2 Financial Stability Review: June 2005 — Financial stability themes and issues
Financial stability
themes and issues
Since last December’s Review, the short-run outlook for the stability of the UK financial system has remained good.
The major UK banks, and the borrowers and other counterparties to which they are exposed, have not in general
shown any signs of financial fragility. However, the ‘search for yield’ has been continuing and longer-term
vulnerabilities may be building because of the still rapid growth in some borrowers’ and financial institutions’
balance sheets. The threats facing the UK financial system are discussed in the Bank of England’s regular
assessment of the Financial stability conjuncture and outlook.
Private firms cannot be expected voluntarily to take full account
of the possible consequences of spillovers from their actions for
the overall stability of the financial system as a whole, unless
their incentives are altered. Hence there is a potential role for
policymakers in influencing incentives appropriately and in some
cases constraining private actions. The Bank’s regular article
Strengthening financial infrastructure considers two exercises
designed to ensure that some of the risks faced by firms are
managed in such a way that they do not give rise to an
unacceptable level of systemic risk. First, it reports on the
proposals of the Basel/IOSCO Trading Book Review, which are
currently being finalised after a period of consultation. An
important aspect of the proposals is that capital standards
should take into account the liquidity of financial markets used
by banks to transfer risk. Second, the article looks at the
management of risks in payment systems. As a practical example,
it describes the agreement put in place earlier this year by the
Bank, the payments industry association APACS and the member
banks of the United Kingdom’s major retail payments systems, to
reduce spillover risks that could arise in the event of the default
of a member of these systems. This agreement required
co-operation between the banks and the payments industry, the
Bank of England and the FSA to ensure that the agreement was
supported by prudential rules.
Another way in which the authorities can contribute to the
maintenance of financial stability is by strengthening the
framework for restructuring sovereign debts. The article by
Paul Bedford, Adrian Penalver and Chris Salmon, Resolving
sovereign debt crises: the market-based approach and the role of the
IMF, notes that, historically, sovereign debt crises have often
entailed protracted and costly debt restructuring negotiations.
As such crises are not unusual, it is important to address these
Financial stability themes and issues — Financial Stability Review: June 2005 3
Financial stability difficulties. The authors argue that, despite some helpful recent
themes
developments, there remains scope both to strengthen
market-based mechanisms for resolving crises and to improve the
clarity of IMF policies.
and issues One of the market-based mechanisms that can help to mitigate
systemic risk is the appropriate design of sovereign bond
contracts. The Bank of England hosted a workshop in January
2005, reported here by Paul Bedford, to facilitate discussion
among market participants. The workshop explored innovations
that, in principle, might help to improve the effectiveness of the
debt restructuring process. Three specific innovations were
considered at some length: engagement provisions; the
appointment of bondholder trustees; and aggregation clauses.
Financial Stability Review Contract design ought to take into account the possibility that
June 2005
debtors may default and the fact that some desirable financial
markets and instruments are missing, so full private insurance
arrangements to eliminate financial fragility are impossible.
Ideally, such issues would be analysed together in a single
coherent model. In A model to analyse financial fragility,
Charles Goodhart and Lea Zicchino sketch a framework for such
an approach to the analysis of financial stability, drawing on
recent research at the Bank and forming part of a wider effort to
develop the theoretical analysis of financial stability. In contrast
to many previous models, it includes features that are essential if
the possibilities of contagion and feedback effects are to be
examined: banks and firms can default, there are incomplete
markets and agents differ in their characteristics. The framework
generates some complex models but, nevertheless, these can be
calibrated empirically (if imprecisely) to examine the welfare
consequences of a range of possible policy measures, such as
capital adequacy requirements. One advantage of this approach
is that it holds out the hope of deriving an empirical measure of
financial fragility.
The Goodhart and Zicchino approach is helpful when assessing
the likely long-run impact of changes in key parameters and
policies on risks to financial stability, as it takes into account
general equilibrium feedbacks. To achieve that goal while
maintaining the model’s tractability requires some strong
simplifying assumptions. In assessing how robust real financial
systems are likely to be in the face of shocks, it is helpful also to
use approaches that accommodate a richer empirical data set
and are more amenable to statistical estimation, even though
they may not capture all the second-round effects of the shocks.
In Stress testing as a tool for assessing systemic risks, Philip Bunn,
Alastair Cunningham and Mathias Drehmann set out the current
stress-testing framework used in this spirit in the Bank of
England to assess the degree of credit risk; this can be seen as
complementary to the Goodhart-Zicchino approach. As an
example, the article updates the analysis of the shocks
4 Financial Stability Review: June 2005 — Financial stability themes and issues
considered in the 2002 UK Financial Stability Assessment
Programme exercise with the FSA and IMF; the results are
reassuring and consistent with the qualitative judgements made
in this issue’s review of the Financial stability conjuncture and
outlook. The authors also discuss some of the challenges
associated with stress testing. Stress events are rare, which
makes calibration of such circumstances difficult, particularly if
the relationships between variables are non-linear and if there
are structural breaks. But the stress-testing framework can be
used to assess the importance of these challenges. The article
is part of the Bank’s wider strategy to communicate its
stress-testing work and highlight some key issues for market
participants, which complements the work being undertaken
with firms by the FSA.
Stress-testing generally uses hypothetical ‘shock scenarios’. But
it is also possible to examine the impact of historical events.
This is the approach taken by Marco Stringa and Allan Monks in
their investigation Inter-industry linkages between UK life insurers
and UK banks: an event study, which considers the impact of six
events that affected life insurers’ equity prices in 2001–03. They
find that adverse events did not spill over to have a significant
impact on the UK banking sector as a whole, but so-called
bancassurers’ equity prices were affected to some degree,
possibly as a consequence of their direct ownership of life
insurance subsidiaries.
The articles in this issue of the Financial Stability Review variously
consider how to think about financial stability, threats to
financial stability and measures to reduce those threats. The
Bank of England, alongside the FSA and HM Treasury, is also
heavily involved in ensuring that, in the unlikely event of a
financial crisis occurring, it can be resolved quickly and
effectively. These are all important aspects of a central bank’s
work, as Sir Andrew Large explains in A framework for financial
stability, a speech reprinted in this Review. Sir Andrew makes the
point that central banks need to be clear, accountable and
transparent as to the reasons for devoting resources to financial
stability work. He articulates a set of general organising
principles for such work, acknowledging that — as in the United
Kingdom — responsibility for this public policy objective is
often shared with regulators and the finance ministry. And he
draws attention to some of the reasons why making such a
framework operational is challenging — not least because of the
increasing complexity of financial systems. But it is important
that the challenge be taken up, given the potential costs to
economies of failure.
Financial stability themes and issues — Financial Stability Review: June 2005 5