Mervyn King: Monetary policy developments
Speech by Mr Mervyn King, Governor of the Bank of England, on the 2012 BBC Today
Programme Lecture, London, 2 May 2012.
* * *
Fifty years of rising living standards came to an end with the financial crisis. As a nation, we
are now significantly worse off than we were four years ago. The crisis has cast a long
shadow. Of course, the immediate challenge is to get our economy growing again. But fifty
years from now will our grandchildren ask why we lacked the courage to put in place reforms
to stop a crisis happening again? I hope not - and that's why I want to speak to you tonight
about the changes we need to make.
Believe it or not, it's more than seventy years since the Governor of the Bank of England last
gave a talk on radio in peacetime. In March 1939, Montagu Norman spoke to the BBC in the
wake of the economic slump that we now call the Great Depression. Just listen for a moment
to the 1930s version of Evan Davis introducing the broadcast:
AUDIO INSERT:
"The Rt Honourable Montagu Norman, Governor of the Bank of England,
speaking in the Empire Series on the City of London."
More the presenter of "yesterday" than "today"!
In those days, the Bank of England, known affectionately as the "Old Lady of Threadneedle
Street", was a private bank performing the role of a central bank only by custom and practice.
Here is how Norman described the relationship between the Bank of England and the
Government in the 1930s:
AUDIO INSERT:
"The Bank of England has always been constitutionally a private body... but what
matters is not the position on paper but the position in practice. In monetary as in
other matters the Government of the day must have the final word and this is fully
recognised."
Today, the position on paper and the position in practice are the same. Our job is given to us
by the Government and by Parliament.
But for me, the story of the modern independent Bank of England began exactly fifteen years
ago in early May 1997. It was a Bank Holiday Monday, immediately following the general
election. After an early morning tennis match, I returned home to find a message from the
Governor, Eddie George. He wanted to meet me in the Bank as soon as possible. An hour
later we met in his office, alone in the imposing building known to most of you only by the
facade shown on television. Eddie told me of his meeting that morning with the Chancellor,
Gordon Brown, who had explained the proposal for Bank independence. It was something for
which Eddie and I had worked for five years since Britain's departure from the Exchange
Rate Mechanism in 1992. Now we had a chance to show what an independent central bank
could do. Although far from clear at the time, the later decision to remove from the Bank of
England the power to regulate banks would return to haunt us.
Over the next decade, the new Monetary Policy Committee established a track record of low
and remarkably stable inflation. In my first speech as Governor in 2003, I warned that this
stability was unlikely to continue. And it didn't. Within a few years, and despite low inflation,
the advanced economies of the world were plunged into a financial crisis which led to the
sharpest decline in world trade since the 1930s, recessions across the world, rising
unemployment and the near collapse of our banking system.
So tonight I want to try to answer three questions. First, what went wrong? Second, what
are the lessons? Third, what needs to change?
Let me start by pointing out what did not go wrong. In the five years before the onset of the
crisis, across the industrialised world growth was steady and both unemployment and
inflation were low and stable. Whether in this country, the United States or Europe, there was
no unsustainable boom like that seen in the 1980s; this was a bust without a boom.
So what was the problem? In a nutshell, our banking and financial system overextended
itself. That left it fragile and vulnerable to a sudden loss of confidence.
The most obvious symptom was that banks were lending too much. Strikingly, most of that
increase in lending wasn't to families or businesses, but to other parts of the financial
system. To finance this, banks were borrowing large amounts themselves. And this was their
Achilles' heel. By the end of 2006, some banks had borrowed as much as £50 for every
pound provided by their own shareholders. So even a small piece of bad news about the
value of its assets would wipe out much of a bank's capital, and leave depositors scurrying
for the door. What made the situation worse was that the fortunes of banks had become
closely tied together through transactions in complex and obscure financial instruments. So it
was difficult to know which banks were safe and which weren't. The result was an
increasingly fragile banking system.
So how did banks find themselves in such a precarious position? Banks are a vital part of our
economy. They run the payment system, allowing us to pay our bills and receive our wages.
They finance businesses investing in new ventures and families buying a new home. Without
a banking system our economy would grind to a halt. Because of that, markets correctly
believed that no government could let a bank fail since that would cause immense disruption
to the economy. This meant that large banks in particular benefited from an implicit taxpayer
guarantee, enabling them to borrow cheaply to finance their lending. In good times, banks
took the benefits for their employees and shareholders, while in bad times the taxpayer bore
the costs. For the banks, it was a case of heads I win, tails you - the taxpayer - lose.
This cheap funding fuelled lending. Banks got bigger. In the UK, their balance sheets rose
from around one-half to more than five times our national income in a generation. As the
banks got bigger, so did the implicit subsidy - by the time of the crisis it reached many
billions of pounds a year. The bigger banks became, the more they were seen as too
important to fail, and the surer markets became that the taxpayer would bail them out. But
there are only so many good loans and investments to be made. In order to expand, banks
made increasingly risky investments. To make matters worse, they started making huge bets
with each other on whether loans that had already been made would be repaid. The seeds of
the eventual downfall of the financial system had been sown. As loans and investments went
bad, those seeds started to sprout.
