Given that the scale of the financial crisis that took place on its watch in the last few years it is remarkable that the Bank of England has not only emerged intact but with its powers actually enhanced. While it is understandable that the Chancellor might want to respond to the failure of the tri-partite regulation process by concentrating regulation and monetary policy back at the Bank, it is in our view wrong to have done so without demanding a wholesale reform at the institution itself. We believe there is a real risk that the Bank of England moulded by Sir Mervyn King over the last decade will not be up to the job that it is now being asked to do. In particular the concentration of power in the Governor, the lack of strong oversight by the Court and the bias towards academic rather than financial expertise are all major weaknesses that need to be addressed.
Sir Mervyn King’s assertion that he should have been shouting from the rooftops ahead of the financial crisis is certainly true. He should have been since he was after all the Governor of the Bank of England, with responsibility for financial stability. But the reality is that he did not shout from the rooftops, so the real question that should be asked is – why didn’t he? The Bank itself does not seem keen to ask such a question. In its, belated, decision to review its conduct in the crisis it confined itself to the following three areas: i) the provision of Emergency Liquidity Assistance in 2008/9 ii) the Bank’s framework for providing liquidity to the banking system as a whole and iii) the Monetary Policy Committee’s forecasting capability. None of them really delve into why the Bank did not see it coming. Surely if we want to prevent a repeat of the crisis why it did not see it coming should be the most important question.
We believe the failure to spot the crisis stemmed from decisions taken to favour monetary analysis and in particular the forecasting of inflation, over an interest in the financial system. Given the removal of the direct responsibility for supervising the banks, the Governor ran down the financial supervisory department, allowing a number of senior officials to leave or retire. In contrast the power of the economists inside the Bank was enhanced. The best example of this was the Governor’s choice as Deputy Governor of his successor as Chief Economist, Charles Bean, which meant that at the time of the crisis two of the three most senior figures at the Bank were academic economists, who had no experience of financial markets. The tradition continues today, with Paul Fisher the head of markets, being a former econometrician rather than someone from the financial sector. That tilt inside the Bank meant all eyes, or almost all eyes, were focused on the work of the Monetary Policy Committee in meeting the inflation target.
To give an idea of how much the Bank of England missed the upcoming crisis in its April 2007 Financial Stability Report it reported that ” The UK financial system remains highly resilient, the banks well capitalised and highly profitable.” Even its severe stress scenario losses were estimated to be 30-40% of tier one capital and it argued that “the strong financial position of the UK banking system provides a substantial buffer against future disturbances.” This was a mere four months before the crisis kicked off properly in the US and five months before Northern Rock was seeking liquidity support. The same document also commented that “Strong profit and revenue growth among LCFIs (Large Complex Financial Institutions) has supported their continued resilience. This makes the chances of distress at an LCFI remote.” Just eighteen months later RBS, perhaps the UK’s pre-eminent LCFI was effectively being taken over by the government.
By turning its focus towards monetary analysis and downgrading its focus on financial stability it managed to miss the biggest threat to the economic stability of the UK. The lack of understanding of what was going on in the financial system and the credit boom that was happening led, in our opinion, to the Bank being too complacent that it was doing its job merely by hitting the inflation target. Similarly in focusing on moral hazard in the case of Northern Rock rather than the implications of a near bank failure, the Bank and its Governor failed to understand the greater implications. While this may be understandable since the Bank were far from on their own in missing the threat, the continued failure to appreciate the enormity of the threat after the crisis was in full flow has to cast real doubt on the Bank’s analytical capabilities. Indeed the Monetary Policy Committee was still debating raising interest rates in July 2008, a full year after the crisis had started. For sure inflation was well above target, but that was due to external shocks, while the UK financial system was teetering on the edge. Only David Blanchflower, on the MPC, was talking of lowering rates at the time. A mere five months later bank rate was being cut to 2%, with QE round the corner.
