On 10 September 2024, Sarah Breeden, the Bank of England’s (BoE) Deputy Governor for Financial Stability gave a speech on how the BoE thinks about financial stability and some of the challenges it is considering currently. Points covered by the speech include how:

• The BoE supports financial stability in a range of ways.
• Its approach to financial stability must always have system-wide dynamics in mind, not just the individual entities in the system.
• The best contribution the BoE can make to sustainable economic growth is to ensure that the system provides vital services even as shocks occur.

How the BoE supports financial stability

Ms Breeden explains that the BoE defines financial stability as the financial system providing vital services to households and businesses reliably in all states of the world, even when shocks hit (with shocks including both structural – or longer-lasting – changes like climate events or cyber threats, and cyclical shocks like severe recessions).

She highlights that, to maintain financial stability, it is important to mitigate externalities, where market participants do not consider the impact of their actions on other participants. Externalities can lead to fire sales, runs on financial institutions, and a worsening of economic shocks. Most of the BoE’s work aims to limit the negative consequences of disruptions in the provision of vital services in bad times, rather than expand provision in good times, so that the system absorbs rather than amplifies shocks. Its intention is to ensure resilience to severe but plausible shocks, and to stand ready to intervene quickly and effectively when disruptions do occur.

The BoE’s focus is on services that are relied upon by households and businesses and have a material role in supporting the economy – which include the vital funding, saving, insurance and payment services that support households and businesses and so economic activity. This is in addition to the financial markets and activities that support the provision of those services to end users, in an intermediate way, as these ultimately support the provision of services that households and businesses use to borrow, save, invest, pay for things, and insure themselves against shocks.

How the BoE’s approach to financial stability must have system-wide dynamics in mind

Ms Breeden flags the need for macroprudential policy to stay focused on systemic risk, and for the BoE to continue to improve its understanding of the dynamics of the financial system. She explains that, to be able to focus its financial stability policy work, the BoE needs to understand how different sources of risk could ripple through the financial system and quantify their potential impact on the vital services that the system provides, particularly for those common risks that can affect the system as a whole. This requires the BoE to work out how systemic a risk is or could be, consider the effect of shocks in a system-wide manner, be deliberate in its prioritisation of the risks to focus on, and think about the effect of policies in a system-wide way.

One way in which the BoE has been applying systemic thinking in practice is through the System-Wide Exploratory Scenario (SWES), which it has been working on closely with the Financial Conduct Authority and the Pensions Regulator over the past year. The SWES is the regulators’ first attempt at running an exercise that quantitatively explores dynamics at a system-wide level in advance of a shock occurring.

The SWES focuses on markets that are core to UK financial stability (markets for government and corporate bonds, repo markets for these assets and associated derivatives markets, such as interest rate, cross-currency and inflation swaps). Participants have been asked to consider how they would behave in a hypothetical market shock with price moves that are faster, wider ranging and more persistent than observed both in the March 2020 ‘dash for cash’ and the 2022 LDI crisis, and the regulators are analysing how those behaviours interact and cascade across markets to better understand the system-wide impact of such a shock.

While the SWES has illustrated the value of system-wide exercises, Ms Breeden notes that the BoE’s systemic thinking must extend beyond such exercises, into its wider policy and risk assessment work. Operational resilience is an example of an area of the BoE’s work where systemic thinking is important. When individual financial firms are operationally resilient it helps them to provide vital services to households and businesses, but sometimes this is not enough to prevent operational disruptions having an impact on the financial system. A systemic approach ensures that financial firms consider how their operational weaknesses affect the stability of the system more widely, not just their businesses.

Ensuring that the system provides vital services even as shocks occur

Ms Breeden notes that, as financial stability policymakers, the best contribution the BoE can make to sustainable economic growth is to ensure the system has enough resilience reliably to provide vital services even as shocks hit – and that is recognised by the Financial Policy Committee’s (FPC) primary objective.

The FPC also has a secondary objective, which should be pursued ‘subject to’ its primary objective, to support the economic policy of the Government, including its objectives for growth and employment. For example, there has recently been some debate around whether the pensions sector can play a greater role in supporting growth in the wider UK economy, and the Government recently launched a review on this. Previous BoE work explored whether arrangements in the pension sector had struck an optimal balance between pensioner protection, economic growth, and financial stability, and Ms Breeden explains that there may be ways to increase the sector’s contribution to economic growth without impacts on the resilience of service provision or financial stability.

The speech flags that policymakers should take seriously any opportunities to increase the system’s contribution to growth if it can be done in a way that does not undermine financial stability.

Next steps

In conclusion, Ms Breeden warns that financial stability authorities must stay focused on risks that could threaten the system. Systemic thinking is only a means to an end – the end is service provision, and financial stability must always be ‘at your service’.

Lastly, she emphasises that the best contribution the BoE can make to sustainable economic growth is to ensure that the system reliably provides vital services even as shocks occur. There are limits to the contribution financial regulation can make to growth, but in some cases, for some services, it may be possible to make small adjustments to increase growth potential without undermining financial stability.