Macroprudential Policy: Have we run into a wall?

 Macroprudential Policy: Have we run into a wall?

Often when it comes to headline economics news it is speeches and views of members of the Monetary Policy Committee (MPC) at the Bank of England (Bank) that take centre stage. The cabinet of nine members in the UK has a government-ordered remit to vote for the best interest rate and Quantitative Easing (QE) strategy in order to maintain the inflation rate at 2%. When the economy saw itself in the process of Brexit with rates at 0.75% and QE at £445bn, there was already talk of the MPC running out of ammunition to combat another economic downturn which was proven to be wrong following the pandemic when the slash of interest rates to 0.1% and increasing the QE programme to the peak of £895bn, not to mentions the additional Term Funding Scheme for Small to Medium Enterprises (TFSME) certainly played a big role in allowing the economy to respond to a significant, sharp and negative economic shock. 

However, I would like to revisit the times when MPC ammo looked to be running low and a more dynamic and interesting function of the Bank was starting to shine brighter, the Financial Policy Committee (FPC). While it is very important for the MPC to maintain a pulse on the UK economy in order to gauge the rhythm and cycles of the economy, the FPC looks more closely at the financial markets in particular to ensure stability that prevents significant disruptions to crucial financial services and transactions. In a recent speech given by Sarah Breeden, the Executive Director for Financial Stability Strategy and Risk at the Bank, she mentions a few of the issues that the FPC currently identifies as sources of financial instability, these are climate, Covid, crypto, cyber, conflict in Ukraine, credit cycles and core banking system. In Breedan’s speech she likens the aim of macro-prudential policy to “improving the trade-off between the financial system’s contribution to the rewards expected in a growing economy and the degree of risk that we will face in the bad times.” The top three challenges that Breedan identifies are firstly the rise of market based finance, the growth of crypto assets and decentralised finance and the transition to net zero. 

What is the current approach to addressing these challenges? Well, when we speak of financial stability the Bank of England oversees financial institutions and as part of that service financial institutions in the UK report back to the Bank of England with requested data some of the smaller banks with less frequency and the much larger ones being required to report with increased frequency and granularity of data. Through analysis of this submitted financial data as well as designing ‘Stress Tests’ that financial institutions internally simulate to provide the Bank with reports and data on how they would perform given different scenarios all provide the FPC with valuable information on the vulnerabilities in the financial system. The FPC also has the ability to provide recommendations and set policy on capital buffers and liquidity requirements to reduce the risk of disruption to financial services. 

Looking back at the top three challenges that Breedan refers to in her speech, the common thread running through all the risks is the lack of data available to assess the risk. Market based finance providers do not report to the Bank and often are not certified by the Financial Services Compensation Scheme (FSCS) which increases the vulnerability of households to a disruption in financial services.  The growth of crypto assets and decentralised finance also provides a similar lack of data as the previous example with the Bank’s governor having even warned holders of Crypto assets that their money is not safe when investing in them. The third challenge of a transition to net zero similarly tries to quantify the impact of climate change on financial assets. There is not a long established method to quantify the risk of climate change when determining the value of financial assets held by financial institutions, however the recent climate stress test is making it necessary for financial institutions to gather the data needed to calculate this risk. 

I remember in 2019 at a Fitch ratings meeting as a panellists of influential people in the finance sector discussed the threats to the Global economy whilst they couldn’t seem to really agree on one that would, they all did agree on the fact that it would not come from financial markets. While it is clear now  that the biggest threat was a virus, it is worth thinking about the vulnerabilities in the financial market  that have become more visible during the period of the pandemic. The excess liquidity in the financial markets brought by increased savings due to lockdown saw the volatile stock market experience record breaking downturns and upturns in a short space of time. For example, the oldest index, Dow Jones industrial, took seven months to recover from the global economic downturn, a record recovery and a completely different narrative to the nearly four years it took to recover from the great financial crisis in 2009. The S&P 500 index which includes more tech firms bounced back even quicker in four months. Both indices are now seeing a downturn as pre-pandemic life tries to make a comeback post-pandemic, this could be insight as to the conflicting or zero-sum game nature of the fighting ideologies post-pandemic or perhaps a sign that a more stable equilibrium must be reached to go on. Is it also a self-correction of markets betting high on a world in lockdown? Meanwhile, the UK's FTSE index is yet to recover from the Covid downturn. 

It is certainly an interesting time for Macroprudential policy makers as they analyse the available data on the future challenges to formulate questions. It steps into slightly more philosophical or ideological questions and grey areas that the UK is known for balancing with expertise. In order to capture and define the risks that lie ahead for the financial sector there needs to be a decent ability to capture and analyse the data previously mentioned and understand the constraints of the opportunities and promises offered by market based and decentralised financial institutions to set the according institutional checks and balance that provide the stability structure paramount to capturing risk.

My next project will be on the political and moral debates that defined the economic institutions that are most influential today. With their founders being mostly seen at the turn of the industrial revolution, thinking of Adam Smith (1723-1790) , who and what are the best contenders to define the moral age and economic structure of the digital revolution?

Mooticity Exercises:

1. Why is Adam Smith known as "The Father of Economics"?

2. What are some examples of Macroprudential policies?