Tag: Bank of England

Central Counterparties and the Too Big to Fail Agenda

In a speech by Andrew Gracie, Executive Director of Resolution of the Bank of England, at the 21st Annual Risk USA Conference, he outlines some of the elements in the Too Big To Fail (TBTF) resolution agenda. The aim is to ensure that in the event that a global systemically important financial institution (G-SIFI) fails there is minimal interruption of the activities of a firm that are critical to the functioning of the broader financial system. And achieving that outcome without recourse to taxpayer bailouts, as public authorities were forced to during the crisis.

He says that progress in developing a new paradigm for global systemically important banks (G-SIBs) has been impressive. Key Attributes of Effective Resolution Regimes for Financial Institutions1 were agreed by G20 leaders around this time four years ago. Statutory regimes consistent with this standard are now in place in the US, EU and Japan – in fact in all but a handful of jurisdictions where G-SIBs are headquartered. Crisis Management Groups (CMGs) have been working on resolution plans for each of the G-SIBs. The authorities participating in the CMGs have committed at a senior level in a resolvability assessment process (RAP) to the resolution strategies emerging for each of the G-SIBs. These CMGs work towards identifying barriers to making resolution work and how these should be removed. Often these barriers are consistent across firms. Perhaps most notable is the requirement for loss absorbency – establishing a liability structure for G-SIBs that is consistent with bail-in, not bail-out. Again, there has been significant progress here. The Financial Stability Board (FSB) issued a consultation document2 on a minimum standard for Total Loss Absorbing Capacity (TLAC) last November and is committed to producing a final standard ahead of the G20 summit next month in Antalya. This will be a major step on the road to ending “Too Big to Fail.”

He goes on to discuss the same TBTF agenda for other types of G-SIFIs, in particular central counterparties (CCPs). CCPs form a key part of the global financial landscape. They have become ever more important since the crisis. This will continue as mandatory central clearing is introduced around the world. These entities are an essential part of the international financial system, and need appropriate regulation and viable resolution paths in an event of failure, without causing a cascading crash. This aspect of the international financial markets and their control bears close watching.

Addressing the systemic risks associated with over-the-counter (OTC) derivatives markets is one of the reasons why G20 leaders introduced mandatory central clearing. People tell us that we have thus created in CCPs concentration risk and critical nodes. This is true in part, but we did this on the basis that in CCPs risks could be better recognised and identified, better managed and reduced via better netting. Nonetheless, as many before me have commented the largest CCPs are becoming increasingly systemic and interconnected such that their critical services could not stop suddenly without risk of wider contagion. Thus, not only do we have to ensure that the level of supervisory intensity matches the risks, something my supervisory colleagues are very focused on, we must also address the issue of what should happen if a CCP were to fail.

This is already widely recognised. So too is the need for an international solution to the questions that CCP recovery and resolution presents. The largest CCPs are systemically relevant at a global level, important for financial stability in multiple jurisdictions due to the nature of their business and the composition of their members and users. They serve multiple markets, having dozens of clearing members from different countries and clearing products in multiple currencies. A patch-work of approaches to recovery and resolution would risk regulatory arbitrage and competitive distortion and so, whilst the fiscal backstop against the unsuccessful resolution of a CCP is ultimately a national one, it is best that the answer on how to avoid this backstop ever being used is developed at a global level.

Fortunately, that work is already underway and CCP recovery and resolution forms an important part of the Financial Stability Board’s (FSB) continuing agenda to end Too Big To Fail (TBTF). In October 2014 an Annex was added to the Key Attributes of Effective Resolution Regimes to cover their application to Financial Market Infrastructures (FMIs). More recently, the FSB published its 2015 CCP workplan. As part of this, a group on financial market infrastructure (fmi CBCM), equivalent to the Cross-Border Crisis Management Group (CBCM) that I chair for banks, has been established within the FSB to take forward international work on CCP resolution. Authorities in a number of jurisdictions are responding to the need for effective resolution arrangements for CCPs, with legislative proposals expected in the EU, Canada, Australia, Hong Kong and elsewhere to add to existing regimes, including in the US under Title II of Dodd Frank. In the UK, the Bank of England has formal responsibility for the resolution of UK-incorporated CCPs. To aid us in drawing up resolution plans for UK CCPs, we have established the first Crisis Management Group for a CCP. We hope and expect it to be the first of many.

