Financial Stability Review
Themes and Issues, Issue 12
27 June 2002
Issue
12 June 2002 - Themes and Issues (Full Article)
(521k)
Over the past five years or so, the international financial system has faced an extraordinary sequence of shocks: the 1997-98 Asian crises, the Russian default and LTCM's collapse in 1998, the 1999 Brazilian crisis, the TMT bubble, the terrible disruption to Wall Street firms and infrastructure on 11 September; and, most recently, the largest ever sovereign and corporate bankruptcies, Argentina and Enron. Throughout, the financial system - in the UK, and internationally - has proved resilient, perhaps remarkably so. Why? This issue of the Financial Stability Review explores some of the reasons, as well as some continuing challenges facing the system.
The past five years have also seen significant developments in the way financial authorities - in the UK and internationally - assess and address threats to financial stability. In 1997, the Bank gained operational independence for monetary policy and the Financial Services Authority was created as a unified regulator of UK financial services. In addition to adjusting to its new monetary role, the Bank reconfigured its work on financial stability, which has traditionally been, and remains, a core part of its central banking mandate. Greater transparency was given to the Bank's view of financial stability risks by introducing a Conjuncture and Outlook assessment article into this Review, while at the same time devoting more space to reporting research. Both reflected shifts in the balance of the Bank's financial stability work, which is organised around three broad areas: surveillance of risks to the financial system; development of policies for strengthening the system; and preparing, so far as possible, for effective crisis management. This issue of the Review reports several pieces of work under the first heading.
The framework for the Bank's assessment of risks to stability has been developed around a few basic ideas. First, that it is important to distinguish between shocks to the system (eg an equity market fall or a wave of credit defaults) and the system's capacity to absorb them, reflecting such factors as capital resources and liquidity; second, that a distinction should be made between the probability of a shock to the financial system and its impact; and third, that a distinction should be made between the direct impact of a shock (say, on a particular firm which suffers a loss, or on a particular part of the infrastructure) and the wider consequences for the system as a whole through spillovers and contagion. In very broad terms, this approach calls for a careful analytical separation between: identifying any material imbalances in the macroeconomic or financial market environment that could give rise to abrupt rather than gradual adjustments; vulnerabilities in financial firms, markets or infrastructure which may render them unusually susceptible to shocks, or to self-fulfilling problems (eg liquidity runs on account of an overdependence on very short-term debt); and links between different parts of the economy or financial system which could cause problems in one part to be transmitted to others. The three articles in this Review tackle elements of this work programme.
The article by Andrew Gracie and Andrew Logan can perhaps best be regarded as a background piece to the Conjuncture and Outlook assessment. It dissects the data sources used by the Bank to analyse the UK banking sector's on-balance-sheet exposures - within the UK, overseas, and to other parts of the international financial system. None of them was designed specifically with aggregate system surveillance in mind, but individually and collectively the three key sources - the monetary statistics, cross-border banking exposures data, and regulatory returns - can be used to explore a fair proportion of the relevant issues. Precisely how they fit together and what they can and cannot sensibly be used for is not straightforward, and so Gracie and Logan's article is a contribution to an international debate on data for banking system analysis.
The article by Glenn Hoggarth and Darren Pain, reporting research by Pain due to be published in full later in the year, explores how macroeconomic shocks have in the past affected the asset quality of UK banks, as manifested in published provisions against bad or doubtful debts. Following the article in the December 2001 Review by Benito, Whitley and Young on producing forward-looking projections of key indicators of corporate and household sector financial health, it represents a further step in the Bank's efforts to complement its qualitative assessment of risks to UK financial stability with more quantitative work.
The third article, by Simon Hall and Ashley Taylor, asks under what circumstances a problem in one emerging market economy might spill over into others. They focus, in particular, on practical measures of two potential channels of contagion: trade links and the extent of dependence on common bank creditors. The area is, however, immensely complex. For example, notwithstanding channels through which contagion could have occurred, Argentina's defaults did not prove systemic, probably because its problems were signalled sufficiently far in advance for financial market participants to adjust their exposures smoothly. The knock-on effects from Enron's failure may have been modest for similar reasons. Other possible explanations of the system's recent robustness include the capital accumulated by financial firms during the late 1990s and improvements in risk management. Both are discussed in the assessment article, which as usual opens the Review.
Key Resources
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Memorandum of Understanding between HM Treasury,
the Bank of England and the Financial Services Authority
Download PDF (50k) |
