Rescuing a SIFI, Halting a Panic: the Barings Crisis of 1890

Eugene White.

The collapse of Northern Rock in 2007 and Bear Sterns, Lehman Brothers, and AIG in 2008 renewed the debate over how a lender of last resort should respond to a troubled systemically important financial institution (SIFI). Based on research in the Bank of England Archive, this post re-examines a crisis in 1890 when the Bank, supported by central bank cooperation, rescued Baring Brothers & Co. and quashed a banking panic and a currency crisis, while mitigating moral hazard. This rescue is significant because it combined features similar to those mandated by recent U.K., U.S., and European reforms to ensure an orderly liquidation of SIFIs and increase the accountability of senior management (e.g. Title II of the Dodd-Frank Act (2010); the U.K. “Senior Managers Regime”).

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Saving Liquidity in a Liquidity-abundant World: Why don’t banks use less liquidity when making high-value payments?

David Seaward.

CHAPS banks have oodles of liquidity and are not afraid to use it, as quantitative easing has meant banks accumulated unprecedented quantities of reserves. And in this liquidity-abundant world, banks are less likely to be concerned with how well they use tools for liquidity saving in the Bank’s Real-Time Gross Settlement (RTGS) infrastructure. And besides, the timings of liquidity-hungry payments are stubborn. They can’t always be retimed to optimise liquidity usage, and this means that the potential for liquidity savings in RTGS from the Bank’s Liquidity Savings Mechanism (LSM) is limited.

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From Berlin to Basel: what can 1930s Germany teach us about banking regulation?

Tobias Neumann.

Two of the country’s largest banks collapse. The subsequent panic brings the banking system to its knees and only a costly government bail-out prevents even greater catastrophe. A radical re-think of regulation is needed. No, it’s not London or New York in 2008. It is Berlin in the 1930s. It’s when risk-weighted capital regulation was born, notably to be used alongside a range of other tools; for example, liquidity requirements and such modern ideas as bonus deferrals and capital conservation. But the idea that no single regulatory measure is likely to be sufficient on its own was forgotten. In 2008 it had to be painfully re-learned making this episode a striking example of the importance of studying past financial crises.

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Uncertainty is no excuse for not using macroprudential tools

Angus Foulis and Saleem Bahaj

The macroprudential toolkit available to policymakers across several central banks is new and largely untested. For example, in the UK, the Bank of England’s Financial Policy Committee (FPC) has, since the financial crisis, received powers to alter bank capital requirements and to place restrictions on the terms of household mortgages for macroprudential purposes. These policy tools have not been used systemically in the past, so their impact and the FPC’s reaction function remain unclear. Moreover, in contrast to monetary policy, where price stability can be judged against inflation, the objective of macroprudential policymakers – the stability of the financial system – is inherently unobservable. Thus macroprudential policymakers face a high degree of uncertainty over the impact and effectiveness of their tools and a target variable they cannot perfectly observe.

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Potential supply, the output gap and inflation

Stephen Millard

Potential supply matters! If an economy is producing less output than it could, then there are resources that are being wasted. And when these resources are human – that is unemployment – this carries an additional social cost. But why, specifically, should it matter for an inflation-targeting central bank? Presumably, because it is a good indicator of inflationary pressure! The trouble is that there are good reasons to think that this is not actually the case. And economic theory suggests there is a much better measure of inflationary pressure we can use.

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Falling off a cliff: what happened to UK corporate debt? A transatlantic comparison.

Christian Schnittker.

Following the financial crisis, net corporate financing has exhibited a similar overall pattern in the UK and the US. But the composition of that financing has been very different – with the net debt stock of UK non-financial corporates falling by more than 20% of nominal GDP. By contrast, in the US the fall was only 10%, and around half of this has since been regained. Why did the two countries’ experiences diverge so much after the crisis? In this post, I argue that the root cause of this divergence was a fall in UK corporates’ demand for debt, rather than a hit to credit supply. Business cycles, and credit conditions appear to be similar in both countries, but in the UK there has been lower demand for corporate gearing from firms, a weaker recovery in M&A activity, and fewer share buybacks than in the US.

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The cheque republic: money in a modern economy with no banks.

Ben Norman and Peter Zimmerman.

What happens when a country’s banking system shuts down? Just how damaging is it to the economy? During the 20th century, the Republic of Ireland’s banking system suffered industrial disputes, some of which caused the main banks to close for several months. When Greek banks closed temporarily last year, some commentators (e.g. Independent (2015), FT (2015)) recalled how, previously, the Irish public ingeniously circumvented the banking system and kept economic activity going. Using material in the Bank of England’s Archive relating to the 1970 dispute, we shed light on how halcyon those days really were.

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Testing the test: How reliable are risk model backtesting results?

Emmanouil Karimalis, Paul Alexander & Fernando Cerezetti.

All models, including those which model financial risk, are in some sense “wrong” – they aim to “approximate” the real word but cannot possibly recreate it. Consequently, in a world in which risk models are used to calculate and exchange vast sums of capital and margin, the need for reliable tests is of paramount importance. The Kupiec-POF test represents the most widely-used test for assessing the reliability of these risk models (typically Value-at-Risk (VaR) models) – a process known as backtesting. As with all forms of testing, the Kupiec-POF test has a degree of error associated with its use and under certain circumstances these errors may be substantial.

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Extracting insight from complexity

John Hill and Jamie Coen.

The financial system is complex and highly interconnected. Indeed, interactions between agents are key to its functioning. But these interconnections have the potential to turn small shocks into systemic crises. Understanding the complex nature of these interconnections is important, but can also be difficult. In this post we introduce new tools designed to analyse the financial network and help analysts build a better understanding of risks posed by interconnectedness.

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How important are interest rates for exchange rates?

Fernando Eguren-Martin and Karen Mayhew.

Many would say that when domestic interest rates rise (relative to abroad) the domestic currency will appreciate. But is it right to think like this? In this blog we use exchange rate theory to inform this discussion and to assess the importance of relative interest rates in accounting for past exchange rate moves. We find that relative interest rates typically move in the same direction as exchange rates but most of the time they account for a small share of exchange rate variation. However, academics might question our use of such a theory as its failure to forecast exchange rates is well documented. We show that this is somewhat unfair, as even if the framework is not very useful in terms of forecasting it is still a useful tool for decomposing past moves in exchange rates.

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