Summary of Quarterly Bulletin
Spring 2001

The Kohn report on MPC procedures (80k)
Report to the non-executive Directors of the Court of the Bank of England on monetary policy processes and the work of Monetary Analysis, prepared by Donald L Kohn on 18 October 2000. Followed by the Bank of England response to the Kohn Report (32k)

Bank capital standards: the new Basel Accord
(78k)
(by Patricia Jackson of the Bank's Financial Industry and Regulation Division).
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.

The financing of technology-based small firms: a review of the literature (143k)
This review assesses the academic literature of recent years on the financing issues faced by technology-based small firms (TBSFs). It was produced as part of the latest report on these firms by the Bank's Domestic Finance Division, published last month. This report finds that, while there may still be market weaknesses in the provision of relatively small amounts of risk capital to TBSFs at the start-up and early stages, these appear to be less than four or five years ago, and to impact on TBSFs less than was the case then. Peter Brierley, Head of Domestic Finance Division, explains why the literature suggests that market imperfections in the provision of finance to small companies may apply with particular force to the start-up and early-stage financing of TBSFs, but concludes that there is little compelling evidence of a major market failure.

Technology-based small firms (TBSFs) are generally defined either as businesses whose products or services depend largely on the application of scientific or technological knowledge, or as businesses whose activities embrace a significant technology component as a major source of competitive advantage. These businesses are generally located in industries such as communications, IT, computing, biotechnology, electronics and medical/life sciences.

Earlier work at the Bank suggested that there might be some inefficiencies in the market for financing TBSFs, especially at the start-up and early stages of finance. Recent official enquiries in this area have focused in particular on possible barriers that high-tech companies in the United Kingdom might face in attracting finance. The profile of this work has been enhanced by the current Government's desire to encourage 'entrepreneurship', by growing interest in the 'new economy', and by the swings in investor sentiment towards high-tech stocks over the past two years.

These factors have motivated a new Bank report on the financing of TBSFs, which was published on 5 February. As background to this report, an extensive review of the economic literature on the financing of TBSFs has been undertaken, the results of which are summarised in this article.

Measuring interest accruals on tradable debt securities in economic and financial statistics
(82k)
(by Chris Wright of the Bank's Monetary and Financial Statistics Division).
This article reports a current methodological debate about the way in which interest flows are recorded in a variety of macroeconomic statistics. When new international statistical standards were published in 1993, one of the major changes to the recommended presentation of the System of National Accounts and the Balance of Payments was the adoption of accruals recording for income and expenditure. However, as countries have begun to implement these standards, questions have been raised about their exact interpretation in respect of interest flows associated with tradable debt.

In essence, the issue is how to measure the property income from a fixed-term debt security on which the cash flows are fixed but whose market value is free to vary. Two methodologies in particular are under scrutiny: the first views the accruing interest income as fixed over the life of the security, once the issue price and conditions of future cash flows are known; the second takes the view that there is no a priori way of determining what proportion of the future payments stream represents interest and what proportion principal. Under this view the income stream is fixed only for so long as market conditions are constant after issue. Following any change in conditions that results in a change in the value of the security, a new future income profile is established.

Choosing between these alternatives raises some profound conceptual and practical questions. At one level, these concern the accounting rules required for coherence within the National Accounts. At a second level, the issues concern the practical implications of a change in terms of both data collection and interpretation. National accountants and government finance statisticians in the United Kingdom, and most other countries, adopted the first of the two methodologies when implementing the new standards. Moving to the alternative methodology would have consequences for recorded interest flows within the accounts, in turn leading to different profiles for national and sectoral saving and deficits, including the general government surplus/deficit.

This article reviews these alternatives and concludes in favour of the second approach. It is a summary of a longer discussion document, commissioned by the International Monetary Fund (IMF). The full paper looks separately at the principles of accruals accounting; the conditions for coherence within the National and Sector Accounts; measurement problems; and the implications for users, particularly in the area of government debt management. The present shorter text aims to give sufficient flavour of the central arguments to indicate why this is an important issue for users of macroeconomic statistics, and the reasons for recommending a change of practice.

Research work published by the Bank is intended to contribute to debate, and does not necessarily reflect the views of the Bank or of MPC members.

Saving, wealth and consumption (98k)
(by Melissa Davey of the Bank's Structural Economic Analysis Division).
Since the mid-1990s the UK household saving ratio has fallen substantially, recently reaching its lowest level since the late 1980s. A key influence has been the large increase in the value of wealth, driven by rises in both equity and house prices, which is likely to have reduced households' incentive to save.

This article discusses the various forms of household saving and their determinants, and discusses the interactions between saving, wealth and consumption.

The first section of this article shows that the fall in the saving ratio has been associated with rising borrowing, including mortgage equity withdrawal, which tends to be related to increases in housing wealth. The second section looks at capital gains and losses, and how these can be considered as part of wider income and hence affect the level of saving. The third section discusses how the sources and composition of wealth gains may affect the response of consumption and saving.

Mortgage equity withdrawal and consumption
(68k)
(by Melissa Davey of the Bank's Structural Economic Analysis Division).
Mortgage equity withdrawal is borrowing that is secured on the housing stock but not invested in it, so it represents additional funds available for reinvestment or to finance consumption spending. Mortgage equity withdrawal was an important source of finance in the 1980s. But it fell back sharply in the 1990s, and remained negative for much of the decade. This article discusses the motivation for and the effects of mortgage equity withdrawal, using evidence from a recent consumer survey carried out for the Bank of England and the Council of Mortgage Lenders.

The first section outlines how the Bank calculates aggregate mortgage equity withdrawal, and explains the relationship between this aggregate measure and other macroeconomic variables. The second section outlines the results of a microeconomic study of the various ways in which households can withdraw equity. The third section reports the results of a recent MORI survey, which investigates how equity is withdrawn, what it is spent on and why this method of finance was used.

The information in UK company profit warnings
(69k)
(by Andrew Clare of the Bank's Monetary Instruments and Markets Division).
A wide range of indicators of UK economic activity is available. One relatively new indicator is a time series of 'profit warnings' issued by UK companies. These profit warnings are trading statements that have been reported in the press identifying an adverse outlook for a firm's future earnings and profitability. Bank staff recorded 88 UK company profit warnings in 2000 Q4, compared with 57 in 1999 Q4.

This article examines the information content of trading statements issued by UK companies between 1994 and 2000. The article summarises work undertaken at the Bank aimed at establishing: whether these statements contain genuine information; which types of statement are most informative; and whether the incidence of the statements can tell us anything about the state of the UK economy.

It appears that statements reporting an adverse outlook for the future prospects of the firm ('profit warnings') do contain market-relevant information, causing financial agents to revise expectations about future profitability dramatically. Statements reporting a positive outlook for future profits tend to have a much smaller (though still significant) impact upon prices—implying that the information content of these statements is lower. There is also some weak and preliminary evidence that the incidence of negative trading statements issued by FTSE 350 companies may be a leading indicator of UK economic activity.

Interpreting movements in high-yield corporate bond market spreads (162k)
(by Neil Cooper, Robert Hillman and Damien Lynch of the Bank's Monetary Instruments and Markets Division).
Spreads of corporate bond yields over risk-free rates are often used as a leading indicator of macroeconomic conditions. The large widening of spreads within the US high-yield bond market during the second half of 2000 might be a precursor of a downturn in the US economy.

Credit spreads in the United States widened considerably during 2000, particularly in the high-yield bond market. Even indices of single-A and AA rated bonds widened in the last few months of the year. By contrast, with the exception of telecoms bonds, there was little evidence of widening in UK credit spreads. In this article we explain why US spreads widened, and assess the implications for the US macroeconomic outlook.