Unifying monetary and macroprudential policy

Julia Giese, Michael McLeay, David Aikman and Sujit Kapadia

Central banks have been using a range of monetary policy and macroprudential tools to maintain monetary and financial stability. But when should monetary versus macroprudential tools be used and how should they be combined? Our recent paper develops a macroeconomic model to answer these questions. We find that two instruments are better than one. Used alone, interest rates can control inflation, but are ineffective for financial stability. Policymakers can do better by also deploying the countercyclical capital buffer, a tool that varies the amount of additional capital banks must set aside. The appropriate combination of tools can vary: both should tighten to counter a joint expansion of credit and activity, but move in opposite directions during an exuberance-driven credit boom.

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What if it’s a perfect storm? Stronger evidence that insurers should account for co-occurring weather hazards

John Hillier, Tom Perkins, Ryan Li, Hannah Bloomfield, Josie Lau, Stefan Claus, Paul Harrington, Shane Latchman and David Humphry

In 2022 a sequence of storms (Dudley, Eunice and Franklin) inflicted a variety of hazards on the UK and across Northwest Europe, resulting in £2.5–4.2 billion in insured losses. They dramatically illustrate the potential risk of a ‘perfect storm’ involving correlated hazards that co-occur and combine to exacerbate the total impact. Recent scientific research reinforces the evidence that extreme winds and inland flooding systematically co-occur. By better modelling how this relationship might raise insurers’ capital risk we can more firmly argue that insurers’ model assumptions should account for key dependencies between perils. This will ensure that insurers continue to accurately assess and manage risks in line with their risk appetite, and that capital for solvency purposes remains appropriate.

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Capitalising climate risks: what are we weighting for?

David Swallow and Chris Faint

Policymakers have been investing heavily, to an accelerated timeline, to better understand the financial risks from climate change and to ensure that the financial system is resilient to those risks. Against that background, some commentators have observed that the most carbon-intensive sectors may be subject to the greatest increase in transition risk. They argue that these risks are not currently included within risk weights in the banking prudential framework and that regulators should adjust the framework to include them. Conceptually, this argument sounds credible – so how might UK regulators approach whether to adjust the risk-weighted asset (RWA) framework to include potential increases in risks? This post updates on some of the latest thinking to help answer this question.

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From Pillar 2 to post: is it time for a change in concentration risk methodology?

Chris Leaney

The Herfindahl-Hirschman Index (HHI) is a measure of diversification, commonly used as an indicator to calculate banks’ credit concentration risk capital requirements (where credit concentration risk is potential losses from undiversified portfolios). According to BCBS (2019) HHI is employed by c. 50% of regulators, including the Prudential Regulation Authority (PRA) since 2016. However, despite some evidence that the data-light, easy-to-implement HHI produces broadly comparable outcomes with formal models (eg Bundesbank (2006)), such evidence is limited to large banks or theoretical datasets. In this post I examine the relationship between HHI and a formal model of sector and geographical concentration risk. I show that, for a wide sample of bank sizes, HHI is poorly correlated with the model outputs for both risk types.

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Do banks need belts and braces?

Marcus Buckmann, Paula Gallego Marquez, Mariana Gimpelewicz and Sujit Kapadia

Bank failures are very costly for society. Following the 2007/2008 global financial crisis, international regulators introduced a package of new banking regulations, known as Basel III. This includes a wider range of capital and liquidity requirements to protect banks from different risks. But could the additional complexity be unnecessary or even increase risks, as some have argued? In a recent staff working paper, we assess the value of multiple regulatory requirements by examining how different combinations of metrics might have helped prior to the 2007/2008 crisis in gauging banks that subsequently failed. Our results generally support the case for a small portfolio of different regulatory metrics: having belts and braces (or suspenders) can strengthen the resilience of the banking system.

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Fluttering and falling: banks’ capital requirements for credit valuation adjustment (CVA) risk since 2014

Giulio Malberti and Thom Adcock

The financial crisis exposed banks’ vulnerability to a type of risk associated with derivatives: credit valuation adjustment (CVA) risk. Despite being a major driver of losses – around $43 billion across 10 banks according to one estimate – there had been no capital requirement to cushion banks against these losses. New rules in 2014 changed this.

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Bitesize: Correction to ‘There are two productivity puzzles’

Patrick Schneider

Last year I published a post arguing that there are two productivity puzzles – one in the level and the other in the growth rate of labour productivity – that contained an error. In the original blog, I showed that we could decompose the puzzle(s!) into contributions from either slower than trend growth in capital services per hour worked (capital deepening) or technology growth (TFP).

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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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