But work on CCP resolution needs to be seen in the broader context of financial reform:

The Committee on Payment and Market Infrastructures, along with the International Organisation of Securities Commissions (CPMI-IOSCO) is continuing its work on CCP resilience and recovery. Work is in train on stress testing, on loss allocation and on disclosure requirements, as well as on ensuring consistent application of the Principles for Financial Market Infrastructures (PFMIs) which set regulatory expectations for CCPs at a global level. All of this is important not only in its own right, but also to provide the market – the users of CCPs – with the tools and incentives to monitor resilience and drive effective risk management in CCPs themselves. To encourage competition between CCPs on resilience, not cost.

At the same time, the first line of defence for a CCP lies in the resilience of its members. Ongoing work to raise the prudential standards for banks on capital and liquidity, among other areas, should greatly reduce the risk of CCPs having to deal with a failing clearing member. And the progress I mentioned before on G-SIB resolution should help to ensure that, where a firm does fail, its payment and delivery obligations to the CCP continue to be met. I should add as an aside that there is more still to be done internationally in terms of removing technical and other obstacles to maintaining continuity of access to CCPs and other FMIs in the context of bank resolution. That continuity is not just essential to the bank in resolution but may also be critical for clients. If there is doubt about continued access to clearing services from a bank in resolution, clients may look to migrate rapidly to another provider. These issues around continuity and portability will be the subject of work within the FSB over the course of the coming year.

Together, these initiatives to improve the resilience and recovery arrangements for CCPs and their members will help to reduce the probability of CCP default. But while improvements to resilience are necessary they may not by themselves be sufficient. No institution is “fail safe”. Ultimately, we need to have a credible resolution approach for CCPs.

If we do, resolution should offer a continuing benefit in helping to incentivise recovery by removing expectations that the taxpayer will be compelled to step in. By contrast, if we do not have a credible regime in resolution, we run the risk of weakening the incentives both to manage a CCP prudently, as well as incentives for clearing members to contribute to a CCP’s recovery should it get into trouble. The benefits of resolution to market discipline and recovery are common to all financial institutions. But that is not the only insight from banks that is relevant to CCPs.

Before going too far in talking up the similarities, I should note – although it should go without saying – that CCPs are very different from their bank clearing members in many important respects, including their business models, legal structures and balance sheets. CCP recovery and resolution therefore poses some specific issues, some of which I will touch on today. However, at base there are principles that are common to the resolution of any systemically important institution.

Perhaps the most obvious similarity between the resolution of banks and CCPs is in the common objective: resolution should deliver continuity of critical economic functions without reliance on solvency support from taxpayers to achieve it. For that continuity to be achieved it is not enough that the financial losses of the institution are fully absorbed; the going-concern resources of the institution, or of any successor institution, must be restored to a sufficient level to command market confidence prior to any post-resolution restructuring or wind-down.

In the case of banks, this means that when a bank suffers losses eroding its going concern capital to the point where triggers for resolution are met, (i) it enters into resolution; (ii) its creditors are bailed in to recapitalise the firm; and (iii) this bail-in replicates what would have happened in a court-based commercial restructuring or insolvency. In other words, losses are allocated according to the creditor hierarchy but without the value destruction created by the hard stop of insolvency. This ensures that the resolution provides continuity and meets the safeguard that creditors are not worse off than in insolvency. While these are the essential elements of a resolution, they are likely to play out differently in the context of a CCP.

Intervention by a resolution authority, especially at a point where default management procedures have yet to be exhausted is action that cannot be taken lightly. Nor can the discretion of a resolution authority to deviate from the existing rules of the CCP be unbounded. Appropriate creditor safeguards are central to ensuring that an effective resolution regime does not unduly interfere with property rights or undermine its own value by introducing unnecessary uncertainty into a financial institution’s contractual relationships both in resolution and outside of it.

Perhaps the most fundamental safeguard to creditors in resolution is that the actions of the resolution authority will not leave them worse off than if the authority had not intervened and the firm had instead entered a liquidation proceeding. For the purposes of determining this No Creditor Worse Off protection, bank resolution takes an insolvency counterfactual; recognition that a failing bank that meets the conditions for resolution would in most likelihood lose its licence at that point if not resolved, thereby tipping it into insolvency (whether cash-flow, balance-sheet or both) if it was not there already. That insolvency counterfactual requires an ex post assessment of the value of assets and liabilities of the firm. That is no easy task but one that can, and has been, credibly undertaken.

