Summary of Quarterly Bulletin
November 2000

Research work published by the Bank is intended to contribute to debate, and is not necessarily a statement of Bank policy.

Economic models at the Bank of England (96k)
In April 1999, the Bank of England published Economic models at the Bank of England, a book that described the economic modelling tools that help the Monetary Policy Committee (MPC) in its work. It was made clear at the time that economic models should not be thought of as fixed in form or content, and that model development is a continual process. An update to the book was published in September 2000 covering model developments over the past 18 months, particularly in relation to the Bank's main macroeconometric modelling tool. The update, while giving details of the core macroeconometric model, also refers to other work within the Bank that has added to the range of models used by the MPC.

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)
(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.

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.

Inferring market interest rate expectations from money market rates (192k)
(by Martin Brooke of the Bank's Gilt-edged and Money Markets Division, and Neil Cooper and Cedric Scholtes of the Bank's Monetary Instruments and Markets Division).
The Bank's Monetary Policy Committee (MPC) is interested in financial market participants' expectations of future interest rates. Knowledge of such expectations helps the MPC to predict whether a particular policy decision is likely to surprise market participants, and what their short-term response is likely to be to a given decision. Expectations of future levels of official rates also play a key role in determining the current stance of monetary policy. The Bank implements the MPC's monetary policy decisions by changing the level of its two-week repo rate which, in turn, influences the levels of other short-term money market interest rates. However, many agents in the economy are also affected by changes in longer-term interest rates. For instance, five-year fixed-rate mortgages are typically priced off the prevailing rates available on five-year swap contracts, and larger firms often raise finance in the capital markets by issuing long-maturity bonds. Changes in these longer-term interest rates depend to a considerable extent on expectations of future official rates. So the Bank needs to have some understanding of expectations of future policy rates, in order to monitor and assess changes in current monetary conditions.

Forward rates are the most commonly used measure of interest rate expectations. In principle, we want to derive forward rates that correspond to future two-week Bank repo rates. Unfortunately, however, there is no instrument that allows us to do this exactly. So we have to estimate forward rates from the sterling money market instruments that are actually traded.

This article argues that first, forward rates estimated from money market instruments are biased estimates of expectations of future Bank repo rates because of term, credit and liquidity premia, as well as contract specification differences. And second, no particular money market instrument is likely to provide a 'best' indication of Bank repo rate expectations at all maturities. The spreads between the Bank's two-week repo rate and the instruments used to estimate our market curves are volatile and so we cannot expect to get a result that is common across all instruments. Reflecting these considerations, the Bank estimates two forward curves: one employing GC repo and gilt data and one that uses a combination of sterling money market instruments that settle on Libor rates. A number of simple ready-reckoner adjustments can be applied to the two estimated forward curves in an attempt to transform them into an estimate of a forward curve equivalent to two-week Bank repo rates. First, the GC repo/gilt forward curve needs to be adjusted up by around 15 basis points and the bank liability curve adjusted down by around 20 basis points. After these changes we still need to consider the impact of term premia effects. Preliminary estimates suggest that this would require us to make a further downward adjustment to both curves beyond a six-month horizon. However, we currently have limited information on the size of the term premia that create biases in forward curves even after we have taken into account estimates of credit and liquidity premia.