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I welcome you to the Chair for this afternoons proceedings, Mr. Gale. Before we adjourned, I had moved on from the debate about the amendments to the clause stand part debate and I was talking about the financial stability objective. I identified three key areas for clarification: what does the objective mean, how is it measured and what tools does the Bank have to deliver financial stability?
I gave the definition of the objective that the Governor of the Bank of England had used in evidence to the Treasury Committee. That definition was amplified when we held our evidence session on Tuesday 21 October. The executive director for financial stability expanded on the Governors definition when he defined a situation of financial stability as one where
the financial intermediation mechanism works normally, where households and corporates can mediate their savings into real investment in the economy at home and abroad, and where the payment system operates normally. It is a situation where intermediation works well, where people have confidence in the system and where the payment system operates well.[Official Report, Banking Public Bill Committee, 21 October 2008; c. 21, Q53.]
That is quite a narrow definition. Clearly, it is one that the Bank is happy to use, and it ties in with one of the new responsibilities that have been given to the Bank in the Bill. I am referring to the regulation of payment systems. There is a clear link between that definition and the Banks responsibility.
I am concerned, however, that the definitions that the Bank has used are very much process-driven, focusing on the payment system and how effectively we can mediate savings and investments. Other definitions are available that focus on broader issues. Andrew Crockett, who was formerly the general manager of the Bank for International Settlements, referred to an absence of financial stability as
a situation in which economic performance is potentially impaired by fluctuations in the price of financial assets or by an inability of financial institutions to meet their contractual obligations.
There are two elements to the definition. One is about processthe ability to meet contractual obligationsbut the first one broadens the definition somewhat by talking about the impact that the fluctuation in asset prices might have on the economy.
That raises a different set of issues and links into a definition of stability given by Garry J. Schinasi in an International Monetary Fund publication called Defining Financial Stability. He described financial stability as
a condition in which an economys mechanisms for pricing, allocating, and managing financial risks (credit, liquidity, counterparty, market, etc.) are functioning well enough to contribute to the performance of the economy.
That defines financial stability much more broadly, and it reflects on some of the current problems in the financial system and indicates why the system is unstable. For example, the pricing of risk related to mortgage-backed securities did not appear to work, as the level of risk inherent in those products was underestimated and consequently lower interest rates were charged. The credit crunch, in its early stages, was a sign that liquidity risks in the market were not well understood. We know that from Northern Rock, where the problem was not the banks solvency but its liquidity, because of its exposure to wholesale markets. Peoples understanding of how wholesale markets functioned did not flow into their understanding of liquidity. Banks that were perceived to have adopted a more cautious approach to risk and were widely criticised for the conservatism of their strategies, have withstood the market turmoil with greater resilience than banks that followed more aggressive policies. Again, there is the issue of understanding the risks and the markets. Part of the problem that we face is the consequence of an asset price bubble that was fuelled by an increase of debt and which has caused instability in the market.
I would argue that it is a combination of those issues that has given rise to some of the current problems, such as the threat to payment systems and the means of intermediation. My concern is that the definition that has been adopted or discussed by the Bank is narrow. If we look at the causes of the current financial instability, we will understand that there are wider issues of financial stability than simply the functioning of the payment system. My concern is that if we have too narrow a definition of financial stability we are at risk of losing sight of the threats to that stability and of the policy actions that we might take to combat that.