The fact remains that the old risks have not all gone away, and upon close examination there are some new ones to fret about, too
The Bank of England's Financial Stability Report must be a tricky thing to put together. Its purpose is to lay bare the risks to the financial system, in the hope of encouraging remedial action and improving market transparency. But there is a thin line between warning of risks, in order to mitigate them, and raising the alarm too loudly and inducing a panic.
Furthermore, the steady increase in the Bank's responsibilities since the financial crisis has been such that its senior executives must now lie in bed at night not only worrying about the risks to the system, but worrying about which risks to worry about. And that is rather how I felt after reading Thursday's Financial Stability Report.
Since 2009, the Bank has had a much keener focus on financial stability, under the still new-ish Financial Stability Committee chaired by Paul Tucker - a recognition of the failure to pay sufficient attention to the big picture, rather than what individual banks were doing, in the run-up to the crisis. Europe-wide scrutiny of the financial system will also grow more intense under the new European Systemic Risk Board.
The Financial Stability Committee is laudably thorough both in categorising the manifold risks to the system and in attempting to gauge their severity. It is true that British banks have made considerable progress in raising the large amounts of financing they will need to meet new capital requirements, and that low interest rates and obliging banks have combined to keep default and repossession rates at surprisingly low levels; but as the Report points out, the fact remains that the old risks have not all gone away, and upon close examination there are some new ones to fret about, too.
Indeed, some of the old worries are still quite scary: British banks are in better shape than many of their European counterparts, but we should not be complacent, now that we know how swiftly contagion can spread; banks still have a lot of financing to do; and a double-whammy of higher interest rates and slower economic recovery could push households and companies over the brink.
The Report also highlights some interesting new risks, quite a few of which are the result of actions to tackle the old ones. That does not mean that it is wrong to attempt regulatory reform. In fact, I find it rather reassuring that the regulator is min
dful of the way that undesirable incentives are inevitably created by new rules: failure to think through the implications of, for example, capital requirements helped create the conditions for the financial crisis.
The Bank now recognises that financial institutions will always try to keep a step ahead, so regulators must also move rapidly. In fact, the Bank wants new powers to adapt rules and range more widely. This makes sense: the recent tightening of bank rules will inevitably push more risky activities outside the regulated financial system, into what is known loosely as the "shadow" banking system. But, again, the Bank must perform a balancing act. Financial stability requires stable rules which allow banks, and their clients, to plan for the long term.
In fact, parts of the shadow banking system will be indirectly constrained by the new rules anyway. Hedge funds, for example, which relied on big, cheap bank credit lines to take highly leveraged bets on market movements will find that they can no longer do so. Not because anyone has told them not to, but because new capital rules will make it uneconomic for the banks to lend to them on such favourable terms.
But the Bank's concerns are justified. Similarly, the post-crisis channelling of trading and settlement through central counter-parties, which was designed to reduce counter-party risk, will also concentrate risk in a single entity. Another unintended consequence - of interest rate policy rather than regulation - has been to encourage yield-hungry investors to take more risks in emerging markets, again increasing systemic risk.
In relative terms, the health of the British banking system has improved in the past year: British banks have higher capital ratios than counterparts in either the US, Germany or France, as well as Spanish and Irish banks. But there is always a flipside, it seems: weakness of some of these carries its own dangers for the financial system.
Our regulators remain nervous – and I prefer them that way. After all, the April 2007 report stated that "the UK financial system remains highly resilient, with banks well capitalised and highly profitable. But strong flows into riskier assets and a gradual increase in corporate indebtedness have caused risks to the UK financial system to edge up."
By Tracy Corrigan
Source: Telegraph Media Group Limited
http://www.telegraph.co.uk
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