In August 2007 came the moment when financial markets began to realise that the emperor
had no clothes. The announcement by the French bank BNP Paribas that it would suspend
repayments from two of its investment funds triggered a loss of confidence and a freezing of
some capital markets. A month later, the crisis claimed its first victim when Northern Rock
failed. In the months that followed, there was a steady procession of banking failures
culminating in the collapse of the American bank Lehman Brothers in September 2008.
Financial waters, already extremely chilly, then froze solid. Banks found it almost impossible
to finance themselves because no-one knew which banks were safe and which weren't.
From the start of the crisis, central banks provided emergency loans but these amounted to
little more than holding a sheet in front of the emperor to conceal the nakedness of the
banks. They didn't solve the underlying problem - banks needed not loans but injections of
shareholders' capital in order to be able to absorb losses from the risky investments they had
made. From the beginning of 2008, we at the Bank of England began to argue that UK banks
needed extra capital - a lot of extra capital, possibly £100 billion or more. It wasn't a popular
message. But nine months later, market pressure forced banks to raise new capital or accept
it from the state. UK tax payers ended up owning large portions of two of our four biggest
banks, Royal Bank of Scotland and Lloyds TSB, but almost all banks would have failed had
not taxpayer support been extended. That bold action in October 2008 could have happened
sooner. But the most important thing is that it was done. And the policy of recapitalising the
banks was soon copied by other countries.
Bailing out the banks came too late though to prevent the financial crisis from spilling over
into the world economy. The realisation of the true state of the banking system led to a
collapse of confidence around the world and a deep global recession. Over 25 million jobs
disappeared worldwide. And unemployment in Britain rose by over a million. To many of you
this will seem deeply unfair, and it is. I can understand why so many people are angry.
It's vital that we learn from the crisis. A good place to start is to ask, as the Queen famously
did, "Why did no-one see this coming?" The answer is extremely simple: no-one believed it
could happen. Recessions were supposed to follow booms and high inflation, not periods of
steady and sustainable growth with low inflation. There seemed to be no reason to expect
the worst recession since the 1930s. After the ravages of inflation in the 1970s - younger
listeners might need to be reminded that inflation hit 27% in 1975 - it was I think
understandable that we focussed on the need to bring inflation down. But conquering
inflation was not enough to ensure stability. Although inflation was under control, fragilities
were building in the banking system. On all sides there was a failure of imagination to
appreciate the scale of the fragilities and their potential consequences. No-one could quite
bring themselves to believe that in our modern financial system the biggest banks in the
world could fall over. But they did.
That isn't to say we were blind to what was going on. For several years, central banks,
including the Bank of England, had warned that financial markets were underestimating risks.
So why, you might ask, did the Bank of England not do more to prevent the disaster? We
should have. But the power to regulate banks had been taken away from us in 1997. Our
power was limited to that of publishing reports and preaching sermons. And we did preach
sermons about the risks. But we didn't imagine the scale of the disaster that would occur
when the risks crystallised. With the benefit of hindsight, we should have shouted from the
rooftops that a system had been built in which banks were too important to fail, that banks
had grown too quickly and borrowed too much, and that so-called "light-touch" regulation
hadn't prevented any of this. And in the crisis, we tried, but should have tried harder, to
persuade everyone of the need to recapitalise the banks sooner and by more. We should
have preached that the lessons of history were being forgotten - because banking crises
have happened before.
In the 1930s, the Great Depression saw a collapse of the banking system in the United
States. So severe was it that President Franklin Roosevelt, only a week after his inauguration
in March 1933, announced a bank holiday shutting the banks to provide a breathing space so
that confidence could be restored. Here he is, in his first fireside chat, explaining banking to
the American people:
AUDIO INSERT:
"My friends I want to talk for a few minutes with the people of the United States
about banking... We have had a bad banking situation. Some of our bankers
have shown themselves either incompetent or dishonest in their handling of the
people's funds. They had used some money entrusted to them in speculation and
unwise loans. This was of course not true in the vast majority of our banks but it
was true in enough of them to shock the people of the United States for a time
into a sense of insecurity and to put them in a frame of mind where they did not
differentiate but seemed to assume that an act of a comparative few had tainted
them all. And so it became the government's job to straighten out this situation
and to do it as quickly as possible and that job is being performed."
We too have had a "bad banking situation". Roosevelt showed bold and decisive political
leadership in explaining to his listeners the reasons why they should not fear banks but trust
their Government to ensure that the economy could be saved from the bank failures that had
led to the Great Depression.
For the sake of future generations, we too must be bold and decisive and, while the memory
is fresh, learn the lessons from this crisis. Reform is essential.
Three reforms top my list. The first concerns regulation of banks. Next year, the
responsibility for regulating banks will return to the Bank of England.
