Financial stability at your
service - speech by Sarah
Breeden

Based on remarks given at Wharton-IMF Transatlantic Dialogue,
Washington DC

Published on 10 September 2024

In these remarks - published alongside a companion article by Bank staff -
Sarah Breeden talks about the Bank's work on financial stability. She makes
the case for policymakers to focus on the provision of vital services, which
requires a better understanding of the dynamics of the system not just a focus
on individual institutions. She also talks about the relationship between
financial stability and economic growth.

Speech

I took over as the Bank's Deputy Governor for Financial Stability just under a year ago. Today
I'll step back to offer some remarks on how we think about financial stability and some of the
challenges we are considering in the current juncture. An accompanying article in the Bank's
Quarterly Bulletin provides an overview of the full range of work that the Bank does to further
its financial stability objective.

To preview the most important points, I hope to convince you of the following:

e The Bank supports financial stability in a range of ways, in close coordination with other
authorities.[1] Microprudential regulators, such as the Prudential Regulation Authority and
the Financial Conduct Authority, ensure that individual institutions or markets are resilient.
The Financial Policy Committee (FPC) addresses risks to the system as a whole. You can't
have macroprudential policy without the micro, but micro alone isn't enough. Indeed,
systemic thinking can lead you to different answers.

e Our approach to financial stability must always have system-wide dynamics in mind, not
just the individual entities in the system. But systemic thinking is only a means to an end:
the end is service provision, with the system reliably providing the vital services to
households and businesses, such as payments, loans and insurance, that matter to the
economy as a whole.

e The best contribution we can make to sustainable economic growth is to ensure that the
system provides vital services even as shocks occur. In doing so, we must avoid the
stability of the graveyard. And while there are clearly limits to the contribution financial
regulation can make to growth, in some cases, for some services, it may be possible to
make small adjustments that increase growth potential without undermining financial
stability.

What is financial stability?

l'll begin my remarks by setting out in simple terms what we're trying to achieve. The Bank of
England's statutory objectives are price stability and financial stability.[2] Price stability is well
understood, and it is even specified in the form of a quantitative target by the Government.
But financial stability is harder to pin down - it is most commonly understood as the absence
of instability. Indeed, its precise definition has been the subject of much debate in policy and
academic circles over the years.

So how do we define financial stability at the Bank? Financial stability means the financial
system provides vital services to households and businesses reliably in all states of the world,
even when shocks hit.[3} By shocks, we mean both structural - or longer-lasting - changes like
climate events or cyber threats, and cyclical shocks like severe recessions. The Annex sets
out a framework for thinking about what we're trying to achieve.

To maintain financial stability, we have to mitigate externalities, where market participants
don't consider the impact of their actions on other participants. For example, a lender might
have an incentive to lend more because their lending is secured by an asset, not considering
that the borrower might have to quickly sell other assets to meet repayments if a shock hits,
reducing the prices of assets held by others. Externalities can lead to fire sales, runs on
financial institutions, and a worsening of economic shocks.I[4]

Of course, one way to bring about financial stability would be to try to build so much resilience
in the system that, as a byproduct, very little activity occurs. A previous Chancellor called that
outcome the 'stability of the graveyard'. That wouldn't be optimal because it would directly
limit the provision of services and damage the economy even in the absence of shocks. And
so accountability for our actions and considering their costs as well as their benefits are
important parts of the statutory regime.

At the same time, it's not our job to ensure all services are provided to all at all times. Most of
our work aims to limit the negative consequences of disruptions in the provision of vital
services in bad times, rather than expand provision in good times - so that the system
absorbs rather than amplifies the inevitable shocks we face. For example, by limiting the
build-up of total household debt in the mortgage market, we make sure people are well placed
to meet their repayments and access further borrowing if needed when recessions hit. That
said, and as I'll come on to, for some services we might be able to use regulation to increase
service provision in a way that increases growth potential without undermining financial
stability, consistent with our secondary objective to support the Government's economic

policy.

We don't want to insure against every possible eventuality. Instead, we want to ensure
resilience to severe but plausible shocks. That implies that a degree of vulnerability remains,
and some disruptions can still occur. Therefore, we also have to stand ready to intervene

quickly and effectively when disruptions do occur, to limit their impact on financial stability now
and in the future.[5] The Annex details some examples of financial instability in the past and
the action we've taken in response.

