Category Archives: Financial Stability

Foreign booms, domestic busts: the global dimension of banking crises

Ambrogio Cesa-Bianchi, Fernando Eguren Martin and Gregory Thwaites.

Why do banking crises happen in “waves” across countries? Do global developments matter for domestic financial stability? Is there such a thing as a global cycle in domestic credit? In this post we link these ideas and show that foreign financial developments in general, and global credit growth in particular, are powerful predictors of domestic banking crises. Channels seem to be financial rather than related to trade, and these include transmission of market sentiment, cross-border portfolio flows and direct crisis contagion.

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Filed under Banking, Financial Stability, International Economics

Capital Inflows: The Good, the Bad and the Bubbly

Glenn Hoggarth, Carsten Jung and Dennis Reinhardt.

Supporters of financial globalisation argue that global finance allows investors to diversify risks, it increases efficiency and fosters technology transfer. The critics point to the history of financial crises which were associated with booms and busts in capital inflows.  In our recent paper ‘Capital inflows – the good, the bad and the bubbly’, we argue that the risks depend on the type of capital inflow, the type of lender and also the currency denomination of the inflows. We find that equity inflows are more stable than debt, foreign banks are more flighty than non-bank creditors, and flows denominated in local currency are more stable than in foreign currency.  We also find evidence that macroprudential policies can make capital inflows more stable.

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Filed under Financial Stability, International Economics, Macroprudential Regulation

How should regulators deal with uncertainty? Insights from the Precautionary Principle

Ian Webb, David Baumslag and Rupert Read.

One September morning, the Lord Mayor of London was called to inspect a fire that had recently started in the City. Believing that it posed little threat, he refused to permit the demolition of nearby houses, probably due to the expense of compensating the owners. The fire spread and ultimately destroyed most of the city. The Great Fire of London had begun. Only when the fire became too extensive to be readily halted did the full extent of the danger become evident. Financial regulators today face a similar challenge preventing financial crises- action causes significant costs to some but the consequences of inaction are much more uncertain. To combat this, we argue they should apply the precautionary principle.

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The tip of the iceberg: the implications of climate change on financial markets

Yuliya Baranova, Carsten Jung and Joseph Noss.

There has been a recent increase in awareness of investors that limiting emissions to prevent climate change might leave a substantial proportion of the world’s carbon reserves unusable, and that this could lead to revaluations across a range of financial assets. If risks are left unaddressed, this could result in large losses for some investors. But is this adjustment in financial market prices likely to be abrupt?  And – even if it is – is it likely to pose risks to financial stability?  We argue that the answer to both these questions could be yes:  financial valuations can move sharply even if the transition to sustainable energy were smooth.  And exposures are sufficiently large to warrant attention from both investors and policymakers.

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Filed under Financial Markets, Financial Stability, International Economics

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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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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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