For CCPs the task of assessing an insolvency counterfactual is likely to be harder still – particularly if it must rely upon a forecast of how the rest of the waterfall would have unfolded, the behaviour of the CCP’s participants and the movements of the markets in the days that would have followed if resolution had not taken place. A liquidation counterfactual must also confront the argument that the CCP would have protected itself from insolvency through full tear-up.

Given these valuation challenges, I suspect there will need to be careful further consideration given to the formulation and practical application of the NCWO safeguard; we must end up with a safeguard that is sufficiently certain and capable of estimation in advance that both creditors and resolution authorities are able to make sensible decisions before, during and after resolution.

 

With that, let me conclude by summing up some key points:

  • CCP resolution is both a necessary and inevitable part of the overall post-crisis reform agenda to end Too Big to Fail. As private, profit-making enterprises CCPs must be allowed to fail, but, given their systemic importance, many will need to be allowed to do so in a manner that maintains the continuity of their critical functions.
  • Having a credible resolution regime for Clearing Members is a big step forward in helping to reduce the risk of clearing member default and from that the risk of CCP failure.
  • But reliance on successful resolution of members does not negate the need for CCP resolution arrangements to be capable of responding to both default and non-default losses emerging from both systemic and idiosyncratic shocks.
  • In thinking about the underlying objectives and needs of a CCP resolution regime, there are many similarities to bank resolution and these should not be forgotten, but clearly there are many differences too and we need to recognise that.
  • Effective resolution requires the ability to act promptly and before the point at which the chance of stabilising the CCP is lost. The resolution authority must have a variety of tools at its disposal to enable it to respond to the reason the CCP failed. It should be able to intervene in a timely and forward-looking way before the end of the waterfall – but incentives must be aligned and we want this to be set up in a way that promotes CCP resilience and makes recovery work.
  • In order to continue a CCP’s critical services in resolution, there must be an ability both to cover the losses credibly in a failure scenario and to recapitalise the CCP’s going concern resources – i.e. its capital, margin and default fund. How we achieve this is something for FSB to address so that the shared interest in maintaining stability in the global financial system can be realised.

Bank of England maintains Bank Rate at 0.5%

At its meeting ending on 4 November 2015, the Bank of England’s Monetary Policy Committee (MPC) voted by a majority of 8-1 to maintain Bank Rate at 0.5%.  The Committee voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion, and so to reinvest the £6.3 billion of cash flows associated with the redemption of the December 2015 gilt held in the Asset Purchase Facility.

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.  This guidance is an expectation, not a promise.  The actual path Bank Rate will follow over the next few years will depend on the economic circumstances.

The MPC  sets monetary policy in order to meet the 2% inflation target and in a way that helps to sustain growth and employment.

Bank of England publishes approach to stress testing the UK banking system

The Bank of England has today published its approach to stress testing the UK banking system. This approach aims to provide clarity for firms and the wider public about our plans for stress testing for the next three years until 2018. Stress testing is a core part of the capital framework which sits alongside risk-based capital and leverage requirements. Stress tests provide an integrated forward-looking assessment of resilience and aim to ensure that banks can continue to support the real economy even in difficult economic conditions.

Key features of the Bank of England’s approach are:

  • The introduction of an annual cyclical scenario that will link the severity of the test to the financial cycle systematically. This scenario will include domestic, global and markets elements.  Its severity is likely to be greater in an upswing, for example when growth in credit is rapid or asset prices unsustainably high.
  • A biennial exploratory scenario covering risks unrelated to the financial cycle that policymakers’ judge to be emerging or latent threats to financial stability or individual banks.
  • A systematic and transparent hurdle rate framework with clear hurdle rates for each firm reflecting minimum capital requirements and additional requirements for globally systemic banks.

The stress test will include banks with total retail deposits greater than £50 billion – at present this covers the same set of firms included in the 2015 stress test. Among this group of firms, coverage may vary for the exploratory scenario if that scenario is unlikely to impact some firms. UK subsidiaries of foreign-owned investment banks will not be brought into scope at this time, but this will be kept under review. The Bank of England will develop its own modelling capabilities further, to enhance its ability to challenge aspects of firms’ own results and to include in the test results the impact of feedback mechanisms across the banking system. The approach will ensure there continues to be a range of modelling input into stress testing.

