Not surprisingly, the FPC focused its attention on unsustainable sovereign debt levels in Europe and the potential for contagion across the EU banking sector.
To minimize the impact of these sources of instability, the FPC recommended that banks increase their liquidity and capital.
Perhaps I am missing something, but isn't the most effective way for a UK bank to achieve this result is for the bank to stop providing loans to the European interbank lending market? By hoarding their cash and putting it into short-term UK government debt, the bank improves both its liquidity and capital (on a risk-adjusted basis).
In short, the FPC appears to have called for the UK banks to contribute to both the run on the European banks and the freezing of the interbank loan market.
Does having UK banks hoard liquidity really increase financial stability? Something tells me that increasing the risk to the EU economy of having its banking system collapse does not improve the UK's financial stability.
From the UK's FPC statement from its policy meeting on September 20, 2011:
... Since its previous meeting there had been severe strains in financial markets, which stemmed in large part from continuing concerns about the sustainability of external and internal debt positions of some countries, especially in the euro area. Anxiety about the consequences of these issues for banks had increased materially and, in turn, the perceived vulnerabilities of banks were adding to strains in financial markets.
The Committee recognised that dealing with the problems facing the international financial system as a whole would require long-term reforms to tackle unsustainable debt positions and the cumulative and persistent loss of competitiveness in a number of euro-area countries. But given the scale of current risks, the Committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system.
UK banks had made progress over the past two years in building up their capital and liquidity, which had placed them in a somewhat stronger position to withstand adverse developments whilst maintaining the supply of credit to the economy. The Committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term.
The Committee therefore recommended that banks should take any opportunity they had to strengthen their levels of capital and liquidity so as to increase their capacity to absorb flexibly any future shocks, without constraining lending to the wider economy. This could include raising long-term funding whenever possible and ensuring that discretionary distributions reflected any reduction in profits.
The Committee also advised the FSA to encourage banks, via its supervisory dialogue, to manage their balance sheets in such a way that would not exacerbate market or economic fragility. For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided.