Category Archives: Financial Stability

Unto us a lender of last resort is born: Overend Gurney goes bust in 1866

John Lewis.

The 1866 collapse of Overend Gurney sparked widespread panic as investors flocked to banks and other institutions demanding their money back.  Failure to provide substantial liquidity threatened to bring down the entire financial system.  The Governors of the Bank of England asked the Chancellor to relax the constraints of the 1844 Bank Charter Act, by granting an indemnity to allow the issue of unbacked currency.  The Chancellor’s reply, and the policy response it initiated, would save the day, and go down in central banking history as pivotal in the foundation of the “lender of last resort”, a function which has been fundamental to central banking practice ever since.

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Filed under Banking, Economic History, Financial Markets, Financial Stability

The Nightmare before Christmas: Financial crises go global in 1857

Tobias Neumann.

A railway boom in America’s Midwest goes spectacularly bust.  Sixty-two of New York’s commercial banks close – out of sixty-three. Meanwhile in Britain, a decade gilt-edged by gold discoveries in Australia and fuelled by the Crimean War was beginning to lose its lustre.  Thus the scene was set for the first global financial crisis shaking markets in New York, London, Paris and across the world.  A crisis so severe it forced the Bank of England to “break the law” to survive.

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Filed under Banking, Economic History, Financial Stability, Macroeconomics

The ghost of crises past, present and future: The Bank Charter Act goes on trial in 1847

Huaxiang Huang and Ryland Thomas.

The financial crisis of 1847 has often been dubbed “The trial of the Bank Charter Act  of 1844 (Morgan (1952)).  The Act sought to remedy the errors of crises past by trying to prevent the overissue of banknotes that many had felt was the major cause of previous crises in 1825 and 1837.   The Act gave the Bank of England an effective monopoly in the issue of new bank notes and those additional notes had to be backed one for one with gold.   But this had a crucial unintended consequence:  it made it difficult for the Bank to act as a lender of last resort.  When the crisis struck, the limits imposed by the Act effectively had to be suspended.

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Filed under Banking, Economic History, Financial Markets, Financial Stability

Designing stress test scenarios – developing doomsday

Colm Aodh Manning.

For the past three years, the Bank of England (the Bank) has carried out an annual ‘stress test’ of the UK’s largest banks. To do this, it designed a narrative-based stress scenario in 2014 and 2015. The goal was to determine the banking sector’s resilience to pertinent threats, like recessions or a sharp fall in house prices. However, changing scenarios each year makes it difficult to judge how banks’ overall vulnerability to risks changes over time. Since the crisis we learned that risks build in the good times and capital in the banking system should rise to reflect this. This is why – beginning this year – the Bank has also run an Annual Cyclical Scenario (ACS).

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Bitesize: Banks’ growing capital surplus since the crisis

Peter Eckley and Liam Kirwin.

In the world of bank capital regulation, minimum requirements grab all the headlines. But actual capital resources are what absorb unexpected losses.  Banks and building societies typically hold resources substantially in excess of requirements – called the capital surplus. One reason is to avoid breaching the minimum due to unforeseen shocks. Another is to build resources in anticipation of requirements arising from growth or regulatory change. The chart shows how capital surpluses (on total requirements including Pillars 1 and 2, and all types of capital) have varied in recent decades. It is based on historical data from regulatory returns.

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Filed under Banking, Bitesize, Financial Stability, Macroprudential Regulation

Making Macroprudential Hay When the Sun Shines

Saleem Bahaj, Jonathan Bridges, Cian O’Neill & Frederic Malherbe.

It’s not just what you do; it’s when you do it – many decisions in life have “state contingent” costs and benefits. The payoffs from haymaking depend crucially upon the weather. Putting fodder away for a rainy day can be quick, cheap and prudent when skies are blue. But results may take a soggy and unproductive turn, if poorly timed. The financial climate is similarly important when assessing the costs and benefits of macroprudential policy changes. We argue that it is best to build the countercyclical capital buffer when the macroeconomic sun is shining. We find strong empirical evidence to support our claim.

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Filed under Banking, Financial Stability, Macroprudential Regulation

Macroprudential Regulation: Two birds with one stone?

Roy Zilberman and William Tayler.

bu-guest-post2Last year the Bank organised a research competition to coincide with the launch of the One Bank Research Agenda.  In this guest post, the authors of the winning paper in that competition, Roy Zilberman and William Tayler from Lancaster Business School, summarise their work on optimal macroprudential policy.

Can macroprudential regulation go beyond its remit of financial stability and also contain inflation and output fluctuations? We think it can and argue that macroprudential regulation, in the form of countercyclical bank capital requirements, is a superior instrument to both conventional and financially-augmented Taylor (1993) monetary policy rules. This is especially true in responding to financial shocks that drive output and inflation in opposite directions, as also observed at the start of the recent financial crisis (see Gilchrist, Schoenle, Sim and Zakrajsek (2016)). This helps to effectively shield the real economy without the need for a monetary policy interest rate intervention. Put differently, a well-designed simple and implementable bank capital rule can achieve optimal policy associated with zero welfare losses.

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Filed under Financial Stability, Guest Post, Macroeconomics, Macroprudential Regulation

When linear models are misleading

Jeremy Chiu and Sinem Hacioglu Hoke.

When shocks cause trouble

Small shocks can lead to big crises. At the heart of this issue is that economic dynamics might play out very differently against different backdrops: the same shock would have a very different effect if it hit the economy at the heights of the Great Recession than if it hit during more benign times. It might knock the economy into a more severe and persistent recession or financial stress if it hits already turbulent periods. It seems reasonable, therefore, that we would want to take into account the economic backdrop when we estimate our models.

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Filed under Financial Stability, Macroeconomics, New Methodologies

Bitesize: Sovereign debt, default and “r-g”

Mark Joy.

Government debt as a share of GDP is at its highest since WWII in advanced economies and since the 1980s debt crises in emerging markets, but so far, apart from Greece, Ukraine and some high-profile close calls in the euro area, this level of debt has caused barely a stir in financial markets. So is it okay to stop worrying?

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Filed under Financial Stability, International Economics, Macroeconomics

Bitesize: Periodicity of GBP/USD trading activities

Jihyoung Yi.

FX assets are traded continuously across the globe.  The majority of GBP/USD trades, however, are executed during typical trading hours in London and New York (NY). Saravelos and Grover (2016) find that: (i) FX moves during these hours are most highly correlated to the overall daily move; and (ii) there is statistically significant periodicity where GBP tends to depreciate in the London morning and appreciate in the NY afternoon against the US dollar.

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Filed under Bitesize, Currency, Financial Markets, Financial Stability