Mark Carney, Governor of the Bank of England said “The United Kingdom needs banks than can weather shocks without cutting lending to the real economy. Our first concurrent stress tests run in 2014 – centred on the housing market – gave us assurance that the banking sector as a whole was well-placed to withstand such a severe scenario. We have also recognised however the need for our approach to evolve. The Bank of England is taking steps to ensure we can assess a range of future risks from a number of different sources to inform our micro- and macro-prudential policy decisions. Our approach embodies a comprehensive and detailed approach, a desire to deepen and strengthen our analysis, and the flexibility to respond to changing risks.”

The Bank of England will publish further information in due course on its approach to stress testing beyond 2018. The Bank of England’s stress testing framework is likely to evolve further to reflect regulatory developments, including structural reform of the banking sector.

What is stress testing? – YouTube video.

 

UK business finance since the crisis – moving to a new normal?

At a speech given at Bloomberg in London, Ian McCafferty, external member of the Monetary Policy Committee, argued that the tight credit conditions which followed the financial crisis have now “diminished markedly” for firms – a fact which has important implications for monetary policy.

McCafferty’s analysis indicates that both large and small firms have been broadening their sources of finance away from banks. While large firms have turned increasingly to capital markets, with growing bond and equity issuance, SMEs have been drawing on new alternative sources of lending, including ‘crowdfunding’ and peer-to-peer lending platforms.

McCafferty warned that it was important to recognise that this form of finance is still small compared to bank lending, on which SMEs remain heavily reliant, but added: “alternative finance is growing, and is likely to be a developing feature of the market in future years.”

McCafferty noted that the UK economy continues to face headwinds – notably fiscal consolidation and sub-par growth in the world economy. However, he argued that the reduction the headwinds in business finance is now supporting the normalisation of the economy. With that, he said: “it is reasonable to expect the neutral interest rate – the level of interest rates consistent with full employment and inflation at target – to also move towards more normal levels”.

He concluded: “If we on the MPC are to achieve our ambition of raising rates only gradually, so as to minimise the disruption to households and businesses of a normalisation of policy after a long period in which interest rates have been at historic lows, we need to avoid getting ‘behind the curve’ with respect to the neutral rate. And for me, that provides an additional justification not to leave the start date for lift off too late.”

Bank of England To Strengthen the UK Financial System

The Bank of England has today published two consultation papers: one on ring-fencing and one on operational continuity. These proposals will ensure that ring-fenced banks are protected from shocks originating in other parts of their groups, as well as the broader financial system, and can be easily separated from their groups in the event of failure.

Well-capitalised, resilient firms mean that when problems occur, critical economic functions, including retail banking, can be maintained and economic growth can be supported through ongoing banking activity.

Today’s proposals seek to ensure that ring-fenced banks have sufficient capital resources on a standalone basis, sheltering them from risks originating in other parts of their groups. The proposed rules also mean that a ring-fenced bank can be more easily detached from the wider group by ensuring intragroup arrangements operate on an arm’s length basis – helping ensure important services remain available in the event of a failure of other parts of the group.

The publication of these two consultation papers means firms will be able to put in place detailed plans to ensure that they are prepared to ring-fence their core retail activities from 1 January 2019.  These consultation papers also provide greater clarity on the operational continuity rules affecting other firms providing functions that are critical to the economy.

Andrew Bailey, Deputy Governor of the Bank of England and Chief Executive of the Prudential Regulation Authority (PRA) said:

“Making our firms more resilient has been at the forefront of our post-crisis reform agenda. Today represents an important step forward in achieving this aim. We have provided clarity for affected banks on how we will implement ring-fencing and this will enable firms to take substantial steps forward in their preparations for structural reform.”

Proposals for ring-fenced banks

The PRA is required under the Financial Services and Markets Act 2000, as amended by the Financial Services (Banking Reform) Act 2013, to make policy to implement the ring-fencing of core UK financial services and activities.

From 1 January 2019, banks with core deposits greater than £25 billion (broadly those from individuals and small businesses) will be required to ring-fence their core retail activities. To prepare for this, the PRA published near final rules on 27 May 2015 on governance, legal structure, and operational continuity and consulted on the approach to ring-fencing transfer schemes on 18 September 2015.

The proposals in today’s consultation papers look to ensure:

  • a ring-fenced bank has sufficient financial resources and liquidity;
  • intragroup exposures and arrangements between the ring-fenced bank and the rest of the group are managed in a prudent manner, at arm’s length;
  • the ring-fenced bank is clear on the PRA’s expectations on the use of financial market infrastructures; and
  • the ring-fenced bank can demonstrate the ability to continue to provide critical economic functions during resolution.