Which services do we care about?

So which services are relevant to financial stability? Our focus is on services that are relied
upon by households and businesses and have a material role in supporting the economy.I[6]

That means we care about the vital funding, saving, insurance and payment services that
support households and businesses and so economic activity. We want to make sure
households and businesses can make transactions and manage and take risks. For example,
payments, credit card, mortgage and insurance services for households, and corporate
financing activity across a range of forms - bank lending, commercial paper, the bond market,
leveraged lending, private debt, private equity and venture capital - have an important role in
supporting the real economy. It is also important to facilitate the financing of the Government.

We also care about the financial markets and activities that support the provision of those
services to end users, in an intermediate way. For example, the gilt market - and the
associated repo market[7] - underpins a wide set of other transactions, through its role in
pricing risk-free assets and in helping liquidity to flow around the system. That ultimately
supports the provision of services that households and businesses use to borrow, save,
invest, pay for things and insure themselves against shocks.I8]

Figure 1: ShocksI[9] to the financial system can disrupt the provision of vital services
that the economy relies on

Source: Bank of England

Macroprudential policy has to stay focused on systemic risk

The Financial Policy Committee (FPC) is the macroprudential authority for the UK. The FPC's
job is to identify, monitor and take action to remove or reduce risks to the resilience of the
financial system as a whole, thereby helping the Bank to maintain financial stability. Whilst the
FPC is an important focal point, the Bank's work on financial stability goes much wider than
the FPC (see figure 2).[10] And indeed other authorities, such as the Financial Conduct
Authority (FCA) and The Pensions Regulator (TPR) which regulate many non-banks and
markets, and HM Treasury which sets the regulatory perimeter, have important roles to play.

Macroprudential authorities need to understand what the activity of firms means for the
markets they operate in, for the wider financial system, and ultimately for the provision of vital
services to the real economy. We need to be deliberate in prioritizing the risks we should
worry about. We have to stay focused on risks that could threaten the system as a whole,
which is why we need a system-wide macro focus that ensures interactions, interconnections
and the availability of alternative service providers are taken into account.

The Bank of England
Protects and enhances the stability of the financial system of the United Kingdom

Key: Aqua = Bank of England; Orange = Other regulator; Purple = Policy area; Gold = Firms.The chart focuses on prudential
regulation and supervision. The PRA also regulates and supervises credit unions, building societies and large investment
firms. FMID also regulates and supervises payment systems recognised by HM Treasury and central securities depositories.
The Bank's functions as lender of last resort, both extraordinary and non-extraordinary, are divided between the Resolution
Directorate and Markets Directorate. The Financial Conduct Authority regulates the conduct of financial services businesses
and is supervisor for other firms that do not fall within the scope of the PRA.Source: Bank of England

Ensuring that individual institutions are resilient - which is the job of the microprudential
regulators - is necessary but not sufficient for financial stability. You can't have
macroprudential policy without the micro, but micro alone isn't enough. And in some cases,
systemic thinking can lead you to different policy answers than what you'd get from a purely
microprudential perspective.

There are several reasons for this.

First, the financial firms themselves, and their microprudential supervisors, will understandably
have a more focused perspective, centred on the part of the system they engage in and their
own objectives.[11] They will not primarily think about how the services they provide could be
provided by other parts of the financial system, nor how their actions impact other participants
in the system.[12]

Second, individual resilience alone cannot ensure that the collective actions of financial firms
in stress do not lead to outcomes that pose risks to financial stability. Indeed, firms might take
actions to ensure their own stability but these might have knock on consequences for the
system as a whole.

Third, in some cases, higher resilience for individual institutions might lead to new or different
systemic risks, if risk is moved to parts of the system that are less able or equipped to
manage it. You could call that 'Whac-A-Mole' risk.

