Why Trusting Experts Is Dissipating

In her final speech as Deputy Governor for Markets and Banking, before becoming Director of the London School of Economics, Minouche Shafik sets out an agenda for rebuilding the trustworthiness of experts. She says, “getting this right is vital for determining whether our futures are shaped by ignorance and narrow-mindedness, or by knowledge and informed debate”.

Addressing the Oxford Union, Minouche explores the backlash against experts after the financial crisis, Eurozone crisis, Brexit, and election surprises. As well as being seen to have “got it wrong”, the growing influence of social media and online news has made experts just one of many voices in a cacophony. “A person like yourself” is now seen as credible as an academic or technical expert, and far more credible than a CEO or politician.

However, the application of expert knowledge has improved life expectancy, tackled diseases, and reduced poverty. These achievements have led to many decisions being delegated to experts deliberately insulated from the political process, including the creation of independent central banks as a means to maintain low and stable inflation. Minouche stresses, however, the importance of experts being subject to challenge and rigorous processes to differentiate quality and reduce the risk of getting it wrong.

The changing landscape of information, opinion and trust

The digitization of freely available knowledge has been hugely democratizing and empowering. Young people are particularly reliant on social media, with 28% of 18-24 year olds saying it is their main source of news, putting it ahead of television.

But there has been a downside – “people can be overwhelmed with information that is difficult to verify, algorithms create echo chambers of the like-minded who are never challenged; fake news distorts reality; “post-truth” fosters cynicism; anonymity bestows irresponsible power onto individuals who can abuse it; a world in which more clicks means more revenue rewards the most shrill voices and promotes extreme views,” Minouche argues.

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We need expertise more than ever. But confidence in experts is at an all-time low. Transparency is not good enough if information is inaccessible and “unassessible”. Instead, we should focus more on increasing trustworthiness.

An agenda for rebuilding trustworthiness

Societies can set standards and empower individuals to assess trustworthiness for themselves. There are many elements to such an agenda:

  • Experts should embrace uncertainty – Minouche argues that “rather than pretending to be certain and risk frequently getting it wrong, being candid about uncertainty will over the long term build the credibility of experts.” Coupled with the need to get their often complex messages across in today’s shortform world, this means “the modern challenge for experts is how to communicate with brevity, but without bravado.”
  • Good practices often found in academia (like declaring conflicts of interest, peer review, and publishing underlying data and funding sources) need to become more widespread to the world of think tanks, websites and the media.
  • Consumers of expertise need better tools to assess quality – Minouche highlights the importance of people being given the tools to “differentiate facts from falsehood”. The e-commerce world has developed an array of tools to help consumers determine quality. We need something similar for the world of ideas. Good examples are the growth of fact-checking, authoritative websites and the FICC Markets Standards Board, which are designed to enhance trustworthiness in areas where trust has been eroded.
  • Listen to the other side – Minouche states that “we can all make an effort to engage with views that are different from our own and resist algorithmic channeling into an echo chamber.”
  • Manage the boundary between technocracy and democracy carefully – Minouche stresses that “technocracy can only ever derive its authority from democracy.” And for that reason there must always be clarity about the boundaries and accountabilities between experts and politicians.
    Minouche concludes, “so what have the experts ever done for us? The application of knowledge and the cumulation of that through education and dissemination through various media and institutions are integral to human progress. So the challenge is not how to manage without experts, but how to ensure that there are mechanisms in place to ensure they are trustworthy.”

Macroprudential – How To Do It Right

Brilliant speech from Alex Brazier UK MPC member on macroprudential “How to: MACROPRU. 5 principles for macroprudential policy“.

He argues that whilst macroprudential policy regimes are the child of the financial crisis and is now part of the framework of economic policy in the UK, if you ask ten economists what precisely macroprudential policy is, you’re likely to get ten different answers. He presents five guiding principles.

There are some highly relevant points here, which I believe the RBA and APRA must take on board. I summarise the main points in his speech, but I recommend reading the whole thing: This is genuinely important! In particular, note the limitation on relying on lifting bank capital alone.

First, macroprudential policy may seem to be about regulating finance and the financial system but its ultimate objective the real economy. In a crisis, the financial system may be impacted by events in the economy – for example credit dries up, lenders are not matched with borrowers. Risks can no longer be shared. Companies and households must protect themselves. And in the limit, payments and transactions can’t take place. Economic activity grinds to a halt. These are the amplifiers that turn downturns into disasters; disasters that in the past have cost around 75% of GDP: £21,000 for every person in this country. So the job of macroprudential policy is to protect the real economy from the financial system, by protecting the financial system from the real economy. It is to ensure the system has the capacity to absorb bad economic news, so it doesn’t unduly amplify it.

Second, the calibration of macroprudential should address scenarios, not try to predict the future but look at “well, what if they do; how bad could it be?” In 2007, he says it was a failure to apply economics to the right question. There was too much reliance on recent historical precedent; on this time being different. And, even more dangerously, they relied on market measures of risk; indicators that often point to risks being at their lowest when risks are actually at their highest.

The re-focussing of economic research since the crisis has supported us in that. It has established, for example, how far: Recessions that follow credit booms are typically deeper and longer-lasting than others; Over-indebted borrowers contract aggregate demand as they deleverage; While they have high levels of debt, households are vulnerable to the unexpected. They cut back spending more sharply as incomes and house prices fall, amplifying any downturn; Distressed sales of homes drive house prices down; Reliance on foreign capital inflows can expose the economy to global risks; And credit booms overseas can translate to crises at home.

When all appears bright – as real estate prices rise, credit flows, foreign capital inflows increase, and the last thing on people’s minds is a downturn – our stress scenarios get tougher.

Third, feedback loops within the system mean that the entities in the system can be individually resilient, but still collectively overwhelmed by the stress scenario.