If the Bank had better understood what was going on in the financial System then perhaps we would have avoided some of the worst of the problems. After all the Federal Reserve in the US, which, through the New York Fed, has much closer links to the banks was cutting interest rates more than a year before the Bank of England. Dan Cohen’s excellent book “Inside the Bank of England” quotes insiders as saying that everything had to be framed as relevant to monetary policy and that “anything that appeared to be remotely connected with financial regulation would be batted away impatiently”.
While the Bank did eventually respond by aggressively easing monetary policy, we believe there was still a reluctance inside the Bank to acknowledge that the financial sector and the banks were the key to the crisis and therefore the key to recovery. When quantitative easing began the then Chancellor, Alistair Darling, tried to prompt the Bank to buy riskier assets such as corporate bonds but the Bank, led by the Governor, only wanted to buy riskless assets such as gilts. While this did boost the money supply to a degree it did not directly address the credit crunch. The Bank argued that QE was successful in boosting the economy, yet its only evidence for this was a study produced internally by its economists. Our belief is that this study significantly overestimated the impact of QE. It has continued to increase QE based on that study, yet money supply growth has failed to recover. The evidence is that it is not working anywhere near as well as the Bank expected.
The only real measure the BOE took to address the strains in the banking system was the Special Liquidity Scheme, whereby it lent money over three years to banks against assets. It thought it would lend £50bn and in fact lent £185bn. Yet it allowed this measure to expire in January this year without putting in place a replacement. Paul Fisher, head of markets, even acknowledged late last year that this would put some upward pressure on funding costs. We argued ahead of its demise that this was unwise but the Bank pressed on, arguing that banks should be weaned off of its support. Six months later as banks started to raise lending rates due to higher funding costs the Funding for Lending Scheme had to be introduced to lower bank funding costs.
Looking at the way it has handled its new responsibilities the Bank we believe the flaws inherent in the structure and attitude of the Bank of England have been evident. The Financial Policy Committee, which has been run in shadow form ahead of the government’s legislation taking effect, has almost solely focused on increasing the financial strength of the UK institutions, arguing that they should continue to build as much capital as possible and shore up their liquidity positions. In doing so it has ignored the effect of this advice on the banks’ ability to lend. Higher liquidity and capital requirements are simply incompatible with higher lending in the current environment. No wonder the Chancellor decided to introduce a specific mandate for the FPC to consider the growth implications of its advice.
The errors made by the Bank in the run up to and since the Financial Crisis serve to underline that the current institution is far from ready to absorb its new responsibilities. The current Governor downgraded financial regulation at the Bank and built an organisation whose focus was on monetary analysis and academic vigour. Understanding or experience of the financial sector are not skills held in high esteem, something which hardly bodes well for the employees of the new Prudential Regulation Authority.
We do not believe that was wise even for an organisation focused purely on monetary policy still less one that has primary responsibility for financial stability and regulation. This makes the appointment of the new Governor, which the government is due to make this autumn, crucial. The new Governor has to understand the financial system and regulation, as well as monetary policy. In the past such a balance may have been found in one person, but we believe the modern financial system is too complex for that. We are also concerned about the power that the current system invests in the Governor. We believe this led to areas being under resourced because they were deemed to be not of interest. This was not even wise in a Bank of England focused on one thing let alone three.
Our contention is that the structure and the culture of the Bank needs to be changed if it is to be successful in its new role. The Treasury Select Committee has called for the Court of the Bank of England to be strengthened and given much stronger powers of oversight of the Executive. We completely agree. But we would go further. We would argue that the new Governor should be cast as a Chairman with three deputy governors heading the MPC, FPC and PRA as Chief Executives running their areas on a day to day basis. In effect he would be Chairman of the Board rather than Sir Mervyn’s Executive Chairman role. We would strongly urge that the heads of the FPC and PRA have financial market experience. If for whatever reason they do not they should have deputies that do. We believe the Bank should encourage movement of employees between itself and the private sector, to ensure that it does not become insular and that senior employees understand the financial sector. Finally we believe there needs to be a majority of non bank members on both the Financial and Monetary Policy Committee to reduce the power of the BOE executive and prevent groupthink.
We believe the Chancellor is right to concentrate financial regulation and monetary policy under one roof, but we believe he is wrong to believe that the Bank of England in its current form is up to the job.