One example of this phenomenon is the move towards greater collateralisation in the financial
system since the global financial crisis.[13] In its most basic form, collateralisation is the use of
an asset (the collateral) to secure a loan. This limits counterparty credit risk and makes the
financial system safer. However, during a stress, collateral requirements can rise sharply. This
can lead to sudden rises in liquidity demand, as counterparties need to find cash or high-
quality assets at short notice. And this can result in fire sales of other assets when liquidity
needs are sudden or unexpected and liquidity management is inadequate. In many cases an
exogenous shock will act as a trigger that kicks off this process. During the 2022 LDI crisis
that trigger was the announcement of changes to UK fiscal policy.[14]

We have to continue to improve our understanding of the dynamics
of the financial system

To focus our financial stability policy work we need to understand how different sources of risk
could ripple through the financial system and quantify their potential impact on the vital
services that the system provides, particularly for those common risks[15] that can affect the
system as a whole and not just a corner of it.

This requires us to:

e Work out how systemic a risk is or could be: what is its potential impact on the system's
overall provision of vital services.

¢ Consider the effect of shocks in a system-wide manner: how might risks be correlated with
or cascade to other parts of the system.

¢ Be deliberate in our prioritisation of the risks to focus on: which matter most for vital
services.

e Think about the effect of policies in a system-wide way: so that actions to reduce one
systemic risk don't inadvertently create others.

To answer these questions, we need to be able to understand and model the financial system,
and not just its component parts. The academic literature in this area has made great
advances in recent years, both theoretically and empirically.[16] The latter has been supported
by the increased availability and better usage of micro-financial data that cover key markets
for bonds, repo and derivatives. The key challenge is to model accurately the dynamic
behaviour and interactions of firms from different sectors - a highly complex endeavour.

So, how are we applying systemic thinking in practice?

The System-Wide Exploratory Scenario (SWES) - where we have been working closely with
the Financial Conduct Authority and the Pensions Regulator over the past year - is a novel
exercise that illustrates the benefits of system-wide scenario analysis.[17]

For a long time, central bankers and academics have spoken about the importance of
understanding feedback and interconnections in assessing financial stability risks. But we
have struggled to run exercises that quantitatively explore these dynamics at a system-wide
level in advance of a shock occurring. The SWES is our first attempt to do just that.

The SWES focuses on markets that are core to UK financial stability - markets for government
and corporate bonds, repo markets for these assets and associated derivatives markets, such
as interest rate, cross-currency and inflation swaps. Participants have been asked to consider
how they would behave in a hypothetical market shock with price moves that are faster, wider
ranging and more persistent than observed both in the March 2020 'dash for cash' and the
2022 LDI crisis. And we are analysing how those behaviours interact and cascade across
markets to better understand the system-wide impact of such a shock. Indeed, it is system-
wide analysis like this that helps firms to understand their dependencies on others' actions -
and so whether their approach to risk management in theory will withstand stress in practice.

All of these markets ultimately support the provision of services to households and
businesses. The gilt market - and the associated repo market - underpins a wide set of other
transactions, through its role in pricing risk free assets and in allowing liquidity to flow around
the system. Derivatives markets allow participants to hedge against the risks they face. And
corporate bond markets directly provide a source of corporate financing.

The system wide thinking in the SWES is thus helping us to understand systemic risk as a
means to an end - where the end is supporting reliable service provision.[18]

What happens to our systemic thinking after the SWES?

We are on course to deliver the final report on the SWES in November this year. But how
might we take this work forward as part of our overall approach to macroprudential policy and
systemic risk assessment?

The SWES has illustrated the value of system-wide exercises.[19] And given the investment
we have made into the first exercise, we think we could get much of the benefit of a further
one through a leaner, more data-driven approach. Importantly, the SWES is now a proven
addition to our toolkit for exploring risks where interconnections, feedback or data constraints
are important. We could for example use this sort of exercise to explore risks to corporate

financing, where a range of market participants, including both banks and non-banks - with
complex interconnections and interdependencies across the two - are involved in providing
services to businesses.[20]

Many of the benefits from the SWES have come from the constructive engagement of
participants. We have learned as much from discussions with firms about investment
approaches and risk management as we have through data based work. And we will engage
firms in our deliberations about what comes next, continuing the active dialogue about
system-level risks.

