Banks and politicians

Six years after the financial crisis began, changes are under way to reduce the likelihood of it happening again. Among them, many countries have given greater powers to their central bank—although debate continues about how best to do this. The relationship with the societies we serve as central bankers has become more extensive, raising questions about how we can demonstrate that we deserve the trust placed in us.

A central bank can have a wide or narrow set of functions, all centred on stability. At the Bank of England, the Monetary Policy Committee (MPC) has a mandate to maintain low and stable inflation. We have recently increased the transparency of our analysis so that people can see how we decide on the extraordinary monetary measures we are taking in these extraordinary times. But the Bank now, once again has powers to achieve and preserve stability in the banking system too, restoring and updating powers it held previously. Legislation passed earlier this year gave the Bank responsibility for supervising the financial soundness of banks, building societies and insurers operating in the UK—through a new arm called the Prudential Regulation Authority. To ensure that we look beyond individual firms, parliament also set up the new Financial Policy Committee within the Bank, to enhance the resilience of the financial system as a whole. These roles, for the first time brought together in legislation, touch every household and business in the UK—and beyond.

With the Bank of England once again supervising banks, we are returning to a judgement-based approach, with less reliance on rules or “box-ticking.” Rules-based regulators work on the basis of: first, write rules; then, check compliance with those rules; finally, punish breaches. But in the past, banks’ management hardly stopped their staff from circumventing the rules. Regulatory arbitrage—exploiting the gap between the spirit and the letter of the regime—was at the heart of the problems that led to the crisis. It would be a fool’s paradise to think we could write a set of rules on the financial health of a bank, or on the professional competence of bankers. Nor, as parliament has underlined, should we seek a zero-failure regime, in which regulators strive to ensure that banks never fail. In a market economy, the failure of individual firms has to be acceptable so long as they can be wound down or reconstructed in an orderly way without taxpayer support.

At the level of individual firms, the Prudential Regulation Authority’s approach to supervision entails making judgements of the kind: “your bank isn’t as strong as you think it is”; “you must cut back on the risk in your book”; “I’m afraid you’re not fit to run the bank.” And at the level of the system as a whole, the Financial Policy Committee will ask whether banks and markets are truly safe. That will sometimes mean heading off threats to stability coming from around the next corner but one.

This shift, from rules to judgement, fundamentally changes the relationship between the regulator and business. But is society ready to return to a system of regulation, centred on judgements by unelected Bank of England officials, of risks that will not always be obvious to the general public? The best reason for entrusting these judgements to unelected officials in central banks is that the task of achieving and preserving stability requires a focus on the medium term, even though the steps taken to get there will sometimes affect the economy in the short run. Politicians and other policymakers might face the temptation of sacrificing medium-term stability for short-term gain. But this is also why society is so interested, rightly, in how unelected central bankers manage any short-term trade-offs.

Part of the answer has to be transparency. Although much of the data on individual firms is confidential, the Financial Policy Committee will be as transparent as possible, in line with parliament’s wishes. We will find ways of putting numbers around the degree of resilience the financial system needs.

Across the Bank’s functions, there is also a deep question about the compatibility of domestic and global objectives. A country cannot combine three different aims: cross-border banking and an integrated international financial system supporting a global economy in manufacturing and services; financial stability; and national regulatory policies focused solely on domestic stability. This issue came home to roost in the crisis, when apparently footloose global banks failed but were bailed out by governments answerable to national taxpayers. The solution, not just for the UK but for our peers also, has to be global cooperation on financial regulation. Although not fast, this is happening, and crucially with broad agreement on how to sort out failing international banks without a taxpayer bailout. That requires laws to be passed and banks to be reorganised, but we can get there. Foreign countries have an interest in the health of our banks, and vice versa. The key policies on global finance are unavoidably international. As a nation strongly committed to free trade and open financial markets, we should welcome that.

But we should be as transparent as possible about how we go about international reform in the pursuit of stability. That is what trust requires. And as a central bank, we are in the business of trust—trust in the value of money.