Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, at the Lord Mayor's Banquet for
Bankers and Merchants of the City of London, London, 20 June 2007.
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My Lord Mayor, Mr Chancellor, My Lords, Ministers, Aldermen, Mr Recorder, Sheriffs,
Ladies and Gentlemen:
Chancellor, this will be your last Mansion House Dinner with the Merchants and Bankers. And I want
to start by warmly congratulating you on your record-breaking period in office, and on the imminent
assumption of the leadership of your party and country. It has been a remarkable decade for the
British economy.
Your decision to grant independence to the Bank of England ten years ago is widely and rightly
regarded as a fundamental improvement to the conduct of economic policy in this country, and we in
the Bank are grateful to you for giving us the opportunity to demonstrate the benefits of an
independent central bank. Your reform illustrates the key principle that institutions matter. Individuals,
however talented, cannot consistently perform well if the institutional structure in which they operate is
badly designed.
For too long the UK economy lurched between success and failure rather in the way that the national
cricket team has recently. Getting the institutions right was a crucial part of the 1997 reforms. Perhaps
there is a lesson here for the ECB - the England and Wales Cricket Board. And I welcome the
changes that you announced last week to make appointments to the Monetary Policy Committee
subject to a more transparent process with a more systematic timetable.
Behind the design of our monetary institutions is a simple principle. I described it last October in a
lecture at Kirkcaldy. It is that the value of paper money depends on trust. Trust that it will hold its
value. Trust that others will accept it as a means of payment.
In particular, our banknotes must be trusted by the public - cash still accounts for over 60% of the
number of transactions. In March the Bank launched a new series of bank notes with enhanced
security features. As an economist, I was pleased that a pioneer of the dismal science should appear
on our bank notes. Adam Smith, who appears on new £20 notes, was a thinker who recognised the
importance of institutions.
Imagine my concern, therefore, when, after 3 1⁄2 years as Governor, I read the following report from the
Wolverhampton Crown Court. "A judge demanded to know why police failed for three and a half years
to arrest a wanted Birmingham man - when all the time he was living at home. Adam Smith,
suspected of passing forged £20 notes, had a fixed address in Edgbaston and was picking up
benefits". So I hope the introduction of one Adam Smith will hinder the activities of the other.
I am proud of the new £20 notes, but I cannot say the same of our £5 notes. There has been much,
and in my view justified, criticism of their availability and condition. Over the past ten years, the value
of Bank of England notes in circulation has doubled, from around £20 billion to around £40 billion. But
none of that is accounted for by the £5 note for which the value in circulation has remained constant
for fifteen years at some £1 billion. And the average lifetime of the note has doubled. As a result, many
more notes are noticeably soiled and scruffy.
ATMs account for over 60% of all cash obtained by the public. Few issue £5 notes. It is more
economical for banks to stock ATMs with £10 and £20 notes. The problem is not at the production end
- we have an ample supply of new £5 notes waiting to be used. We want to see them in circulation.
There is a need for an adequate supply of low denomination notes that can be used for small
transactions where cash is the predominant means of payment. Such mutual convenience is a public
good, and may not correspond to the private interest of commercial banks.
That is why we must not let this situation continue any longer. The public need £5 notes. The solution
may involve some alteration in the incentives for banks to obtain different denomination notes from the
Bank of England, new arrangements to increase the availability of notes to retailers, and an
improvement in the durability of the notes that we print. So the Bank will be initiating discussions to
see what methods might ensure greater access by the public to new £5 notes.
Your reforms, Chancellor, encompassed not just monetary policy - through the Bank of England Act -
but also financial regulation - through the creation of the FSA and the 1997 Memorandum of
Understanding between the Bank, FSA and Treasury. There was, however, some unfinished business
in that Memorandum. The Bank of England was given responsibility for the oversight of payment
systems. But it was given no formal powers to discharge that responsibility. Instead it relies heavily on
the influence afforded by its operational role at the centre of the high-value payment system. But that
influence extends only so far.
The time has come to deal with the imbalance between responsibilities and powers. The "plumbing" of
the financial system represented by payment and settlement systems may not be as glamorous as the
trading activity which attracts so many bright young people to work in the financial sector, but it is
absolutely crucial to maintaining stability. To have responsibility without power is the misfortune of the
bureaucrat. The solution, in my view, does not mean more powers for the Bank, but narrower
responsibilities. Proposals are under active discussion among the tripartite partners, and they give me
confidence that the imbalance will soon be resolved.
Financial stability more generally is a topical concern in financial markets. More than one banker and
merchant in the City has said to me recently, "I cannot recall a time when credit was more easily
available". How worried should we be? Let me begin with the implications for the stability of markets
and institutions before turning to monetary policy.
Securitisation is transforming banking from the traditional model in which banks originate and retain
credit risk on their balance sheets into a new model in which credit risk is distributed around a much
wider range of investors. As a result, risks are no longer so concentrated in a small number of
regulated institutions but are spread across the financial system. That is a positive development
because it has reduced the market failure associated with traditional banking - the mismatch between
illiquid assets and liquid liabilities - that led Henry Thornton and, later, Walter Bagehot to promote the
role of the Bank of England as the "lender of last resort" in a financial crisis.
But the historical model is only a partial description of banking today. New and ever more complex
financial instruments create different risks. Exotic instruments are now issued for which the distribution
of returns is considerably more complicated than that on the basic loans underlying them. A standard
collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps,
into tranches. But what is known as a CDO-squared instrument invests in tranches of CDOs. It has a
distribution of returns which is highly sensitive to small changes in the correlations of underlying
returns which we do not understand with any great precision. The risk of the entire return being wiped
out can be much greater than on simpler instruments. Higher returns come at the expense of higher
risk.
Whether in banking, reinsurance or portfolio management, risk assessment is a matter of judgement
as much as quantitative analysis. Ever more complex instruments are designed almost every day.
Some of the important risks that could affect all instruments - from terrorist attacks, invasion of
computer systems, or even the consequences of a flu pandemic - are almost impossible to quantify,
and past experience offers little guide.
Be cautious about how much you borrow is not a bad maxim for each and every one of us here
tonight. Ignore the unsolicited emails that rain down on us offering unwanted credit. I received one last
week that began, "We have the solution, Mervyn, for your bankruptcy".
The development of complex financial instruments and the spate of loan arrangements without
traditional covenants suggest another maxim: be cautious about how much you lend, especially when
you know rather little about the activities of the borrower. It may say champagne - AAA - on the label
of an increasing number of structured credit instruments. But by the time investors get to what's left in
the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing
financial system is far from straightforward, and the liquidity of the markets in complex instruments,
especially in conditions when many players would be trying to reduce the leverage of their portfolios at
the same time, is unpredictable. Excessive leverage is the common theme of many financial crises of
the past. Are we really so much cleverer than the financiers of the past?
Concerns about the rate at which credit is being created extend to monetary policy. As I said last week
in Cardiff, it would be optimistic in the extreme to suppose that the rapid growth of money and credit
could be dismissed solely as a positive shock to the demand for money. The spread between interest
rates paid by households and businesses and interest rates available in the money market has fallen.
This has been one of the factors behind the strength of demand in the UK economy over the past
year. Despite greater availability of labour, businesses have not expanded employment sufficiently to
prevent stronger demand from increasing capacity pressures. Such pressures encourage businesses
to raise prices. And that is exactly what the business surveys suggest has been happening. That
underlying upward pressure on inflation has in part been hidden by the volatility of domestic energy
prices. But it is why we have raised interest rates four times and by 1 percentage point in all over the
past year.
Our central view remains that inflation will fall back this year as the rises in domestic gas and
electricity prices last year drop out of the annual comparison, and the recent cuts in prices feed
through to household bills. But it is important to look through those temporary effects to the outlook
further ahead. The discussion within the Monetary Policy Committee is explained in the minutes of our
June meeting which were published this morning. As ever, there is room for differences of judgement
as to the appropriate level of Bank Rate - as shown by the differing views within the MPC. But every
member of the Committee is determined to bring inflation back to target and keep it there - or as close
to the target as possible - indefinitely.
In the long run, it is of the utmost importance that the right institutions to secure both monetary and
financial stability are in place. I believe they are. Chancellor, you are now moving on. Our country
continues to benefit from the institutional arrangements you introduced in 1997. As that great political
commentator Niccolo Machiavelli noted, "nothing brings a man greater honour than the new laws and
new institutions he establishes". I encourage you to be equally bold in your next job.
Institutions outlast us all. Over time, they are adapted as we learn the lessons of the past in the light of
a changing present to meet our future needs. Lord Mayor, you know the importance of learning, and
the Chancellor has emphasised again this evening the role of education in shaping Britain's place in
the world economy. Both the Chancellor and I have been enthusiastic about the theme of your
mayoralty: "City of London - City of Learning". And all of us here tonight would like to pay tribute to
your work since you became Lord Mayor, and to thank both the Lady Mayoress and yourself for the
splendid hospitality which you have extended to us all this evening.
So I invite you all to rise and join me in the traditional toast of good health and prosperity to "The Lord
Mayor and the Lady Mayoress".