But whilst scenario exercises are an important part of our work, our systemic thinking must
extend beyond them, into our wider policy and risk assessment work.I[21]

The normalisation of central bank balance sheets, for example, will affect bank funding and
liquidity conditions in the UK banking sector in coming years. In that context, my colleagues
have spoken recently about the critical role that central bank reserves play in the financial
system to meet our objectives for price stability and financial stability, and the related thinking
around how to structure our steady state balance sheet facilities.[22] A microprudential
approach to that question might lead you to conclude that reserves should be abundant, to
help banks to manage their liquidity risk. But a systemic approach would place more weight
on the importance of providing incentives to manage liquidity well - endogenously reducing
liquidity risk taking by banks - and making sure that liquidity flows freely around the financial
system, including to non-banks, so that the system is more resilient in stress.

Operational resilience is another example of an area of our work where systemic thinking is
important.[23] When individual financial firms are operationally resilient it helps them to provide
vital services to households and businesses. However, sometimes this is not enough to
prevent operational disruptions having an impact on the financial system as a whole, for
example, because firm-level disruptions can lead to a widespread loss of confidence in the
system or because firms are exposed to common vulnerabilities. A systemic approach
ensures that financial firms consider how their operational weaknesses affect the stability of
the system more widely, not just their businesses.

How does the FPC decide where and when it should take action?

Given the wide range of potential vulnerabilities in the system and the large policy toolkit
potentially available to the FPC, it has to be deliberate about where, when and how it takes
action, including through working in concert with other regulators given the vital role they play
in ensuring the resilience of individual institutions. [24]

First, the FPC has to take action where microprudential regulation has not adequately
addressed systemic risks.

In most instances, building the resilience of individual firms - which is the role of
microprudential policy - will build the resilience of the system. But in some instances,
macroprudential policy has to build more resilience than microprudential policy otherwise
might - as occurred with LDI funds given the correlated, concentrated nature of their
positions.[25] In other instances, macroprudential policy has to intervene to lean against
defensive actions to build individual resilience that would weaken the system as a whole. For
example, the FPC can release the UK countercyclical capital buffer in downturns that would
otherwise lead to unwarranted reductions in lending.

Second, the FPC must remain focused on the biggest risks to the provision of services.

Stress testing is an established way of sizing risks. The Bank is evolving its stress testing
framework in a number of ways. I've already mentioned the SWES and the future work that
may allow us better to take into account systemic risk arising from amplification and feedback
channels and interconnectedness. We are also taking stock of our framework for concurrent
bank stress testing - to embed the adaptability it has shown in recent years and allow us to
make best use of it to reflect the risk environment. Importantly, too, where banks went first
others have now followed: as well as the concurrent stress tests of the banking system, we
now conduct stress tests of the insurance and CCP sectors.

Third, the FPC has continually to adapt to the changing shape of the financial system.

In the early years of the FPC almost all of its policy recommendations focused on banks. [26]
Since then, reflecting the increase in bank resilience and the structural shift in activity towards
non-banks, the FPC's recommendations have shifted away from banks - notwithstanding the
greater difficulties in identifying risks in a more complex ecosystem and in tackling
vulnerabilities in a global market.

Fourth, macroprudential authorities should be pragmatic and creative about where they can
make a difference.

In some cases, the most effective way to change behaviour is by communicating privately or
publicly with market participants. At the same time, the FPC must be deliberate and targeted
in its public communications, focusing its public statements when it needs to get a particular
message to market participants or the public, for example to encourage behaviour changes.
[27] For example, the FPC's Brexit checklist encouraged others to take action to reduce the
risks associated with the UK's departure from the European Union.[28]

Fifth, we invest time in engaging with international authorities, because shocks and financial
markets are global. As an international financial centre and small open economy, the UK is
particularly exposed to global shocks. That underlines the importance of pursuing strong

international standards to support UK financial stability. We also have learned that whilst
global actions are sometimes needed, they need not hold up domestic action where it can be
effective.

In many areas the cross-border nature of finance means that the most effective way to take
action is in coordination with our global partners, through bodies like the Basel Committee or
Financial Stability Board. But in some cases, we can take effective action to build resilience
domestically or in coordination with smaller groups of jurisdictions, as we did for LDI funds
recently. [29]

How can the financial system contribute to growth?

