Behavioural biases on the BoE's FPC and the BoE's MPC
Views From the Marsh - David Owen
The biggest regulatory failure of recent years was not the one sparked off by the LDI crisis following the Liz Truss/Kwasi Kwarteng mini-budget of September 2022.
Then, targeted and time limited buying of the Gilts market by the BoE (less than £20bn) ensured that order was relatively quickly restored to the markets.
But, it did have the effect of raising more concern at the BoE about the possible need to rapidly supply cash on demand to parts of the UK’s financial pumping, as the BoE’s balance sheet continued to shrink.
Hence the focus now on the banking sector making use of longer-term repos, in an environment of far fewer bank reserves.
No, the biggest regulatory failure of recent years was the direct result of actions by the Chancellor Gordon Brown and his advisor Ed Balls in 1997, who along with giving the BoE its operational independence (a very good thing), also sowed the seeds of the GFC, by outsourcing financial regulation and making it a purely box-ticking exercise.
By 2007 the UK banking sector’s balance sheet was over 5 times UK GDP; with a huge funding gap and hard to value assets.
None of this was helped by a BoE Governor at the time (Mervyn King) who downplayed the role of market intelligence, such that going into the banking crisis there were still members of the MPC voting for rate rises.
Bringing back financial regulation in house and establishing the FPC (their first meeting was held in June 2011, although the BoE’s operational responsibility for managing the financial sector happened later), was a major step forward in trying to head off financial risks before they occurred, especially in a world of near zero interest rates and QE.
Clearly, this did not work with the LDI crisis - as the BoE’s former Deputy Governor Paul Tucker pointed out at the time, regulators had not stress tested the system for much more of a spike in Gilt yields.
Many of us still what happened in the bond rout of 1994, led by significant international selling of US treasuries.
But we have moved on a lot further from a situation where the BoE is more flying blind in terms of imbalances that may be building up elsewhere in the system, reducing the risk of the MPC being forced to cut rates sharply and kick-start QE on financial stability grounds.
Initially coming out of the GFC, concern centred on the residential and buy-to let housing markets, and the risks they could pose to the overall health of the banking system. But that is not to say the BoE has everything covered. Far from it.
Data on the hard to value and potentially fast moving commercial real estate market is still difficult to come by - a major issue given the importance of the sector for the overall health of the banking sector and the wider economy.
Arguably, risks stemming from climate change have been downplayed in recent years (perhaps because, unlike the ECB, the BoE did not load up its balance sheets with lots of brown credits, as part of QE).
And then we have one of the biggest known unknows, the rapid growth of market based finance and the risks this potentially poses to the wider economy. Regulate one part of the system and problems can appear elsewhere. Andrew Bailey again addressed such concerns in a recent speech (see here).
The problem is that along with other central banks the BoE can still be somewhat in the dark when it comes to all such matters.
For example, wind the clock back only a few months, and it became clear that the Chief Risk Officers and boards of UK regulated banks had not quantified their overall exposure to PE. This followed several years of relatively rapid growth in market based finance and many commentators believing that UK banks did not have much direct, or indirect, exposure to PE.
When the BoE’s FPC was first established the argument went that it should put the MPC in a much better position to start normalizing interest rates, without putting undue stress on other parts of the system. This included things like the housing and commercial real estate markets, that have adjusted relatively well to a world where Bank Rate rose from 0.1% to over 5%.
As a general rule, things have worked out relatively well (the LDI crisis is one example where it clearly didn’t), but we do wonder if some of the split that we have seen on the MPC is due to those that are also sitting on the FPC, and are looking at things, in the round, in a slightly different way.
In a research note published earlier in the month we pointed out that, with the exception of the external Swati Dhingra, who has consistently been more dovish than other members of the MPC, the other four voting for a rate cut in August (Andrew Bailey, Sarah Breeden, Clare Lombardelli and Dave Ramsden) all sit on the FPC.
Which brings us to Wednesday’s budget.
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