Step 2 relates to the potential for market participants, acting on their own or in concert with the authorities, to reduce vulnerabilities by strengthening market-wide infrastructures or practices. The recent proposal by Darrell Duffie to mandate central clearing of US government bonds is an example of this type of work.3  But my topic today relates to Step 3: the role that central bank balance sheets should play in dealing with market dysfunction. I deliberately come to this last, because, while it is central banks’ job to restore financial stability where self-insurance is too socially costly, they should be backstop providers of liquidity, not a first port of call. In that sense, their tools should complement, not substitute for, the other vertices of the triangle. Outside of pandemics, massive doses of system-wide anti-inflammatories do not meet that design brief. Long-term protection requires a more targeted remedy, as the Bank’s Financial Policy Committee concluded last October.4  2  https://www.fsb.org/2020/11/fsb-acts-to-address-issues-highlighted-by-march-market-turmoil/ https://www.brookings.edu/research/still-the-worlds-safe-haven/ 4 ‘The FPC considers it important to examine whether central banks should have facilities to provide liquidity to the wider financial system in stress, in order to support market functioning. Any such backstop of liquidity would need to be provided in a way that is not just effective and efficient but that also, through appropriate pricing and accompanying regulatory requirements, reduces incentives for excessive risk taking in the future’ (https://www.bankofengland.co.uk/financial-policy-summary-and-record/2020/october-2020). See also Box 7 of the August 2020 FSR (https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/august-2020.pdf) and the Governor’s remarks at Jackson Hole (https://www.bankofengland.co.uk/speech/2020/andrew-bailey-federal-reserve-bank-of-kansascitys-economic-policy-symposium-2020).

The public authorities cannot afford to ignore such dysfunction if it reaches a scale that threatens financial stability. But equally we cannot rely on central bank medicine of the scale and duration seen in 2020 every time we see an inflammation. The costs, in terms of bloated public sector balance sheets and mispriced private sector risks, will be too high. And the policy actions needed to secure monetary and financial stability may not always be as well aligned as they have been during the current crisis. If financial markets are to support the increasing reliance placed on them safely, we must do more to reduce the scale of inherent vulnerabilities ex ante, and build better-targeted tools for dealing with financial instability caused by market dysfunction ex post. And that, in turn, requires work in three separate but self-reinforcing areas – as illustrated in Chart 2. 3  All speeches are available online at www.bankofengland.co.uk/news/speeches and @BoE_PressOffice  3  Chart 2: Strengthening market functioning  Step 1: reforms to strengthen the resilience of private non-bank financial institutions to liquidity shocks  Step 2: strengthened market-wide infrastructure  Step 3: Better targeted central bank backstops  Step 1 – ensuring that non-banks active in financial markets are more resilient to future liquidity shocks – is under way, co-ordinated by the Financial Stability Board.2 If successful, this should both reduce the likelihood of instability arising in the first place, and improve the private sector’s ability to deal with it, if it does occur.