This consultation closes on 15 January 2016.

Operational continuity proposals

The PRA is also consulting on rules to ensure a broader range of banks, building societies and PRA-authorised investment firms structure their operations in a way that allows critical shared services to continue even in times of stress or failure.

Ensuring operational continuity is a necessary condition to make certain that firms can be resolved in an orderly fashion to support financial stability.

The PRA invites feedback on the proposals set out in this consultation paper, but respondents may wish to wait for the publication of the addendum, which will set a closing date for the consultation period.

Fixing the global financial safety net: lessons from central banking

In a speech to the David Hume Institute in Edinburgh, Minouche Shafik, Bank of England Deputy Governor for Markets and Banking, describes the global safety net for dealing with sovereign debt crises as “more of a patchwork than a safety net.” The need to fix the safety net has been brought into sharper focus by the challenges facing emerging markets: lower growth, falling commodity prices and potential spillovers from the possible exit of exceptional monetary policy in advanced economies. Drawing on lessons from central banks’ response to banks’ liquidity needs during the financial crisis, she identifies policy reforms that could reduce the systemic implications of sovereign debt crises and allow nations to cope with shocks.

“The benefits of free trade are now well established. Similarly, economic theory provides compelling arguments for the potential advantages of integrated global capital markets based on the efficient allocation of resources. But, in practice, cross-border capital flows can be fickle and flighty, with destructive effects on the real economy.” They leave nations exposed to a ‘capital stop’, in much the same way that banks can experience a run on their deposits.

Minouche concludes that the current safety net – a mix of national foreign exchange reserves, regional financing arrangements, central bank swap lines and the International Monetary Fund (IMF) – is suboptimal: fragile, fragmented, and inefficient. If we are to continue to benefit from global financial integration then we need a system that can effectively and efficiently provide liquidity insurance to fundamentally sound sovereigns in order to contain spillovers to other parts of the globe.

Drawing on the experience of central banks, she notes that more reliable provision of liquidity support has been made possible by the fact that supervision is tougher on capital and liquidity requirements, banks undergo regular stress testing, and credible resolution tools are being put in place. What would the equivalent enablers be for sovereigns? Minouche suggests:

• Better surveillance, and particularly of the vulnerabilities to sudden stops;
• Stress testing countries’ balance sheets through better debt sustainability assessments; and
• Better mechanisms for dealing with debt restructuring and reducing the risk of disorderly spillovers.

Given the “complex and messy process whereby markets and the official sector deal with sovereign debt restructurings”, how might the risk of disorderly spillovers be reduced? Three preliminary ideas are suggested:

• Using state-contingent bonds to increase risk-sharing with private sector creditors, for example GDP-linked bonds.
• Facilitating agreements on a debt restructuring in bond contracts by expanding the use of new style collective action clauses so that decisions can be taken by a majority of creditors across all bond issuances, without the need for an issuance-by-issuance vote.
• Reducing international spillovers by reviewing the preferential treatment that cross-border sovereign exposures receive in prudential regulation.

At the heart of the global safety net, Minouche suggests, needs to be a more reliably resourced IMF that has well defined arrangements for collaborating with regional financing arrangements. Unless improvements are made, it will be difficult to achieve and sustain the benefits of integrated global capital markets.

The Future of Cash – a UK Perspective

The Bank of England says those claiming “the death of cash” is imminent, are mistaken. They do so in a pre-released an article from its Quarterly Bulletin 2015 Q3 – How has cash usage evolved in recent decades? What might drive demand in the future?

The issuance of banknotes is probably the most recognisable function of the Bank of England. Banknotes are a form of physical money that people use as a store of value and as a medium of exchange when buying or selling goods and services. The Bank of England seeks to ensure that demand for its banknotes is met, and that the public retains confidence in those banknotes.

The payments landscape has changed considerably in recent decades. People can now make payments using debit and credit cards (including contactless technology), internet banking, mobile ‘wallets’, and smartphone apps.

Yet despite these developments, cash continues to be important in the United Kingdom, with demand for Bank of England notes growing faster than nominal GDP.

BOE-CashThere is now the equivalent of around £1,000 in banknotes in circulation for each person in the United Kingdom.