These are the feedback loops that helped to turn around $300 bn of subprime mortgage-related losses into well over $2.5 trillion of potential write-downs in the global banking sector within a year. Loops created by firesales of assets into illiquid markets, driving down market prices, forcing others to mark down the value of their holdings. This type of loop will be most aggressive when the fire-seller is funded through short-term debt. As asset prices fall, there is the threat of needing to repay that debt. But even financial companies that are completely safe in their own right, with little leverage, and making no promise that investors will get their money back, can contribute to these loops.

The rapid growth of open-ended investment funds, offering the opportunity to invest in less liquid securities but still to redeem the investment at short notice, has been a sea change in the financial system since the crisis. Assets under management in these funds now account for about 13% of global financial assets. It raises a question about whether end investors, under an ‘illusion of liquidity’ created by the offer of short-notice redemption, are holding more relatively illiquid assets. That matters. This investor behaviour en masse has the potential to create a feedback loop, with falling prices prompting redemptions, driving asset sales and further falls in prices.

And in a few cases, that loop can be reinforced by advantages to redeeming your investment first. Macroprudential policy must move – and is moving – beyond the core banking system.

Fourth, prevention is better than cure.

Having calibrated the economic stress and applied it to the system, it’s a question of building the necessary resilience into it. The results have been transformative. A system that could absorb losses of only 4% of (risk weighted) assets before the crisis now has equity of 13.5% and is on track to have overall loss absorbing capacity of around 28%. Our stress tests show that it could absorb a synchronised recession as deep as the financial crisis.

And if signals emerge that what could happen to the economy is getting worse, or the feedback loops in the system that would be set in motion are strengthening, we will go further.

But bank capital is not always the best tool to use to strengthen the system and is almost certainly not best used in isolation.

We have applied that principle in the mortgage market. Alongside capitalising banks to withstand a deep downturn in the housing market, we have put guards in place against looser lending standards: A limit on mortgage lending at high loan-to-income ratios; And a requirement to test that borrowers can still afford their loan repayments if interest rates rise.

These measures guard against lending standards that make the economy more risky; that make what could happen even worse. Debt overhangs – induced by looser lending standards – drag the economy down when corrected. And before they are, high levels of debt make consumer spending more susceptible to the unexpected. So they guard against lenders being exposed to both the direct risk of riskier individual loans, and the indirect risk of a more fragile economy. This multiplicity of effects means there is uncertainty about precisely how much bank capital would be needed to truly ensure bank resilience as underwriting standards loosen.

A diversified policy is also more comprehensive. It guards against regulatory arbitrage; of lending moving to foreign banks or non-bank parts of the financial system. And by reducing the risk of debt overhangs and high levels of debt, it makes the economy more stable too.

Fifth, It is that fortune favours the bold.

The Financial Policy Committee needs to match its judgements that what could happen has got worse with action to make the system more resilient. Why will that take boldness? Our actions will stop the financial system doing something it might otherwise have chosen to do in its own private interest – there will be opposition. The need to build resilience will often arise when private agents believe the risks are at their lowest. And if we are successful in ensuring the system is resilient, there will be no way of showing the benefits of our actions. We will appear to have been tilting at windmills.

As the memory of the financial crisis fades in the public conscience, making the case for our actions will get harder. Fortunately, we are bolstered by a statutory duty to act and powers to act with. And whether on building bank capital or establishing guards against looser lending standards, we have been willing to act. Just as building resilience takes guts, so too does allowing the strength we’ve put into the system to be drawn on when ‘what could happen’ threatens to become reality. Macroprudential policy must be fully countercyclical; not only tightening as risks build, but also loosening as downturn threatens. Without the confidence that we will do that, expectations of economic downturn will prompt the financial system to become risk averse; to hoard capital; to de-risk; to rein in. To create the very amplifying effects on the real economy we are trying to avoid.

A truly countercyclical approach means banks, for example, know their capital buffers can be depleted as they take impairments; Households can be confident that our rules won’t choke off the refinancing of their mortgage. And insurance companies know their solvency won’t be judged at prices in highly illiquid markets. We must be just as bold in loosening requirements when the economy turns down as we are in tightening them in the upswings. Boldness in the upswing to strengthen the system creates the space to be bold in the downturn and allow that strength to be tested and drawn on. Macroprudential fortune favours the bold.


Latest UK Inflation Expectations Stronger

The Bank of England released their latest economic and inflation update. They are now expecting a stronger inflation rate in the short term, higher than their immediate post-Brexit-vote projections.  GDP looks pretty good too.

UK economic activity remained resilient in the second half of 2016. Growth is likely to slow over 2017 as households adjust their spending to lower real income growth resulting in large part from the 18% fall in sterling since late 2015. That fall in sterling will raise CPI inflation, which is likely to return to around the 2% target by February and then rise above it over the following months.

Conditioned on a market path for Bank Rate that rises to just under 0.75% by early 2020, the MPC projects CPI inflation to fall back gradually from the middle of 2018. Continued pass-through of higher import prices means, however, that inflation is projected to remain somewhat above the 2% target at the end of the Committee’s three-year forecast period.

The UK economy has remained resilient, with activity growing at close to its past average rate in 2016. Growth has been stronger than envisaged in the immediate aftermath of the vote to leave the European Union when survey evidence pointed to a sharp slowdown in activity. That partly reflects robust growth in consumer spending, with few signs that households are cutting back expenditure ahead of a squeeze in their real incomes. Official data for investment have been considerably weaker, although above recent expectations. Reinforcing the domestic news, there are signs of increasing momentum in the global economy with a stronger medium‑term outlook in several economies, supported by fiscal policy (Key Judgement 1). That has been reflected in global asset prices, with longer‑term interest rates and equity prices rising.

