the central bank knows "absolutely nothing" about how the policy instruments its new watchdog, [the Financial Policy Committee], has asked for to combat systemic financial risks will work in practice, and that it will need to win a battle of hearts and minds when it starts using them.And what exactly are the unproven tools that have been asked for to prevent another financial crisis?
The FPC is seeking from parliament the power to ensure banks have countercyclical capital buffers, the ability to force banks to hold more capital against exposure to specific sectors judged risky and the power to set leverage ratios.Of these tools he observes,
"One thing I want to stress is that this is an experiment. It really is an experiment," he said of the policy instruments at a conference in Washington on Saturday.
"We know absolutely nothing about how these instruments are going to work. It is very important that we play it safe and be cautious."
- Those areas of the financial system which are characterized by disclosure (where market participants have access to all the useful, relevant information in an appropriate, timely manner) have been stable even in the presence of instability in other parts of the financial system for the last 70+ years.
- Those areas of the global financial system which are characterized by opacity (where market participants do not have access to all the useful, relevant information in an appropriate, timely manner) have been prone to instability.
In principle, powers to require financial institutions to publish consistent information in a timely manner about their activities could be a powerful tool in fostering awareness of risks in the financial system and allowing market participants to take appropriate mitigating actions, thus enhancing market discipline.
Disclosure issues had accounted for a significant part of the Committee’s deliberations over the past year and the Committee was engaged through several channels in promoting transparency to enhance financial stability.
But the Committee recognised that a general power to set disclosure requirements may not meet the test set by HM Treasury that powers of Direction should be specific.
The Committee agreed that, at some point in the future, it might need to be able to compel specific disclosure to mitigate systemic risk.
So a key question was whether HM Treasury might be prepared in this particular area to ask Parliament to grant the FPC a broad power of Direction over disclosure, within any appropriate constraints, without knowing what specific future disclosure the FPC would judge necessary to tackle systemic risks.
Like other central banks, the Bank of England is grappling with how to spot potentially systemic risks to the financial system and wider economy even as other indicators of health, such as inflation, are under control.
Sir Mervyn said that the FPC narrowed its choice of instruments to three because it will be important to explain to parliament and the wider public why it is or isn't using them.
"If we are to maintain the ability to act independently and make unpopular decisions, it will be pretty crucial to explain what we are doing and why," said Sir Mervyn. "Setting realistic expectations of what can be achieved is an important ingredient."
- It allows the FPC's to gamble with financial stability. If it identifies and heads off a source of financial instability, it is a hero.
- If not, it also preserves the FPC's ability to say that the next financial crisis isn't its fault because it emerged from an opaque corner of the financial system.