The growth in demand for banknotes has been driven by three different markets:

  • The evidence available indicates that no more than half of Bank of England notes in circulation are likely to be held for use within the domestic economy for legitimate purposes. This includes cash used for transactions and for ‘hoarding’.
  • The remainder is likely to be held overseas or for use in the shadow economy. However, given the untraceable nature of cash, it is not possible to determine precisely how much is held in each market.

The future rate of growth in demand for cash is uncertain and will depend on a number of factors including alternative payment technologies, retailer and financial institution preferences, government intervention, and socio-economic developments. Finally — and probably most importantly — it will depend on the public’s attitude towards cash. Over the next few years, consumers are likely to use cash for a smaller proportion of the payments they make. Even so, given consumer preferences and the wider uses of cash, overall demand is likely to remain resilient. Cash is not likely to die out any time soon.

As such, the Bank continues to work with the cash industry, and to invest in banknotes. The next few years will see the launch of new banknotes for the £5, £10, and £20 denominations. The new notes will be made of a polymer substrate — a cleaner and more durable material — and will incorporate leading-edge security features that will strengthen their resilience against the threat of counterfeiting.

They also released a short video on the topic.

Bank of England maintains Bank Rate at 0.5%

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy in order to meet the 2% inflation target and in a way that helps to sustain growth and employment.  At its meeting ending on 9 September 2015, the MPC voted by a majority of 8-1 to maintain Bank Rate at 0.5%.  The Committee voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion.

Twelve-month CPI inflation rose slightly to 0.1% in July but remains well below the 2% target rate.  Around three quarters of the gap between inflation and the target reflects unusually low contributions from energy, food, and other imported goods prices.  The remaining quarter reflects the past weakness of domestic cost growth, and unit labour costs in particular.  Although pay growth has recovered somewhat since the turn of the year, the recent increase in productivity means that the annual rate of growth in unit wage costs is currently around 1% – lower than would be consistent with meeting the inflation target in the medium term, were it to persist.  Additionally, sterling’s appreciation since mid-2013 is having a continuing impact on the prices of imported goods.  A combination of these factors has meant that the average of a range of measures of core inflation remains subdued, although it picked up slightly in July to a little over 1%.

Inflation is below the target and the Committee’s best collective judgement is that there remain at least some underutilised resources in the economy.  In that light, the Committee intends to set monetary policy in order to ensure that growth is sufficient to absorb the remaining economic slack so as to return inflation to the target within two years.

The Committee set out its most recent detailed assessment of the economic outlook in the August Inflation Report.  The aim of returning inflation to the target within two years was thought likely to be achieved conditional upon Bank Rate following the gently rising path implied by the market yields prevailing at the time.  Private domestic demand growth was forecast to be robust enough to eliminate the margin of spare capacity over the next year or so, despite the continuing fiscal consolidation and modest global growth.  And that, in turn, was expected to result in the increase in domestic costs needed to return inflation to the target in the medium term, as the temporary negative impact on inflation of lower energy, food and import prices waned.  In the third year of the projection, inflation was forecast to move slightly above the target as sustained growth led to a margin of excess demand.

The Committee noted in the August Report that the risks to the growth outlook were skewed moderately to the downside, in part reflecting risks to activity in the euro area and China.  Developments since then have increased the risks to prospects in China, as well as to other emerging economies.  This led to markedly higher volatility in commodity prices and global financial markets.

While these developments have the potential to add to the global headwinds to UK growth and inflation, they must be weighed against the prospects for a continued healthy domestic expansion.  Domestic momentum is being underpinned by robust real income growth, supportive credit conditions, and elevated business and consumer confidence.  The rate of unemployment has fallen by over 2 percentage points since the middle of 2013, although that decline has levelled off more recently.  Global developments do not as yet appear sufficient to alter materially the central outlook described in the August Report, but the greater downside risks to the global environment merit close monitoring for any impact on domestic economic activity.

There remains a range of views among MPC members about the balance of risks to inflation relative to the target.  At the Committee’s meeting ending on 9 September the majority of members judged that the current stance of monetary policy remained appropriate.  Ian McCafferty preferred to increase Bank Rate by 25 basis points, given his view that building domestic cost pressures would otherwise be likely to lead to inflation overshooting the target in the medium term.

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.  This guidance is an expectation, not a promise.  The actual path that Bank Rate will follow over the next few years will depend on the economic circumstances.