Domestic demand growth is still expected to slow over the course of this year as higher prices for imported goods and services begin to weigh on households’ spending power (Key Judgement 2). That pulls down four-quarter GDP growth, which settles at around 1¾% from the end of 2017 (Chart 5.1). That slowdown comes a little later than previously assumed. Moreover, the Government’s Autumn Statement represented a fiscal stimulus, relative to previously announced plans, the outlook for global growth is stronger, and credit conditions and equity prices are more supportive. Taking all the news together, the MPC now judges that the growth outlook is stronger than thought in November. Overall, in the central projection that leaves the level of GDP around 1% higher in three years’ time than projected in November. Relative to expectations in the May 2016 Report, just before the EU referendum, however, the level of GDP is still around 1½ lower in the medium term despite the significant monetary, macroprudential and fiscal support since then.

The Bank of England On Fintech

Mark Carney,  Governor of the Bank of England, spoke on ‘The Promise of Fintech.” Specifically, he looked across the banking value chain, and highlighted how digital transformation may be applied across it, as well as the risks which may emerge is so doing and how regulators need to respond.

To its advocates, this wave of innovation promises a FinTech revolution that will democratise financial services.

  • Consumers will get more choice, better-targeted services and keener pricing.
  • Small and medium sized businesses will get access to new credit.
  • Banks will become more productive, with lower transaction costs, greater capital efficiency and stronger operational resilience.
  • The financial system itself will become more resilient with greater diversity, redundancy and depth.
  • And most fundamentally, financial services will be more inclusive; with people better connected, more informed and increasingly empowered.

With hundreds of millions now entering the digital financial system every year, could higher economic growth and a quantum leap in social equity be on the horizon? Or will the range of new financial technologies primarily make existing institutions and markets more efficient and effective? No small prize but hardly a transformation.

FinTech’s true promise springs from its potential to unbundle banking into its core functions of: settling payments, performing maturity transformation, sharing risk and allocating capital. This possibility is being driven by new entrants – payment service providers, aggregators and robo advisors, peer-to-peer lenders, and innovative trading platforms. And it is being influenced by incumbents who are adopting new technologies in an effort to reinforce the economies of scale and scope of their business models.

In this process, systemic risks will evolve. Changes to customer loyalties could influence the stability of bank funding. New underwriting models could impact credit quality and even macroeconomic dynamics. New investing and risk management paradigms could affect market functioning. A host of applications and new infrastructure could reduce costs, probably improve capital efficiency and possibly create new critical economic functions.

The challenge for policymakers is to ensure that FinTech develops in a way that maximises the opportunities and minimises the risks for society. After all, the history of financial innovation is littered with examples that led to early booms, growing unintended consequences, and eventual busts.

Conduct regulators are in the lead in addressing regulatory issues posed by payment services innovations. This is both because, at least in advanced economies, FinTech payment service providers have not chosen to undertake banking activities and individual providers have not yet reached the scale that might be considered systemic.

Looking ahead, it is possible that virtual currencies and FinTech-based providers, particularly where they gain direct membership to central bank payment systems, could begin to displace traditional bank-based payment services and systems. Such diversification could be positive for stability; after all the existing tiered and highly concentrated system has created single point of failure risks. At the same time, regulators would need to monitor such changes for any new concentrations.

In this regard, with a view to such future proofing, the Digital Economy Bill in the UK proposes to extend the definition of a payment system beyond those that are inter-bank, to include any that become systemically important. If these are so designated by HMT, they would be supervised by the Bank. This would be akin to the recent recognition by HMT of Visa Europe and Link.

Changes to payments and customer relationships may have more fundamental implications for financial stability.

Specifically, while FinTech may make conventional banking more contestable, improving efficiency and customer choice, the opening up of the customer interface and payment services business, could, in time, signal the end of universal banking as we know it. If today’s universal banks lose the loyalty I saw on the Canadian prairie and instead have less stable funding and weaker, more arms-length client relationships, the volatility of their deposits and liquidity risk could increase. In addition, with weaker customer ties, cross-selling (my old preserve as a teller) could be less prevalent, hitting profitability. The system as a whole wouldn’t necessarily be riskier, but prudential standards and resolution regimes for banks may need to be adjusted.

The diversity in funding brought by market-based finance, as an alternative to retail banking, means that peer-to-peer lending has potential to provide some consumers and small businesses with affordable credit, when retail banks cannot. At the same time, this implies that borrowers in some segments may be placing increased reliance on this source of funding. How stable this funding will prove through-the-cycle is not yet clear, as the sector’s underwriting standards, and lenders’ tolerance to losses, have not been tested by a downturn.

Due to its small scale and business models, the P2P lending sector does not, for now, appear to pose material systemic risks. That said, as a general rule, it always pays to monitor closely fast-growing sources of credit for slippages in underwriting standards and the promotion of excessive borrowing. Moreover, it is not clear the extent to which P2P lending can grow without business models evolving in ways that introduce conventional risks, including maturity transformation, leverage and liquidity mismatch, or through the use of originate and distribute models such as those seen in securitisation in the 2000s. Were these changes to occur, regulators would be expected to address such emerging vulnerabilities.

In wholesale banking and markets, robo-advice and risk management algorithms may lead to excess volatility or increase pro-cyclicality as a result of herding, particularly if the underlying algorithms are overly sensitive to price movements or highly correlated. Similarly, although algorithmic traders have become a more important source of market liquidity in many important financial markets, they tend to be more active during periods of low volatility giving an illusion of plentiful liquidity that may subsequently be withdrawn during periods of market disruption when it is needed most.

FinTech innovations, such as distributed ledgers, are being trialled for use within, or as a substitute to, existing wholesale payment, clearing and settlement infrastructure, will need to meet the highest standards of resilience, reliability, privacy and scalability.

For all financial firms, the advent of FinTech materially changes operational and cyber risks. Regulators need to be alert to new single point of failure risks such as if banks come to rely on common hosts of online banking or providers of cloud computing services.

In recent years, the cyber threat to the system has grown as financial institutions have become more reliant on interconnected IT systems. As the FinTech future envisages the sharing of data across a wider set of parties, coupled with greater speed and automaticity in executing transactions, the challenges around protecting data and the integrity of the system are likely to increase. One sign of this is a growing preoccupation in the insurance industry with how best to underwrite such risks.

Recognising the vital importance of learning from international experience, in late 2016 the G20 called upon the FSB to stock-take existing cyber security regulation, as a basis for developing best practices in the medium-term.

While only private sector ingenuity will make these gains possible, authorities have essential, supporting roles in reinforcing them and managing the associated risks to financial stability. To help realise FinTech’s promise, we should refresh our supervisory approaches in a few ways.

First, regulatory sandboxes can allow businesses to test innovative products, services, business models and delivery mechanisms in a live environment and with proportionate regulatory requirements. This supports innovation and learning by developers and regulators. The FCA was an early mover launching Project Innovate in 2014.21 The G20 might consider the extent to which such approaches should be adopted more widely.

Second, existing authorisation processes can also be adapted to ensure they do not unnecessarily block new business models and approaches. This is why in the UK, the PRA and FCA now work closely with all firms seeking new authorisation as banks.

Third, the Bank of England is expanding access to central bank money to non-bank payments service providers (“PSPs”). Allowing access to the Bank’s Real Time Gross Settlement System allows PSPs to compete directly with banks, and so supports innovation, competition and financial stability.

Fourth, a number of authorities, including the Bank of England with its FinTech accelerator, are developing Proofs of Concepts with new enabling technologies from machine learning to distributed ledgers. And, to explore what could be genuinely new under the sun, we are researching the policy and technical issues posed by Central Bank Digital Currencies. On some levels this is appealing; people would have direct access to the ultimate risk-free asset. In the extreme, however, it could fundamentally reshape banking including by sharply increasing liquidity risk for traditional banks

This last point underscores that, in order for FinTech’s potential to be realised, authorities must manage its impact on financial stability. On the positive side, FinTech could reduce systemic risks by delivering a more diverse and resilient system where incumbents and new entrants compete along the value chain. At the same time, some innovations could generate systemic risks through increased interconnectedness and complexity, greater herding and liquidity risks, more intense operational risk and opportunities for regulatory arbitrage.

As those risks emerge, authorities can be expected to pursue a more intense focus on the regulatory perimeter, more dynamic settings of prudential requirements, a broader commitment to resolution regimes, and a more disciplined management of operational and cyber risks. And we will be alert to potential impacts on the existing core of the system, including through business model analysis and market impact assessments.
By enabling technologies and managing risks, we can help create a new financial system for a new age… under the same sun.



Analysis of Mortgage Risk Under Basel

The Bank of England just published a staff working paper “Specialisation in mortgage risk under Basel II“.  Lenders using the less sophisticated risk models (generally smaller banks) are found to have a higher concentration of higher-risk mortgages than those using the advanced models.

They looked at the two models which were introduced under Basel II, lenders’ internal models (IRB) and the less risk-sensitive standardised approach (SA) by using a dataset covering 7 million UK mortgages from 2005-15. The switch to Basel II gave lenders using IRB models a comparative advantage in capital requirements (compared to lenders using the SA approach), particularly at low loan-to-value (LTV) ratios, and this was reflected in prices and quantities. They concluded:

First, mortgage risk is concentrated in lenders using the SA approach, which is typically used by smaller lenders, suggesting a potential higher failure rate than among IRB banks.

Second, macroprudential tools may affect the strength of the specialisation mechanism. This should be accounted for in calibrating such tools.

Third, they validate the view from competition authorities who have identified the cost of adopting IRB as a potential barrier to entry and expansion. IRB provides a competitive advantage in low LTV ratio mortgages.

Finally, the effect, is not specific to the mortgage market and this needs  further research.

IRB risk weights increase with the LTV ratio, the main indicator for credit risk used by UK mortgage lenders. In contrast, SA risk weights are fixed at 35% for LTV ratios up to 80%, and are then 75% on incremental balances above the 80%

LTV threshold. IRB risk weights tend to be lower than SA risk weights across most LTV ratios, but the gap is larger for lower LTV ratios. In 2015, the gap between the average IRB risk weight and the SA risk weight was about 30 percentage points for LTV ratios below 50%, compared to less than 15 percentage points for LTV ratios above 80%. The scale of variation in risk weights between IRB lenders is smaller than the gap between the IRB average and SA risk weights, at least at lower LTV ratios.

IRB lenders gain a comparative advantage in capital requirements compared to SA lenders, particularly at low loan-to-value (LTV) ratios. This comparative advantage is reflected in prices and quantities.

We expect all lenders to price lower for lower LTV mortgages. But under Basel II versus I, IRB lenders did so by 31 basis points (bp) more, and increased the relative share of low-LTV lending in their portfolios by 11 percentage points (pp) more, than SA lenders. Such specialisation leads to systemic concentration of high risk (high LTV) mortgages in lenders who tend to have less sophisticated risk management.

With an average 30 percentage point gap between IRB and SA risk weights for LTV ratios below 50%, this corresponds to an economically significant price advantage of 30bp. From the perspective of a typical borrower at this LTV level, with a 50% LTV mortgage against a $200,000 property, repayable over a remaining 15 year term, 30bp translates to around $170 per year or 0.7% of median household disposable income. From the lender’s perspective, a 30bp disadvantage translates to several places in `best buy’ tables, and thus likely material loss of market share.

If instead of risk weights we consider directly the variation in capital requirements, which is driven by both risk weights and lender-specific capital ratio requirements, a 1pp reduction in capital requirements causes a 6bp decrease in interest rates. These latter results can also be interpreted as `pass-through’ rates from lender-specific changes in risk weights or capital requirements to prices, subject to limits on external validity due to the Lucas critique.