Next time we find ourselves with steady growth and low inflation, but with risks building in the
financial sector, we shall be able to do something about it. The Bank's new Financial Policy
Committee will have the power to step in and prevent a hangover by taking away the
punchbowl just as the party in the financial system is getting going.
We believe that successful regulation means understanding and guarding against the big
risks, not compliance with ever more detailed rules. That means focussing on the wood not
the trees, looking not just at individual banks but also at how their fortunes are tied together
with other banks and with the rest of the economy. For example, the biggest risk to banks at
present stems from the troubles in the euro area. These are far from over. That's why we've
been pushing banks to pay out less to their shareholders and employees and instead retain
profits as a cushion against possible losses.
In future, to protect the rest of the economy from failures in the banking system, we need to
ensure that more of banks' shareholders' own money is on the line, and banks rely
correspondingly less on debt. If banks and their shareholders have more to lose, they will be
more careful in choosing to whom they lend. And, when banks make losses, there is more of
a cushion before the bank fails, and less chance that the taxpayer will have to foot the bill.
Nevertheless, bank failures will happen from time to time - indeed failure is part and parcel
of a prosperous market economy. So the second reform on my list aims to make sure badly
run banks can fail safely - that is, without causing damage to ordinary depositors and the
rest of the economy, and without billing the taxpayer. That requires a special legal framework
to allow a failing bank to continue to provide its essential services while its finances are being
sorted out. Such a framework is called a resolution mechanism. It's precisely what was
lacking when Northern Rock failed in 2007, leaving nationalisation as the only alternative.
That painful lesson has been learnt, and the 2009 Banking Act introduced a resolution
mechanism in Britain for the first time. But that won't work for big global banks with
operations around the world. So there is much more to do.
The third reform is to restructure the banking system. In so doing we must recognise the
crucial distinction between essential banking services to people like you and me, on the one
hand, and complex and potentially risky trading activities, on the other. We don't build
nuclear power stations in densely populated areas; nor should we allow essential banking
services and risky investment banking activities to be carried out in the same "too important
to fail" bank. Last autumn, the Independent Commission on Banking, chaired by
Sir John Vickers and comprising some of our most brilliant bankers and economists,
published recommendations on how to do this. It's vital that Parliament legislates to enact
these proposals sooner rather than later.
Regulation, resolution and restructuring of the banks are the three Rs of a new approach to
make banking, and so our economy, safer.
The three Rs will be central to the work of the Bank of England. And all of that will come on
top of our responsibility for monetary policy to reduce inflation while supporting a gradual
recovery of our battered economy. It's the biggest challenge the Bank has faced for decades.
We are up to the task. Already we see vested interests rise up to defend their bonuses and
profits. But, as an independent central bank with over three centuries of history, we can resist
those short-term pressures and take the longer view needed to prevent another crisis.
Independence is, however, not the discretion to do as you wish, but the exercise of specific
powers delegated to us by Parliament to meet a remit set by Parliament. So with
independence come the responsibilities of transparency and accountability. Back in 1997,
with independence to set interest rates, we revolutionised the openness of monetary policy.
Our decisions, deliberations and even the disagreements within the Monetary Policy
Committee are open to public scrutiny. I want to build on that track record to do the same for
our new tasks because in everything the Bank does, I and my colleagues are conscious that
we are accountable to you.
The Bank of England has changed radically since that Bank Holiday Monday in 1997 when
Eddie George and I sat in the Bank contemplating our new role, unaware of the roller coaster
ride on which we were about to embark. The Bank will change again next year with its new
responsibilities. But some things don't change. Here again is Mr. Montagu Norman:
AUDIO INSERT:
"I would sum up the vital characteristics of the Bank as experience in affairs,
cooperation on all sides, independence of judgement. But you know these three
things - experience, cooperation, independence - are no good unless people
have confidence in you. I like to believe that the Bank, with its long history and
tradition, stands high in public esteem. But only by service to the community can
that esteem be maintained through times good and bad."
That's true not just for Montagu Norman's day, but for today too.
The present crisis is far from over, as events in the euro area illustrate weekly. Our own
economy is still not back to health. Although inflation has fallen back in recent months, it is
still too high. And despite efforts to stimulate the economy, the recovery is proving slower
than we had hoped. It will come. But dealing with the consequences of our "bad banking
situation" is likely to be a long, slow process.
Just as, if not more, important, in my view, is to look further to the future, to the economic
possibilities for our grandchildren. To give them the prospect of economic stability, we must
reform the three Rs of our financial system. We have an historic opportunity, and a duty, to
do that.
The day-to-day tasks of controlling inflation and curbing the excesses of the financial system
will fall to the Bank of England. When, as it will, the economy returns to normal, our role will
be to take away the punchbowl just as the next party is getting going. That won't make us
popular among bankers, politicians and even at times some of you, and it's not supposed to.
But it will, I hope, reflect the trust and confidence that the citizens of this country can place in
the Old Lady of Threadneedle Street.