History shows that there are two things we can be sure of when it comes to financial crises: there will be another one, and the next one won’t be the same as the last.
That’s a big problem because they can be very damaging.
A financial crisis causes so much harm because people rely on financial institutions every day: banks provide debit cards so we can pay for things more easily; pension providers help us plan for the future; and insurance companies provide cover in the event that our belongings are damaged, lost or stolen.
When a crisis hits, the after-effects can be felt for many years after. Looking at various examples throughout history, one estimate places the total economic cost of a typical financial crisis at around 75% of GDP. That’s equivalent to £21,000 for every person in the UK.
Take the 2007-08 financial crisis, which was one of the most severe ever seen. Some financial markets effectively closed. Others were so badly damaged that businesses and households were unable to get the finance they needed. As a result the UK economy suffered the deepest recession since the Second World War.
That led to a real impact on wages, jobs and access to credit for people across the country.
Increase in the number of people without jobs.
Fall in wages below 2007 levels.
Ground to a complete halt.
Where will the next financial crisis come from?
History tells us there are many different causes of crises – some more bizarre than others.
For example, in 1636, “tulip mania” took hold in the Netherlands. As the price of tulip bulbs went up and up, it is said that people spent their life savings to buy them. But this craze came to an abrupt end and the price of tulips crashed, causing huge losses and a slowdown in the Dutch economy.
No one can say where the next crisis will come from.
But what we do know is that the next crisis will be different from past crises: history may rhyme, but it rarely repeats.
How is the financial world different today?
The way we look after the financial system has changed.
To reduce the chances of a crisis occurring, it is now the Bank of England’s job to:
Ensure that individual banks have sufficient financial resources - in good times as well as bad.
Entire financial system
Scan the entire financial system as a whole for risks.
What is stress testing?
The Bank also carries out “stress tests”. These involve looking at a range of “what if” scenarios – such as a sudden downturn in economic conditions – and checking that banks would be able to cope.
Bank of England's explainer on stress-testing.
Hi my name is Noor and I work at the Bank of England. Here at the Bank of England, we need to keep an eye on how banks would cope with difficult economic situations. We do this by stress testing banks, against various hypothetical scenarios. The Bank of England then ensures that should these situations occur, banks hold sufficient capital to meet unexpected losses.
From 2016, we will use two ‘what if’ scenarios to test banks. The first will be a yearly test of shock scenarios of different levels of severity, based on the UK current economic cycle. The annual cyclical scenario could include falls in output or house prices or increases in interest rates or unemployment. The second will be an exploratory scenario every two years. This scenario will look at risks that are unlikely to happen but are still a concern, for example what might happen if a large bank fails. Banks have always been required to hold a minimum amount of capital to absorb losses, but from 2016 how the Bank of England looks at stress test performance is changing. With larger and more risky banks needing to carry more loss absorbing capital.
Should a bank not perform satisfactorily, the Bank of England has a range of powers, such as requiring the bank to take action to strengthen its capital position within a certain period of time.
There have been other important changes, too.
In the event that a large commercial bank did go bust today, the Bank of England now has the powers to deal with the situation in an orderly way. Crucially, there would no longer be a need for the UK government to bail-out a failing bank at the expense of taxpayers. We also require banks to prepare for their own failure so we can use our powers as quickly and effectively as possible.
What does the future have in store?
The vote to leave the European Union in June 2016 led to a lot of uncertainty surrounding the future of the UK’s trading arrangements. The Bank of England cut interest rates and announced other measures to increase the amount of spending in the UK economy, which in turn will boost employment and wages.
The leave vote jolted financial markets but we have made sure that banks now have substantial financial resources to help them weather this and any future storm.
So the system is much safer today than it was in 2007-08.
But no one can prevent crises from ever taking place again.
It is the Bank of England’s role to monitor and assess the risks that are out there and to use the tools it has at its disposal to maintain a stable financial system.