Finally, we find that the pass-through from capital requirements to prices is significant only when lenders have low capital buffers (the surplus of capital resources over all regulatory requirements). Lenders with a buffer below 6pp of risk-weighted assets increase prices by 1.7bp basis point for a 1pp increase in risk weights.

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee or Prudential Regulation Authority Board.

Bank of England Admits Economic Forecasting Errors

From TheDailyBell.

Chief economist of Bank of England admits errors in Brexit forecasting … Andrew Haldane says his profession must adapt to regain the trust of the public, claiming narrow models ignored ‘irrational behaviour.’  The Bank of England’s chief economist has admitted his profession is in crisis having failed to foresee the 2008 financial crash and having misjudged the impact of the Brexit vote. -Guardian

The top economist at England’s chief central bank has said economists are often wrong. He called critisisms about lack of accuracy in forecasting a “fair cop” and said the industry would have to do a better job.

Andrew Haldane, said it was “a fair cop” referring to a series of forecasting errors before and after the financial crash which had brought the profession’s reputation into question.

Blaming the failure of economic models to cope with “irrational behaviour” in the modern era, the economist said the profession needed to adapt to regain the trust of the public and politicians.

Before Brexit, the actual head of the English central bank, Mark Carney, said that agreeing to Brexit would cause grave economic problems, So far that hasn’t happened yet. Then there was Lehman Brothers, which was supposed to have little impact on England. Instead it had a lot.

Haldane was speaking at the Institute for Government in central London. Despite his negative message, he was upbeat. He believed that economic forecasting  could improve a good deal.

Nonetheless, Haldane is bothered by criticisms and is worried forecasts will not be taken seriously if they continus to be wrong,

Former Tory ministers, including the former foreign secretary William Hague and the justice secretary Michael Gove, last year attacked the Bank of England governor, Mark Carney, for predicting a dramatic slowdown in growth if the country voted to leave the EU.

The statement regarding Brexit’s bad effects was even taken as hoax by such individuals as Treasury’s Boris Johnson. Boris was pro Brexit. He said the chief central banker was criticizing Brexit just to make it sound bad.

Prime Minister Theresa May, criticised the bank as well. The bank should not have cut rates and boosted stimulus after the vote. It later turned out the economy was OK without the stimulus.

Haldane admitted the bank did not project such economic strength. But he also believed the timing was off, not the underlying forecast.

“I think, near-term, the data, the evidence we’ve been accumulating since the referendum, has surprised to the upside. [There’s been] greater resilience, in particular among consumers and among the housing market, than we had expected. Has that led us to fundamentally change our view on the fortunes of the economy looking forward over the next several years? Not really.”

And he is said to have added: “This is more a question, I think, of timing than of a fundamental reassessment of the fortunes of the economy. So back in November we published a forecast for inflation which was the highest we’ve ever published. And the forecast for growth in the UK economy, that was the lowest we have ever published.  We are still expecting this rather difficult balancing act for monetary policy with a slowing, not a huge slowing, but nonetheless a material slowing, during the course of next year as the effects of higher prices in the shops begin to chew away a little at the spending power of consumers and cause them to rein back a little in their spending.”

He even blamed British citizens for a lack of numeracy. So we can see that Haldane may want to cast the net of blame a good deal wider than just central bank affililiated economists.

In truth when it comes to economics, especially as it pertains to central banks, Haldane is mostly if not entirely wrong. The Bank of England is basically a government monopoly. Economists affiliated with it will certainly take positions agreeing with it.

The Bank of England was pro EU and thus apt to foresee some sort of calamitous event if Brexit passed. You won’t get a full range of predictions until the bank ceases to be a monopoly and economists don’t feel the need to answer in a certain way.

Conclusion: Until then, Haldane can say whatever he wants but important economists will continue to make forcasts that favor the English central bank for the sake of their jobs and promotions. As central bank outlooks continue to worsen, forecasts among many senior economists will grow even more inaccurate as a result.

UK Holds Bank Rate At 0.25%

At its meeting ending on 14 December 2016 the Committee voted unanimously to maintain Bank Rate at 0.25%. In their statement they refer to rising long term rates reflecting looser fiscal settings in the USA, and elevated risks from China, the euro zone and elsewhere.

The Committee voted unanimously to continue with the programme of sterling non-financial investment-grade corporate bond purchases totalling up to £10 billion, financed by the issuance of central bank reserves. The Committee also voted unanimously to continue with the programme of £60 billion of UK government bond purchases to take the total stock of these purchases to £435 billion, financed by the issuance of central bank reserves.

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment

In the November Inflation Report, the Committee set out its projections for output, unemployment and inflation, conditioned on average market yields.  Output was expected to grow at a moderate pace in the near term, but slow from the beginning of next year.  In part that reflected the likelihood that household real income growth would slow and hence weaken household spending.  It also reflected uncertainty over future trading arrangements, and the risk that UK-based firms’ access to EU markets could be materially reduced, which could restrain business activity and supply growth over a protracted period.  The unemployment rate was projected to rise to around 5½% by the middle of 2018 and to stay at around that level throughout 2019.  Largely as a result of the depreciation of sterling, CPI inflation was expected to rise to around 2¾% in 2018, before falling back gradually over 2019 to reach 2½% in three years’ time.  Inflation was judged likely to return to close to the target over the following year.

Since November, long-term interest rates have risen internationally, including in the United Kingdom.  In part, this reflects expectations of looser fiscal policy in the United States which, if it materialises, will help to underpin the slightly greater momentum in the global economy evident in a range of data since the summer.  At the same time, however, the global outlook has become more fragile, with risks in China, the euro area and some emerging markets, and an increase in policy uncertainty.

