Andrew Bailey: Today's challenges in financial stability - the new and
the not so new
Speech by Mr Andrew Bailey, Governor of the Bank of England, at the Bloomberg
Regulatory Forum, New York City, 22 October 2024.
* * *
Thankyou - it is a pleasure to be here. I am going to use my time to talk about global
financial stability and the challenges we face today. But I am going to start with some
theory. The reason is that there is an issue with financial stability in that the risks can
take on a laundry list character, and a long list at that. This can leave a 'take your pick'
mindset, and a sense that this is all too much, or that it is not sufficiently grounded.
So, bear with me for a short travel into theory, and then I will seek to put today's big
issues or at least some of them, into that context.
For me, the founding father of more developed financial stability theory was Hyman
Minsky. His core argument was that money and finance matter together for
understanding economies, and particularly for understanding susceptibility to stress,
Unstable finance contributes to economic instability, and the institutional arrangements
by which money and finance operate do matter. Capital and financial instruments are
traded and have their prices determined in markets, and these are separate from, but
linked to, the prices of current output in the economy. Financial practices change over
time, and these changes can impact the behaviour of the economy. Economies can
therefore oscillate between robust and fragile financial strictures, the latter being a
contributor to financial crises. And, as a previous financial crisis recedes over time, it is
not unusual to believe that a new era has arrived. In such conditions, Cassandra like
warnings that nothing basic has changed and there is a financial breaking point that can
have severe economic consequences are ignored.
One paragraph can't do full justice to the breadth of Minsky's thinking, but I believe the
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core of it is clear .
Before wrapping the theory part up, let me also set out some of the important work
done by historians. Charles Kindleberger drew on case studies to point out that the
connections between financial markets and macro economies extended beyond those
running through money flows (the banking system), and they can operate via arbitrage
in internationally traded commodities. Autonomous shocks can change investment
opportunities prompting high spirits and an overshooting of equilibrium price levels. But
over time such expectations of continuous asset price rises weaken and distress sets
in. The movement out of liquid assets into the now overvalued illiquid assets reverses
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and, if precipitous, a crash or panic ensues . Kindleberger drew on Adam Smith's
observation that "when the profits of trade happen to be greater than ordinary,
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overtrading becomes a general error . And the rate of profit" is always highest in the
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countries that are going fastest to ruin .
More recently, Harold James has reminded us that although the Great Depression on
both sides of the Atlantic is often associated with bank failures, there was a critical
interaction with financial markets. The effect of this was to reduce the wealth and
collateral available for corporations and individuals to borrow, which led to a reduced
credit supply, forcing borrower liquidation of assets thereby pushing asset prices down
further. This was the debt deflation of Irving Fisher and the credit channel of
transmission of Ben Bernanke. Moreover, as James notes, surviving sudden crises
requires extraordinary public policy measures to be used - such as short-run actions to
alleviate long-run problems, even if on their own they are not compatible with long-run
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stability .
Enough theory and history. I hope though that you will understand why it matters. I am
going to use the rest of my time to apply it to today's world.
First of all, let me make an overall point. There is a tension in financial stability between
the overall or macro-prudential approach and one that is more of a disaggregated list of
stuff that could go wrong and cause a wider crisis. Macro-prudential policy has to stay
focused on risks that could threaten the system as a whole, taking into account
correlations, concentrations, interconnectedness and opacity. This macro-pru approach
is more ambitious and harder to pull off. It can come and go in terms of the attention it
gets, the cycle of which tends to be related to the incidence of crises. A good (or bad)
crisis tends to provide a more macro focus for a time, but then as memories fade the list
approach can come back to prominence. I believe we have to push against such a
listlike tendency keeping our focus on the system-wide perspective, and the correlated,
concentrated, interconnected and opaque positions that matter for the stability of the
system as a whole. This is the spirit of Minsky and others, and it provides a firmer
grounding. So, Message One, taking the macro-prudential approach matters, and yes it
can be harder.
Onto the second message. Cassandra was fated by the god Apollo to utter true
prophecies but not to be believed. The prophecies were of course not of the good sort.
In financial stability speak she dedicated herself to one tail of the distribution.
Somebody will of course say that she was ahead of her times, and thereby missed her
vocation as a central banker. Let me borrow her mantle for a moment, in the context of
Minsky's argument that memories of financial crises recede over time and can be
replaced by thoughts of a new era arriving. I can observe this happening with the global
financial crisis fifteen years or so on. I do get people telling me that 'you have solved
that one so we can relax'. But the work I set out above on theory and history is timeless.
