for reliable trading-book capital calculations.
The article sets out the results of the tests carried out by the Bank to assess the accuracy of the risk-measurement models used by firms to evaluate risk on their trading-book portfolios. The main conclusions from these tests were as follows:
- Different VaR models performed more or less well in supplying unbiased measures of the value at risk. (For some VaR models built with a 99% confidence level, significantly more than 1% of losses exceeded the value-at-risk estimate.)
- Simulation-based VaR models met this test better than parametric VaR models based on normal distributions, because of the severely fat-tailed nature of reasonably diversified fixed-income exposures. Most banks' trading books are made up largely of such exposures.
- Use of short data samples (or a weighting scheme that places heavy weight on recent data) worsened the biases in the VaR estimates for parametric models.
- The extra safeguards around the use of the VaR models (the requirement that a firm must meet the higher of the estimated VaR, or three times the 60-day moving average of the current and past VaRs) would probably mean, for market-risk models of the kind tested, that only extremely risky portfolios would fail to be covered by sufficient capital.
- The back-testing requirements incorporated in the Basel approach are likely to lead to some banks holding higher capital. A bank holding the portfolios employed in the study could find its capital requirements adjusted upwards from time to time if it used the parametric approach.
||Financial Stability Review-a profile of the new publication (9k)|
The Bank, in association with the Securities and Investments Board, launched a new publication, the Financial Stability Review, at the end of October. The Review will highlight developments, whether in the United Kingdom or overseas, which might affect the stability of the financial system. It will also promote the latest thinking on risk, regulation and market institutions, as well as providing a forum in which ideas about regulatory change can be debated dispassionately.
Regulating investment business in the Single Market (39k)
The developing Single Market in financial services (27k)
By Professor Richard Dale.
Examines the regulatory framework for investment business put in place by the Capital Adequacy and other Directives, focusing on the attempt to establish a level playing-field for banks and other financial institutions. The article is the second in an occasional series - begun in the May Bulletin - of pieces by contributors from outside the Bank.
Summarises the views, outlined in discussions with the Bank, of a range of financial sector firms on the development to date of the Single Market in that sector.