Domestically, data released since the Committee’s previous meeting continue to indicate that activity is growing at a moderate pace, supported by solid consumption growth.  Forward-looking components of business surveys are weaker than those regarding current output, however, suggesting that some slowing in activity is in prospect during 2017.  The timing and extent of this slowing will depend crucially on the evolution of wages and how resilient household spending is to the pressure on real incomes from higher inflation.

Twelve-month CPI inflation stood at 1.2% in November, up from 0.9% in October and 1.0% in September.  Looking forward, the MPC expects inflation to rise to the 2% target within six months.  Since the Committee’s previous meeting, sterling’s trade-weighted exchange rate has appreciated by over 6%, while dollar oil prices have risen by 14%.  All else equal, this would result in a slightly lower path for inflation than envisaged in the November Inflation Report, though it is still likely to overshoot the target later in 2017 and through 2018.

Banks like RBS still look risky, but getting too tough could cause greater problems

From The Conversation.

Even in less politically volatile times, the news that the UK’s biggest bank, RBS, failed the Bank of England’s toughest everstress tests” would have dampened financial spirits. The bank must now raise an extra £2 billion to protect itself from future downturns. This may be made easier because RBS is 73% publicly owned, but that’s an unwelcome legacy of its exceptionally poor condition after the crash of 2007-08.

Meanwhile, the Bank of England (BoE) singled out two other banks – Barclays and Standard Chartered – for having “some capital inadequacies”. So why haven’t eight years of economic recovery cured the banks’ woes?

Banks remain solvent as long as their assets, the money they’ve lent to borrowers or invested, exceed their liabilities, the money they’ve borrowed from depositors or other lenders. If the economy worsens, a bank’s assets can fall because their investments lose value and “non-performing” loans have to be written off.

For this reason, the core “equity” capital that banks have raised from shareholders is regarded as a safety margin between assets and liabilities; unlike loans, it never has to be repaid. For building societies, accumulated reserves take the place of shareholders’ equity in providing this buffer.

Stressful times

Stress tests calculate the fall in a bank’s asset values under various adverse economic scenarios. If a shock looks big enough to wipe out the “Tier 1 capital” safety margin, the bank is asked to raise more capital and/or boost the value of assets or make them better hedged against losing value. The BoE and European Central Bank are among the institutions that have regularly conducted these tests since banks were caught with their capital ratios down in 2008.

Downturn became crisis in 2007-08 because, in the unusually long and placid upturn beforehand, banks ran their core capital to dangerously low levels. Regulators found Tier 1 capital in some cases to be worth just 1-2% of assets, once they removed permitted adjustments that exaggerated the capital and understated the risks to asset value.

The Bank of International Settlements (BIS), the central bank for central banks, duly imposed stricter requirements. These included core capital equal to at least 8% of what are known as risk-weighted assets – a system that sets lower capital requirements for assets considered less risky. Acknowledging that this system had itself contributed to risk being underestimated, the BIS also recommended a minimum “leverage ratio” of capital to total assets. (The BoE has continued to argue over the terms of this, fearing it could erode the cushion of reserves it’s supposed to promote.)

Alarm bells?

RBS failed the latest test, having passed in previous years, because the terms have been toughened. That’s a recognition that simultaneous setbacks could hit the world’s major economies before the BIS reforms are fully in place in 2019. If loans to businesses, individuals and governments in multiple countries all started going bad, banks’ assets fall much further than if it’s just one sector in one country. Countries’ problems became contagious in 2008 when household and corporate assets, especially property, plunged on both sides of the Atlantic.

Policy measures taken to calm the last crisis might have raised the risks of another. Low interest rates and “quantitative easing” have encouraged more household and commercial debt, driving up property and financial asset prices. China, whose property bubble looks particularly pronounced, is among the greatest worries. Governments have also exacerbated their debts by spending to try to stop national output and price levels falling, leaving them ill-equipped to rescue collapsing banks again.

American economist, Irving Fisher.

These worries are deepened by the possibility that banks’ capital and reserves are still too low to withstand shocks. Some experts believe they need to rise by a factor of ten or more in relation to assets for the system to be totally safe. That view, pioneered by the American economist Irving Fisher, who identified the dangers of “debt deflation” in the 1930s, now has a range of powerful advocates including distinguished commentator Martin Wolf.

Wolf was a member of the UK’s Independent Commission on Banking, which in 2011 accepted the BIS’s recommendation of raising core capital to 8% of risk-weighted assets. More recently he argued it should be 100%. Where the current system reflects the fact that banks create money when they lend it, this “full reserve banking” would mean they could only lend what they had raised from the markets.

Regulatory dilemmas

Critics counter that such a radical move could bring the stability of the graveyard. It would give governments (via their central banks) complete control over their economies’ supply of money. Whereas banks currently generate most of the money supply by lending, they would be reduced to intermediaries channelling savings into investment.

For economic liberals, this would give the state an unacceptable monopoly over money – unless it returned to a gold standard that tied its currency to precious metals, which would effectively put a ceiling on how much money it could create. Others fear any substantial move away from the present “fractional reserve” system would cause a huge downturn while banks run down their lending and boost their capital.

Even then, central banks might be no better than now at phasing credit growth with economic growth to keep prices and production stable. And a gold standard might be inherently deflationary, unless breakthroughs in mining (or alchemy) kept precious metal stocks expanding in step with national output.

From out of the shadows … Inhabitant

But above all, private enterprise would always innovate to break this public monopoly. This is already visible in the rise of “shadow banking” – loans by institutions like hedge funds and private equity funds that escape bank regulation because they technically aren’t banks. Official statistics, which may understate the true situation, show shadow banking assets rising steadily to 12% of the total since regulation began tightening, mostly in rich economies where banking rules are tightest.

If once aberrant lenders like RBS are forced to mend their ways too radically, the next boom might just be powered from the shadows, causing new bubbles to burst in an even darker place. So central banks will stick to their present plan for gradual increases in capital, hoping any coming slowdown in growth won’t topple the banks that proved unstressed by their latest test.

Author: Alan Shipman, Lecturer in Economics, The Open University

Some UK Banks Fail Latest Stress Tests

The results of the 2016 UK Bank stress testing has been released by the Prudential Regulation Authority (PRA). The test did not reveal capital inadequacies for four out of the seven participating banks but the Royal Bank of Scotland Group (RBS), Barclays and Standard Chartered revealed some capital inadequacies and remedial work is required.

However, the PRA concluded that given the results, no system-wide macroprudential actions on bank capital were required in response to the 2016 stress test. Despite a more severe scenario, the aggregate low points for CET1 capital and Tier 1 leverage ratios were higher than in the 2014 and 2015 tests.


In March 2016, the Bank of England launched its third concurrent stress test of the UK banking system. The 2016 stress test covered seven major UK banks and building societies (hereafter referred to as ‘banks’), accounting for around 80% of PRA-regulated banks’ lending to the UK real economy.

The 2016 stress-test scenario was designed under the Bank’s new approach to stress testing. Under this framework, the stress being tested against will generally be severe and broad, in order to assess the resilience of major UK banks to ‘tail risk’ events. Its precise severity will reflect the risk assessment of the FPC and PRA Board.

uk-stress-2016As such, the 2016 test was more severe than earlier tests. The severity of the stress in the 2016 scenario is based on the risk assessment the FPC and PRA Board made in March 2016 — that overall risks to global activity associated with credit, financial and other asset markets were elevated, and that risks associated with domestic credit were no longer subdued but
were not yet elevated.

The 2016 annual cyclical scenario incorporates a very severe, synchronised UK and global economic recession, a congruent financial market shock and a separate misconduct cost stress. Annual global GDP growth troughs at -1.9%, as it did during the 2008 global financial crisis. Annual growth in Chinese real GDP is materially weaker than in the financial crisis and troughs at -0.5%. The level of UK GDP falls by 4.3%, accompanied by a 4.5 percentage point rise in the unemployment rate. Overall, the UK stress is roughly equivalent to that experienced during the financial crisis, albeit with a shallower fall in domestic output, and a more severe rise in unemployment and fall in residential property prices.

The stress test also includes a traded risk scenario that is constructed to be congruent with this macroeconomic stress. Having fallen significantly during 2015, the price of oil reaches a low of US$20 per barrel, reflecting the slowdown in world demand. Investors’ risk appetite diminishes more generally and financial market participants attempt to de-risk their portfolios, generating volatility. The VIX index averages 37 during the first year of the stress, which compares to a quarterly average of around 40 between 2008 H2 and 2009 H1.

Interest rates facing some households and businesses increase in the early part of the stress, partly reflecting a rise in term premia on long-term government debt. Credit spreads on corporate bonds rise sharply, with spreads on US investment-grade corporate bonds, for example, rising from around 170 basis points to 500 basis points at the peak of the stress. Meanwhile, policymakers pursue additional monetary stimulus, which starts to reduce long-term interest rates.

Residential property and commercial real estate (CRE) prices also fall. Following rapid recent growth, these falls are particularly pronounced for property markets in China and Hong Kong, with residential property prices falling by around 35% and 50%, respectively. In the United Kingdom, house prices fall by 31% and average CRE prices fall by 42%. These falls are even greater for prime CRE, reflecting the fact that prices of these properties have risen more robustly since the financial crisis.

The 2016 stress test also incorporates stressed projections, generated by Bank staff, for potential misconduct costs, beyond those paid or provided for by the end of 2015. These stressed misconduct cost projections are not a central forecast of such costs. They are a simultaneous, but unrelated, stress alongside the macroeconomic stress and traded risk scenario incorporated in the 2016 test.

Impact of the stress scenario on the banking system

The stress scenario is estimated to lead to system-wide losses of £44 billion over the first two years of the stress, around five times the net losses incurred by the same banks as a group over 2008–09. Based on the Bank’s projections, the 2016 stress scenario would reduce the aggregate CET1 capital ratio across the seven participating banks from 12.6% at the end of 2015 to a low point of 8.8% in 2017, after factoring in the impact of management actions and the conversion of AT1 instruments into CET1 capital (Table 1).(1) The aggregate Tier 1 leverage ratio falls from 4.9% at the end of 2015 to a low point of 3.9% in 2017.

Compared to previous tests, the fall in the aggregate CET1 capital ratio from start to stressed low point was larger in the 2016 stress test, reflecting the greater severity of the stress scenario. Nevertheless, at 8.8% that low point was well above the 7.6% low point reached in 2014 and 2015.

Lloyds Banking Group and Santander UK cut their ordinary dividends to zero by the low point of the stress, in line with their published payout policies.(1) In reaction to losses made during both the first and second years of the stress, HSBC makes a substantial discretionary cut in ordinary dividend payments in 2016 and then pays no ordinary dividend in 2017,
as it makes a loss and becomes subject to CRD IV distribution restrictions. Meanwhile, Barclays and Standard Chartered are loss-making during the first two years of the stress and cut their ordinary dividend payments to zero as they become subject to CRD IV distribution restrictions. The Royal Bank of Scotland Group does not pay an ordinary dividend in any year
of the stress scenario. Nationwide continues to make distributions on its Core Capital Deferred Shares (CCDS).

In general, the stress has the greatest impact on those banks with significant international and corporate exposures. The three banks operating principally in domestic markets — Lloyds Banking Group, Nationwide and Santander UK — remain well above their hurdle rates throughout the stress. This reflects, in part, improvements in the asset quality of banks’ core UK mortgage businesses, through a combination of rising property prices, which have bolstered the value of collateral backing loans, as well as banks adopting more prudent new lending standards.