Zombie loans and a £300bn cushion: inside the Bank of England rates dilemma

From The Conversation.

When the men and women of the committee which sets UK interest rates get together these days, they are dealing with a deceptively simple question. Rates will go up, but how far and how fast? Their answer will decide the fate of a fragile recovery.

The UK economy is getting back to normal. Output has overtaken its peak of 2007 and is growing at close to the average pre-crisis rate; unemployment is low, employment is increasing. Real wages and investment have finally begun to improve. There are even signs of a return to productivity growth.

You might well argue that the financial crisis was unnecessary; that the imposition of austerity meant that recovery was slower than it needed to be and that the burden of adjustment was unfairly shared. But notwithstanding this, the economy is recovering.

This means that interest rates also have to get back to normal. The most recent meeting of the Bank of England’s Monetary Policy Committee left things as they were – at a historic low of 0.5%, where it has remained since February 2008. It is both the lowest rate ever and the longest period without a change in rates. This cannot go on for much longer. We will get another rate decision on September 10 and even members of the committee who usually argue for lower rates, such as David Miles, are openly discussing the moment when the rate will start to rise.

Spent force?

But why do interest rates have to rise? Well, consider the choice between spending now or delaying expenditure into the future. In an economic downturn, the benefits of increasing spending in the present outweigh the costs of reducing it in the future. This is why low interest rates, which encourage spending right now, were a useful policy response to the financial crisis.

Notes and queries. How far and how fast? nataliej, CC BY-NC

But in more normal times, low interest rates encourage levels of expenditure which may exceed the productive capacity of the economy and so cause rising inflation. They may also lead to excessive borrowing and so risk another financial crisis. Higher interest rates, which encourage saving that can be channelled into productive investment, are then more appropriate.

So, if interest rates have to go up in order to manage the transition to another kind of economy, how quickly will they rise? Here, policymakers face two major risks. The first is within the banking system.

Risk factors

Banks are holding more than £300 billion in reserves at the Bank of England. This has been a useful cushion in turbulent times (reserves increased recently during the latest Greek crisis) but going forward, the economy needs banks to make loans rather than accumulate cash.

As a first step, the Bank of England has to stop paying interest on these reserves. This will encourage banks to run down reserves and increase lending. But reducing bank reserves by, say, £200 billion will increase lending by roughly £2 trillion (economists call this the “money multiplier”: historically the multiplier has been around 10). Doing this too quickly risks destabilising the economy. So this suggests we will see a modest and gradual increase in interest rates.

Zombies in our midst. The loans that bit back. Follow, CC BY-NC-ND

The second risk lies with households and firms. Low interest rates have enabled some individuals to stave off bankruptcy by managing to keep up loan repayments. This will no longer be possible once interest rates start to rise. These are the so-called “zombie loans” that stalk the economy, and no one knows how many of these are out there, or at which point in the interest rate cycle they will become a serious danger. Caution again suggest a modest and gradual increase until the scale of the problem becomes clearer.

Level up

Finally, let’s consider how high interest rates will eventually rise.

Policymakers have suggested that the pre-crisis average of 5% may be too high. Why? First, it is not clear how much of the damage caused by the financial crisis is permanent. If the economy has sustained serious damage to its productive capacity, interest rates will need to stay low for a protracted period, until investment has rebuilt capacity.

Second, it has been argued that there are now fewer investment opportunities than there were before the crisis, as the wave of productive investments opened up by the rapid spread of globalisation and new technology has ebbed away, robbing us of opportunities to generate growth and support a robust recovery. This “secular stagnation” hypothesis argues for lower interest rates into the future.

Of course, these arguments are all about successfully managing the recovery of the domestic economy – and we know only too well that external factors, such as US sub-prime mortgages, can have devastating effects across the world. It will be a useful by-product of the expected modest and gradual rate rises from the Bank of England that if and when the next crisis strikes from out of the blue, then there remains the room to bring rates straight back down again.

Author: Chris Martin, Professor of Economics at University of Bath

Credit Traps In A Financial Crisis

The Bank of England recently published a working paper “Bank leverage, credit traps and credit policies” which looks at why, following a financial crisis growth tends to stagnate for a long period and how macroprudential policy tools should be used both before and after a crisis.  They look at “credit traps” which arise when shocks to bank equity capital tighten banks’ borrowing constraints, causing them to allocate credit to easily collateralisable but low productivity projects. Low productivity weakens bank capital generation, reinforcing tight borrowing constraints, sustaining the credit trap steady state.