As financial stability policymakers, the best contribution we can make to sustainable economic
growth is to ensure the system has enough resilience reliably to provide vital services even as
shocks hit. That is recognised by the FPC's primary objective. The FPC also has a secondary
objective, which should be pursued 'subject to' its primary objective, to support the economic
policy of the Government, including its objectives for growth and employment.[30] It is
incumbent upon us therefore to remain open to the possibility that in some areas we might be
able to increase the ability of the system to contribute to sustainable economic growth without
undermining financial stability.[31]

To take one example, there has recently been some debate around whether the pensions
sector can play a greater role in supporting growth in the wider UK economy. The Government
recently launched a review and is gathering evidence from interested parties. Previous
Bank work - explored whether arrangements in the pension sector had struck an optimal
balance between pensioner protection, economic growth and financial stability. More recent
work has looked at how the sector could facilitate greater investment in longer-term less liquid
assets. There may be ways to increase the sector's contribution to economic growth without
impacts on the resilience of service provision or financial stability.

Other specific aspects of the provision of financial services might have a particular impact on
growth that we might want to consider as we go about our work. For example, the financial
system's provision of services to small and medium enterprises (SMEs)/[32], innovations in the
money and payments landscape[33] and how the financial system supports the transition to a
lower emissions economy.[34] Much more evidence is required before we can draw firm
conclusions, but policymakers should take seriously any opportunities to increase the
system's contribution to growth if it can be done in a way that doesn't undermine financial
stability.

Conclusion

I'll finish by summing up what I've said today.

First, financial stability authorities must stay focused on risks that could threaten the system
as a whole. Microprudential work is necessary but not sufficient for financial stability -
systemic thinking can lead you to different answers to important policy questions.

Second, the Bank must make sure our work on financial stability always has the provision of
vital services in mind because that is ultimately what matters to households and businesses.
Systemic thinking is only a means to an end - the end is service provision. Financial stability
must always be 'at your service'.

Third, the best contribution we can make to sustainable economic growth is to ensure that the
system reliably provides vital services even as shocks occur. There are also clearly limits to
the contribution financial regulation can make to growth. But in some cases, for some
services, it may be possible to make small adjustments to increase growth potential without
undermining financial stability.

I'd like to thank Anne-Caroline Huser and Danny Walker for their assistance in drafting these
remarks. I would also like to thank Martin Arrowsmith, Andrew Bailey, Mary Bentley, Nathanaél
Benjamin, Julia Black, Geoff Coppins, Morgane Fouché, Lee Foulger, Dan Gray, Paul
Hawkins, Bonnie Howard, Kishore Kamath, Clare Lombardelli, Grellan McGrath, Sasha Mills,
Harsh Mehta, Nikhil Rathi, Tim Rawlings, Rhiannon Sowerbutts, James Talbot, Matthew
Waldron, Jack Worlidge, Michael Yoganayagam for their helpful input and comments. The
views expressed here are not necessarily those of the Monetary Policy Committee (MPC) or
the Financial Policy Committee (FPC).

Annex:

Stylised framework: financial stability and sustainable growth

Figure A uses a highly stylised diagram to bring our approach to financial stability to life. The
y-axis shows a measure of the resilience of the services provided by the financial system.
(Although conceptually clear, this would be very difficult to quantify in practice, given that it
should take into account the reliability of service provision even when future shocks hit.) The
x-axis shows a measure of sustainable economic growth.

I Resilience of
service provision

'Stability of
the graveyard'
e

e@
High growth
and resilience

Minimum level POPP? Siri irs
of resilience

e
Pre-crisis

Economic growth
through the cycle
_-_

The chart shows a stylised example of an indifference curve for financial stability policymakers. The precise magnitudes are
indicative. The y-axis is an abstract measure of the resilience of the services provided by the financial system and the x-axis
is the level of sustainable economic growth through the cycle. Source: Bank of England

The green line should be thought of as a form of indifference curve for financial stability
policymakers. Outwards shifts of this curve, if they were attainable, would bring about greater
net benefits to policymakers. The chart does not include a budget constraint or possibility
frontier, but of course some combinations of resilience and growth would be impossible to
attain.

We want to make sure that the system provides a set of vital services that are essential for
businesses and households in a reliable manner. That is shown in abstract form by the flat
part of the indifference curve and the dotted line on the chart. Below that level of resilience,
policymakers would not want to trade off lower levels of resilience even if it came with higher
economic growth.

The blue dot on the chart depicts where the UK financial system might have found itself on
this diagram before the post-global financial crisis reforms to the financial regulatory
framework.[35] The resilience of service provision was shown to be lacking when the crisis
struck, and services were rapidly withdrawn by important parts of the financial system. At the
same time, the high growth in the economy in the lead up to the crisis was unsustainable,
given it was associated with levels of credit growth that were unsustainable in the face of
shocks.

Focusing on the situation that the financial system found itself in before the crisis, as financial
stability policymakers we would have preferred an alternative situation where better regulation
left us with more resilient service provision - and therefore greater financial stability - as well
as higher growth potential in the economy. That increase in resilience (alongside a
sustainable level of growth) has occurred as a result of our reforms since then, as shown by
the blue arrow.

If the financial system were at a point exactly on the green line in figure A (the indifference
curve), but above the dotted line on the y-axis, we may be willing to increase sustainable
economic growth even if came with some reduction in the resilience of service provision. By
the same token, we may be willing to decrease sustainable economic growth if it came with
some increase in the resilience of service provision.

The red dot in figure A would come with a high level of resilience of service provision and very
low sustainable economic growth. A high level of resilience of service provision is another way
of saying a high level of financial stability. That combination of outcomes would be a version of
what has been called the 'stability of the graveyard'. It would clearly be unfavourable relative
to outcomes along the green indifference curve.

It is worth noting that the indifference curve depicted here does not imply that we need to
trade off the resilience of service provision and sustainable economic growth. If it were
possible to bring about a situation where both resilience and growth could be increased, that
outcome would lie on a higher indifference curve than the one shown in figure A, indicating
that it would be a preferred outcome for financial stability policymakers. That benign outcome
is shown by the gold dot on figure A.

What does financial instability look like?

The financial system has been hit by a number of shocks in recent years, some of which have
led to disrupted service provision and some of which haven't.

Some of those shocks to the financial system have been systemic in part because we didn't
have ex ante policy, but we have made sure to fill those gaps in response.

The global financial crisis exposed many systemic vulnerabilities, such as banks' vulnerability
to macroeconomic shocks and the opaqueness and complexity of the OTC derivatives
network.[36]

These policy responses have been effective at preventing recent shocks from becoming
systemic. Two recent examples support this. First, the higher interest rate environment has
been challenging for both mortgagors and lending banks, but the mortgage market tools as
well as the bank capital regime and regular stress testing exercises have supported resilience.
[37]

Second, UK banks have been resilient to the causes of other recent bank failures.[38] Silicon
Valley Bank failed because it mismanaged its interest rate risk, but UK banks have an explicit
capital charge for this.

Two examples relate to financial instability in markets. In March 2020, the actions of some
NBFls amplified the initial market reaction to the COVID19 pandemic to create a severe
liquidity shock globally (the 'dash for cash').[39] And in late September 2022, the rapid
repricing of long-dated UK government bonds generated stress and forced selling by
leveraged LDI funds.I[40]

Both instances severely disrupted gilt market functioning and threatened to harm the wider
economy by tightening financing conditions for UK households and businesses.

That's because first and most directly, gilt yields are the benchmark for other borrowing rates
for UK households and businesses. If gilt yields go up, mortgage rates tend to go up.

Second, the gilt market is vital to the functioning of other financial markets, such as repo
markets, where gilts are commonly used as collateral. The firms providing financing to
businesses and households will use the gilt and associated repo market for their cash and
collateral management, so if these markets do not function smoothly, the service provision by
these firms to end-users will be disrupted as well.[41]

Table A: Examples of financial instability

Shocks that
weren't
systemic
because of ex
ante policy

Higher rates
for
households
and
businesses
(June 2024
FSR)

SVB

Brexit

(Carney
2018
Report 2018

Interest