The PRA Board judged that:

  • The test did not reveal capital inadequacies for four out of the seven participating banks, based on their balance sheets at end-2015 (HSBC, Lloyds Banking Group, Nationwide Building Society and Santander UK).
  • The Royal Bank of Scotland Group (RBS) did not meet its common equity Tier 1 (CET1) capital or Tier 1 leverage hurdle rates before additional Tier 1 (AT1) conversion in this scenario. After AT1 conversion, it did not meet its CET1 systemic reference point or Tier 1 leverage ratio hurdle rate. Based on RBS’s own assessment of its resilience identified during the stress-testing process, RBS has already updated its capital plan to incorporate further capital strengthening actions and this revised plan has been accepted by the PRA Board. The PRA will continue to monitor RBS’s progress against its revised capital plan.
  • Barclays did not meet its CET1 systemic reference point before AT1 conversion in this scenario. In light of the steps that Barclays had
    already announced to strengthen its capital position, the PRA Board did not require Barclays to submit a revised capital plan. While these steps are being executed, its AT1 capital provides some additional resilience to very severe shocks.
  • Standard Chartered met all of its hurdle rates and systemic reference points in this scenario. However, it did not meet its Tier 1 minimum capital requirement (including Pillar 2A). In light of the steps that Standard Chartered is already taking to strengthen its capital position, including the AT1 it has issued during 2016, the PRA Board did not require Standard Chartered to submit a revised capital plan.
  • The FPC judged that the system should be capitalised to withstand a test of this severity, given the risks it faced. It therefore welcomed the actions by some banks to improve their capital positions. Despite a more severe scenario, the aggregate low points for CET1 capital and Tier 1 leverage ratios were higher than in the 2014 and 2015 tests. The FPC noted the increased resilience to stress provided by banks’ AT1 capital positions and banks’ stated intention to reduce dividends in stress. It also noted the strong performance of the most domestically focused banks. Given the results, no system-wide macroprudential actions on bank capital were required in response to the 2016 stress test.
  • The FPC is maintaining the UK countercyclical capital buffer rate at 0% and reaffirms that it expects, absent any material change in the outlook, to maintain this rate until at least June 2017. This reflects developments since the stress test was launched in March, which suggest greater uncertainty around the UK economic outlook and an increased possibility that material domestic risks could crystallise in the near term. The FPC was concerned that banks could respond to these developments by hoarding capital and restricting lending. That position has not changed.

Why are interest rates low?

In a speech at the University of Manchester on Wednesday, Bank of England Deputy Governor for Financial Stability, Sir Jon Cunliffe, discusses the factors that have influenced the level of interest rates over the recent past. He examines the policy challenges posed by a prolonged period of low underlying interest rates, and looks ahead at the trade-offs that the Monetary Policy Committee will have to make to bring inflation back to target.


Jon explains that in order to understand why official rates are so low, it is necessary to analyse the drivers of two concepts of interest rate: the trend real rate of interest and the natural real interest rate (R*).

The trend real rate is a longer-term measure which balances the demand for investment with the supply of saving when the economy is growing at trend. Over the years, this has been depressed by a glut of savings, reduction in investment opportunities and expectations of a lower rate of real global economic growth. The natural real interest rate, meanwhile, is a shorter-term concept and is necessary to offset the impact of unexpected shocks hitting the economy. It is useful as a reference point for policymakers to assess the tightness or looseness of the monetary policy stance.

“It is generally acknowledged that the exceptional monetary policies implemented in the years immediately following the crisis were necessary. However we are now eight years on and monetary policy still appears to many exceptionally loose by reference to historical rates of interest. Can this still be justified by reference to the natural rate? My own view is that it can.”

Jon explains that while the natural rate has risen since 2012 from its post-crisis trough, it is now closer to the zero mark and is still likely to be negative. This is due to headwinds to demand from fiscal tightening, weakness in the global economy, restoration of credit spreads to more sustainable levels and elevated risk aversion. A further reason may be a drop in the trend real rate itself.

Jon identifies two main implications for central banks if the natural rate remains around zero and does not rise even as headwinds abate.

First, is that policy rates will remain low and will rise slowly and to levels materially below those that prevailed before the crisis; second, the tools deployed by central banks to offset shocks to the real economy will have more complex effects on the financial sector and the price of financial assets.

He observes that even if policy is following the natural rate of interest, the effects can be felt more powerfully when policy rates are at what appear to be very high or very low absolute levels. Central banks are mandated to make difficult trade-offs: most notably, when inflation is off-track, they have to balance the speed with which it is brought back to target against the impact on growth. However, it is not for central banks to make more granular judgements on the distributional effects of policy: such decisions should remain the province of elected authorities that have many instruments to address these issues.

The impact of the depreciation of sterling on future inflation has increased the salience of such a trade-off for the MPC, Jon notes.

“As the Committee has made clear, there are limits to the extent to which above-target inflation can be tolerated. These limits depend, inter alia, on what is driving the inflation overshoot, on the impact on inflation expectations, and on the scale of the output gap. The exchange rate shock has made it more difficult for policy to follow the natural rate,” according to Jon.

Finally, Jon examines the challenges posed by a secular period of very low interest rates. In that scenario, authorities with a longer policy horizon and with instruments with a more enduring impact are best placed to address those challenges, namely, raising the growth rate of productivity. Another challenge might be to address some of the longer term factors driving the imbalance in the supply of savings, and the demand for investment, including lower public investment, that appear to have pushed the trend real rate down.

“The answers to these challenges are not simple,” Jon concludes. “Structural change to raise productivity can be very difficult; it often means there will be losers and winners. Likewise, fiscal policy needs to balance public spending with sustainability through time.”

“These are certainly not, I readily admit, issues for central bankers. It is not so much that we have our plates quite full meeting our much narrower and shorter-term mandates – though that is surely true. It is that, more fundamentally, these are decisions and actions that only governments can and should take.”