Financial crises tend to have severe negative effects on real activity, and recoveries following crises tend to be weak and slow. In Japan, for example, real GDP remained some 30 per cent below its pre-crisis trend 10 years after the onset of its financial sector distress in 1991. In the UK, the gap between realised real GDP and the level implied by the pre-crisis trend was around 20 per cent five years after the onset of the crisis in 2007. And in the USA, Japan, the UK and the euro-area, the rate of credit growth collapsed around the onset of the crises. In Japan, anaemic credit growth continued for at least a decade.

These consequences have triggered various policy responses. On the one hand, reform of financial regulation continues apace. Across jurisdictions, macroprudential policy authorities have been established and tasked with conducting system-wide prudential policy, including the use of countercyclical bank capital requirements. At the same time, central banks and governments have introduced a range of ‘unconventional’ monetary and credit policies, including asset purchases, policies to support bank funding, and recapitalisation of financial institutions. In light of these sweeping changes to the policy landscape, there is a real need to understand the mechanisms, costs and benefits of these interventions, and the conditions under which they can be effective. This paper enhances the understanding of such ‘credit policies’ – both ex-ante (to avoid credit crises), and ex-post (to escape their consequences) – by presenting a novel, tractable macroeconomic model to understand their effects.

We do this by constructing a simple overlapping generations model featuring financial intermediation and credit frictions, and use it to study the credit policies mentioned above. The key feature of our model that makes it particularly useful for studying these policies is its ability to generate a ‘credit trap’ steady state – that is, a steady state of the economy that features low real activity, low productivity, low bank capital, and weak bank profitability. In our model, the borrowing constraints facing banks depend on the health of the banking system: when the net worth of the banking system is low, banks’ ability to finance productive investment through borrowing is severely constrained. The economy enters a ‘credit trap’ when a large unanticipated shock to bank assets reduces bank capital below a critical threshold, causing banks’ funding conditions to tighten, inducing them to invest in less productive assets that, nonetheless, have higher pledgeability to creditors. Thus, even a temporary shock can have extremely persistent effects if it causes a large reduction in bank capital. And it is the possibility of entering a credit trap that has profound implications for policy that have not been examined by existing work in this area.

Concluding remarks
The recent financial crisis has raised the question of whether there is something fundamentally different about economic recovery following a severe financial crisis and, if so, how macroprudential policy tools should be used both before and after a crisis. Most modern macroeconomic models are unsuitable for addressing this question, with their economies quickly returning to health once a negative shock is unwound. In this context macroprudential policy tools play the role of reducing volatility, rather than avoiding a catastrophe or supporting the recovery from a crisis. By contrast, in this paper we explicitly consider a model in which the economy can become trapped in a steady state featuring permanently lower output, bank credit and productivity following a sufficiently severe financial shock, a confluence of characteristics we call a credit trap.

In this paper we have developed a simple, tractable OLG model for analysing credit traps. We have examined the effectiveness of policy both at preventing a credit trap occurring, and helping the economy to escape (which becomes necessary as it will not recover without intervention). Our analysis shows that a leverage ratio cap is effective in increasing the resilience of the economy against shocks and reducing the probability of a credit trap. However, this comes at the cost of lowering the level of output in the ‘good’ steady state, and hence the policymaker needs to set the cap to trade off these costs and benefits. Relaxing the leverage ratio cap is effective in encouraging faster recovery after a negative productivity shock, provided that the shock is sufficiently small. But if the shock is large enough to tip the economy into a credit trap, then relaxing the leverage ratio cap will not help the economy get out of it. To escape a credit trap other policies are needed, and we consider the efficacy of a set of ‘unconventional’ credit policies: direct lending; bank recapitalisation; and discount window lending. These policies present rich, realistic trade-offs which vary with their relative efficiency costs. Their effectiveness depends on the state of the economy, with all more effective when the economy is weaker.

In future work, it would be interesting to analyse more thoroughly the optimal leverage cap that would be set by a policymaker in advance of a trap. We have shown that the level of the leverage cap that maximises resilience is countercyclical: it would be interesting to analyse numerically if the optimal level of the leverage cap is too, and whether this would vary with the state of the economy in a non-linear way. This would be particularly interesting when the economy is just above the trap threshold, and the policymaker has to trade-off rebuilding the health of the banking system with the possibility of further negative shocks. .

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy.