The first is that central banks use their balance sheets not, like commercial banks, to generate economic returns for their shareholders, but to deliver the policy goals of monetary and financial stability. That may sound innocent enough: dull even. But that would be misleading – because  2  All speeches are available online at www.bankofengland.co.uk/speeches  2  maintaining stability means central banks must be prepared to act like financial firefighters – rushing into burning buildings (taking on certain types of financial risk) when everyone else is rushing out. That dynamic is clearest when central banks act as lenders of last resort: stepping in to provide temporary liquidity (to individual firms, or the market as a whole) when private liquidity providers take fright. They are uniquely able to do this because their ability to create fiat money means they face no liquidity risk in their own currencies of issue. Of course, central bankers go to great lengths to limit the other forms of risk they take on in such circumstances: lending only to institutions assessed as solvent and viable; taking high-quality collateral, with conservative haircuts; charging suitably penal interest rates; and typically lending only for limited periods. But they can still find themselves lending, sometimes in large size, when everyone else prefers not to, in order to limit the financial instability that would be caused by wider contagion. That inversion of the normal definition of risk tolerance – illustrated schematically in Chart 1 – is strike one against the risk professional’s standard operating manual.

In large part, that demand follows directly from the increased breadth and scale of central banks’ responsibilities and financial exposures. But in the Bank of England’s case the desire to build a strengthened financial risk framework also reflects an important consequence of taking on responsibility for the micro-prudential regulation of banks, which is that we should be willing to do unto ourselves as we would do unto others: a Golden Rule for central bankers. And it reflects a strong desire to investigate new ways of driving innovative analysis and lean against the risks of groupthink. Strengthening the Bank of England’s financial risk framework  The Bank has had strong first- and third-line financial risk functions for some time. An expert first-line team assesses, prices and haircuts the wide range of collateral pre-positioned with us, monitors the specific risks taken in live operations on a day-to-day basis, and evaluates the financial condition of our counterparties, 6  liaising with our supervisory colleagues in the Bank’s Prudential Regulation Authority arm . And internal and external auditors regularly assess the effectiveness of the Bank’s financial controls. Until recently, however, the Bank has not had a dedicated second-line financial risk function, reflecting a perception that central banking operations did not give rise to tensions of the sort seen between profit making and risk control in private firms. The amount of residual risk to which the Bank was actually exposed, after taking account of large collateral haircuts and government indemnities, was also felt to be relatively small.