In recent weeks, the global financial system has undergone a period of exceptional instability. This instability was rooted in weaknesses within the financial system that developed during an extended global credit boom: rapid balance sheet expansion; the creation of assets whose liquidity and credit quality were uncertain in less benign conditions; and fragilities in funding structures.

While these weaknesses had been identified, including by the Bank in previous Reports, few predicted that they would lead to such dislocation in the global financial system.

Over the past six months, rising macroeconomic uncertainty, partly due to tightening credit conditions, helped expose these weaknesses. Falling asset prices and a weakening economic outlook added materially to expected losses and increased uncertainty about the value of banks’ asset portfolios. As counterparty risk rose, lenders became progressively more reluctant to offer term financing, accentuating pressures on institutions with a high dependence on wholesale funding.

Banks and other financial institutions sought to protect their balance sheets through asset sales and tighter credit supply. But that led to further asset price falls and increased uncertainty about economic prospects and banks’ viability, as an adverse cycle began to develop.

Towards the end of the summer, stress at the two largest US mortgage corporations and the failure of Lehman Brothers were followed by severe strains in the global interbank funding network and widespread institutional distress. In response, central banks provided additional liquidity and national authorities supplied or brokered new capital for specific institutions under stress or facilitated the merger or exit of firms without an independent future. While helpful, these institution-specific measures failed to forestall acute system-wide pressures on financial institutions during late September and early October.

In response, on 8 October the UK authorities announced a comprehensive and system-wide support package that addressed directly weaknesses in UK banks’ balance sheets. The package supports capital raising to bolster confidence in the resilience of UK banks. And an extension of the Special Liquidity Scheme and the provision of guarantees on new debt issuance offer assurance about banks’ short-term and medium-term funding positions. Subsequently, other countries adopted system-wide measures with similar underlying principles.

These exceptional interventions by governments and central banks should help to stabilise the banking system in the period ahead. While there are still risks in the wider financial system, the immediate response to the measures has been positive. Over time, against the backdrop of an economic downturn, banks will need to adjust their balance sheets and funding models, weaning themselves off current high levels of official sector support. Lending growth is likely to remain slower than in recent years.

Looking further ahead, recent events have highlighted the need for a fundamental rethink internationally of appropriate safeguards against systemic risk, including through the development of macroprudential policies to dampen the financial cycle.

Download Bank of England Financial Stability Report, October 2008

PDF format, 2.8MB, 61Pages.

CONTENTS
Foreword 1
Executive summary 5
Introduction 6
1 An extended global credit boom 7
2 An adverse spiral develops 10
Box 1 Losses on financial assets 14
3 Institutional risks materialise 17
Box 2 Counterparty credit risks in OTC derivatives markets 21
Box 3 Changes to the composition of the UK banking sector 24
4 A system-wide response 26
Box 4 Recapitalising UK banks 28
Box 5 Government financial support to the banking industry 31
5 Near-term prospects for the financial system 34
6 The medium-term agenda 41
Box 6 Countercyclical measures 44
Box 7 Banking Bill: overview of the special resolution regime 49
Conclusion 52
Annex 53
Index of charts and tables 56
Other financial stability publications 58
Glossary and other information 61

Visit Bank of England Financial Stability Report Website

Financial Stability Report
October 2008 | Issue No. 24

The Financial Stability Board:
John Gieve, Chair
Martin Andersson
Andrew Bailey
Charles Bean
Spencer Dale
Nigel Jenkinson
Mervyn King
Paul Tucker

The Bank of England has two core purposes — monetary stability and financial stability. The two are connected because serious disruption in the financial system can affect the implementation and effectiveness of monetary policy, while macroeconomic stability helps reduce risks to financial stability.

The Bank’s responsibilities for monetary stability are set out in the Bank of England Act 1998. Responsibility for financial stability in the United Kingdom is shared between the tripartite authorities — HM Treasury (HMT), the Financial Services Authority (FSA) and the Bank of England. Their roles are set out in a Memorandum of Understanding (MoU).

The Bank’s responsibility for contributing to the maintenance of the stability of the financial system as a whole derives from its responsibility for setting and implementing monetary policy, its role in respect of payment systems in the United Kingdom and its operational role as banker and supplier of liquidity to the banking system. The Bank aims to bring its expertise in economic analysis and its experience as a participant in financial markets to the assessment and mitigation of risks to the UK financial system including, as necessary, helping to manage and resolve financial crises. In so doing, the Bank works closely with authorities domestically and overseas on issues relevant to the stability of the UK financial system, including the international financial architecture and regulatory frameworks.

The Financial Stability Report aims to identify the major downside risks to the UK financial system and thereby to help financial firms, authorities overseas and the wider public manage and prepare for these risks. The Report is produced half-yearly by Bank staff under the guidance of the Bank’s Financial Stability Board, whose best collective judgement it represents.

Comments (0)

Name

Email

Comment

smaller | bigger

Add Comment