So, let's not fall into the trap of complacency. Yes, we must debate the right level of
regulation, it cannot be assumed to be perfect, but let's not confuse that with the
timeless nature of the threat. That's Message Two.
My third message is to pick up the theme that was at the heart of Minsky's critique of
Keynesian economics post-war, though not of Keynes himself, and is also reinforced by
Kindleberger and James. This is that money and finance matter together because they
interact and in so doing create instability. One of the blind alleys that this type of debate
went along before the financial crisis was to see it only in terms of whether there were
asset price bubbles or not. Ultimately that was not only a blind alley but a dangerous
one too.
Since the financial crisis we have seen a change in the relative scale globally of bank
and non-bank finance, with the balance shifting towards the latter. And so the focus of
authorities has shifted, rightly, towards the latter too. You can see this in the work
programme of the global Financial Stability Board. In one sense, we should not be
surprised by this shift. We have upped the regulation of banks, reflecting the lessons of
the crisis.
But then we should remember the focus of Minsky and others. The macroprudential
risks of the non-bank sector have not originated from this shift, they have been there for
well over a century or more. Kindleberger's study of the 1873 panic affecting Berlin,
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New York and Vienna is a good illustration of this . The contemporary shift in the
balance of intermediation towards non-banks makes such risks more pressing, but it
should not be thought of as new. That's Message Three.
The non-bank word and its interaction with the banking world - money and finance as
Minsky put it - has evolved in ways that require us to look not just at regulation, but at
two additional key components of our response as authorities, namely the tools of
surveillance and the tools of remedy.
I will start with surveillance. The non-bank sector is very large and growing. It is
disparate in nature, opaque in important places and the interlinkages are,
unsurprisingly, therefore complex and hard to observe. In the banking sector we have
developed post-crisis our stress testing tools. At their core, these are institution specific,
though to leave it there would be a mistake and so we have developed cross-sector
tools to capture system-wide risks. For example, where the actions of individual banks
to restrict credit lead to a collectively worse outcome for the system.
For the non-bank sector and its interaction with the bank sector we have to focus on
stress exercises that simulate the spread of stress and thereby seek to pick out the
institutional points of weakness and lack of resilience, for instance in markets and
infrastructures as well as the firms themselves. I think this is very much in the spirit of
Minsky. At the Bank of England we are conducting our first System Wide Exploratory
Scenario. It doesn't claim to cover every risk in the system, you should be disbelieving if
I said otherwise. It is more in the way of a flow test - simulate shocks, let them flow
through the system and see what happens. We expect to report on the results by the
end of this year. Message Four is that we need to develop more of these tools of
surveillance of risks.
You will I am sure be pleased to know that my fifth point is the last. It covers the tools of
response that authorities use in a crisis. As I noted earlier, Harold James has set out
how surviving such crises requires extraordinary measures to solve short-run situations
and alleviate long-run problems, but on their own such approaches may not be
compatible with long-run stability. This can sound like an impasse, but I don't see it that
way. Central banks are the providers of liquidity of last resort to the banking system.
That we should use this extensively in a crisis and be expected to do so was at the
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heart of Walter Bagehot's stricture of the Bank of England in the 19 century. It remains
a key tenet of how central banks should operate. There are at least three
accompanying parts to operating the Bagehot approach in practice.
The first is that money is unique, it's different from finance. It must at all times hold its
nominal value, whereas the nominal value of finance (assets) should and will naturally
vary. Second, the way money has developed within the discipline of holding its nominal
value means what I call the singleness of money. Banking systems have developed so
that money is made up of central bank money (the stuff we create) and commercial
bank money (bank deposits). The singleness of money applies critically as the glue
across both. This is why central banks need to be responsible for monetary policy and
bank regulation. The third accompanying part is an assumption that if a central bank
injects money into the banking system, it will naturally find its way to all the places in
need, at a price of course. In other words, if there is a liquidity need in the non-bank
world, we can reach it via the banks.
I think Minsky was not a dissenter from the first two propositions but was sceptical
about the third. Moreover, Kindleberger used case studies to cast doubt on the third. In
my view the modern growth of the non-bank sector has cast more doubt on the
effectiveness of the third proposition. For a long time in history there have been
emergency interventions to forestall financial stability problems in the non-bank world.
But we are left trying to square a circle. Can we preserve the uniqueness of money as a
feature of the banking system and intervene where needed to solve such financial
stability problems in the non-bank sector?
Fortunately, I think the answer is yes. Money is unique and the relationship between
central banks and the banking system is unique too. This was Bagehot's point at a high
level. Banks must have access to central bank liquidity on a standing basis - i.e. all of
the time. To do otherwise is to ask for trouble. And this underpins the singleness of
money which ensures that central bank and commercial bank money are fully aligned in
nominal (and real) value terms. In normal times, that should take care of the needs of
the non-bank sector because the liquidity should reach where it is needed via banks.
But in times of stress it may not. To avoid a systemic crisis, and reflecting the growth of
the non-bank sector, central banks should consider permanent emergency facilities for
non-banks. But these should not be standing facilities, because the value of money is
not the issue here. Non-banks cannot decide when they would like access to the central
bank. Rather the central bank can trigger or activate these facilities if it senses stressed
conditions and their possible economic consequences warrant such action. But these
facilities are temporary in their availability and should be unwound and repaid as soon
as possible. I think this deals with Harold James's point about short and long-run
consistency.
You may already be aware that at the Bank of England this is what we are doing, by
putting into place emergency facilities for a range of non-banks which we consider
exposed to the systemic risks that should call the use of such facilities into action. But
to reiterate, these are not standing facilities of the traditional sort.
Minsky's analysis is pertinent today as memories of the Global Financial Crises recede
and the discussion moves on to putting more emphasis on growth and competition in
economies and the role of finance in these objectives. To be clear, these objectives are
important, no doubt about that. But we have learned from hard experience that we can
only achieve them with a foundation of financial stability. There isn't a trade-off. The
best contribution we as financial stability policymakers can make to sustainable
economic growth is to ensure that the financial system is resilient when shocks hit.
That foundation requires confidence in the nominal value of money and therefore it's
singleness. Money and finance are different and should be treated as such. Profits and
some losses should be made as the normal state of affairs. We should not use
regulation to limit these outcomes beyond enabling efficient markets with strong
institutional foundations and well-established rules of the game. But as authorities, it is
our job to intervene to prevent damage to the foundations of financial stability which
could in turn compromise economic growth. Those interventions can be continuous in
the sense of regulations or emergency and temporary where the threat is so great and
costly that it would be inefficient to regulate constantly on the assumption that
something on such a scale will happen more regularly. Most of the tail of bad outcomes
is best dealt with by regulation, but the very extreme end can be better tackled by one
off interventions. That is not a failure of regulation.
To sum up, I have five messages on financial stability. System-wide matters and should
not disappear amid laundry lists. Second, we must heed Minsky's warning that
memories of financial crises past do recede. Message three is that we have seen a shift
in financial intermediation towards non-banks - from money to finance if you like and
this presents distinct challenges. Message four is that one of these challenges is the
pressing need for new surveillance tools. And message five is that there is also a need
for central banks to reconsider their liquidity provision tools to non-banks while not
undermining the singleness and uniqueness of money.
Thank you.
I would like to thank Nathanal Benjamin, Colette Bowe, Sarah Breeden, Karen Jude,
Zertasha Malik, Harsh Mehta, Rhys Phillips, Georgie Shelley, James Talbot and Sam
Woods for their help in the preparation of these remarks.
1
Minksy was a prolific author. His work is well described in Hyman P. Minsky
"Stabilizing an unstable economy" Yale University Press 1986. His views on Keynes
and the Keynesians are found in Hyman P. Minsky "John Maynard Keynes", Columbia
University Press, 1975.
2
Kindleberger was also a prolific author. His class work was Charles P. Kindleberger
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"Manias, Panics and Crashes: A History of Financial Crises"; Basic Books, 1 Edition,
1978.
3
Adam Smith "The Nature and Causes of Wealth of Nations"; Clarendon Press, Oxford
1978, P438.
4
Smith "Wealth of Nations" p266.
5
Harold James, "Seven Crashes: The Economic Crises that Shaped Globalization",
Yale University Press, 2023, P139.
6
Charles P. Kindleberger, "The Panic of 1873" in Kindleberger "Historical Economics:
Art or Science" Harvester Press 1990. P310-325.