The Bank of England

KEY FACTS
  1. Founded in 1694 as a private bank to the UK government
  2. First denominated bank notes issued in 1725
  3. Given the power to print all bank notes in 1884 (the Bank Charter Act)
  4. Nationalised in 1946
  5. First Inflation Report published in 1993
  6. Made independent in 1997
  7. Monetary Policy Committee (MPC) formed in 1997
  8. Prudential Regulation Authority (PRA) and Financial Policy Committee (FPC) formed in 2012 in the wake of the financial crisis of 2007-2008.

Role of the Bank of England

Like most central banks, the Bank of England has a number of important roles, including:

Maintaining monetary stability

Ensuring that a country has stable money is an important role, given that numerous economic problems that can result from monetary instability.

Monetary stability means ensuring the value of money remains stable, and hence provides confidence in the monetary system. The part of the Bank of England responsible for this is the Monetary Policy Committee.

Monetary Policy - The Monetary Policy Committee

The Bank of England’s Monetary Policy Committee (MPC) was established in 1997 to ensure that monetary policy would be implemented in an independent fashion as the Bank prepared itself for full independence. Until this point, monetary policy was the responsibility of the UK Treasury.

Granting the Bank of England independence was important for financial stability given the loss of credibility associated with the UK’s exit from Europe’s Exchange Rate Mechanism (ERM) on Black Wednesday in 1992.

The MPC comprises nine members - four appointed by the UK’s Chancellor. The MPC’s goal is to achieve financial stability by hitting its inflation target of 2%.

To achieve this, the Bank of England has responsibility for setting the key interest rate in the economy (Bank Rate) in order to keep inflation at the agreed target rate of 2% (+/- 1%), which is set by the Treasury.

The Bank produces its own statistics and undertakes detailed monetary analysis to help it create financial stability.

The policy toolbox

The MPC has at its disposal several tools to help maintain monetary stability.

Interest rates

Adjusting interest rates ('the Bank Rate') to acheive monetary stability is fundamental to the operation of monetary policy.

In practice, the bank rate is set through a repurchase ('repo') agreement which is the rate at which the Bank of England will buy back previously issued securities. These securities will have initially been sold to the ‘money markets’, which include banks, building societies and other financial institutions.

The ‘buy-back’ commitment is important in that it reduces some of the risk in the system. If I sell you a car, and guarantee to buy it back – at a slightly lower price – then you are more likely to purchase it in the first place as your loss in known in advance. The repo rate is this small difference between what a security is sold for, and what it will be repurchased at.

The reason the Bank of England might change its repurchasing rate is to alter short term liquidly in the monetary system. When this rate changes, other 'market' rates are highly likely to change in the same direction.

Quantitative easing

Quantitative easing (QE) has become an important additional tool ever since the financial crash of 2008 and the drop in Bank Rate, from 5% to 0.5%. When interest rates drop so low, futher reductions may be difficult to implement, and may not have the desired effect on monetary stability, so directly pumping money into the system through QE became the preferred tool of many central banks.

QE involves central banks (in this case, the Bank of England) purchasing government bonds (gilts) and corporate bonds from bond holders, such as large pension funds. When they purchase these bonds, the market price rises, and the yield (the interest rate) falls. [1] Two things then happen.

  1. Firstly, other interest rates are driven down, so that households and firms are encouraged to spend, rather than save.
  2. Secondly, as the interest rate on these bonds fall, bond holders use the additional funding (from the sale to the Bank of England) to invest in other assets, such as company shares. This drives up the price of these assets, and creates a wealth effect for these asset holders. This encourages them to spend, or invest even more.

Forward guidance

Forward guidance is a commitment by the MPC on future changes to interest rates. Essentialy its allows private and corpoate investors to know in advance when changes in interest rates are likely, and 'renforces' existing market expecations regarding the direction of monetary policy.

Negative rates

The 'textbook' approach to negative rates is that they are theoretically possible, but unlikely to have the desired effect - namely, to enourage households and firms to borrow.

In theory, the chain of events following lower interest rates would be:

  1. Market rates fall
  2. Asset prices rise
  3. Exchange rates fall
  4. Demand would be stimulated

However, indications from the Bank of England suggest that 'pass-through' would be weak as savings (deposit) rates for households are unlikely to ever fall below zero. Hence, if banks reduced their lending rates to negative, but their deposit rates (borrowing rates) stayed positive, the bank's profitability would suffer. [2]

Maintaining financial stability

The second key role for the Bank of England is to maintain financial stability. This means regulating the financial system to make it work effectively.

The Financial Policy Committee (FPC)

To achieve financial stability the Bank of England's Financial Policy Committee (FPC) undertakes macro-prudential regulation. Macro-prudential regulation focuses on the financial system as a whole, and attempts to limit the build-up of system-wide (systemic) financial risk.

The Prudential Regulation Committee (PRC)

The bank’s Prudential Regulation Committee (PRC) is responsible for making decisions about micro-prudential regulation. Micro-prudential regulation means the regulation and supervision of individual firms in the financial services sector to ensure they are solvent and can cope with financial shocks, and that they work in the interests of consumers.

Stress testing

One of the roles of the FPC is to work with the PRC to design stress tests which assess bank’s ability to withstand shocks, and helps achieve the financial stability objective.

The Financial Conduct Authority (FCA)

Regulation is also undertaken by the Financial Conduct Authority (FCA), which is separate from the Bank of England. Its job is to make sure that financial markets work effectively and that the conduct of firms in financial markets meets the standards laid down in legislation. The FCA is, effectively, the watchdog that ensures competition is maintained, and that banks and other financial institutions do not abuse their dominant positions. The FCA is also responsible for the prudential regulation of financial services firms not supervised by the PRA, including asset managers.

Overseeing the money supply

The Bank of England oversees the supply of money in the economy to ensure that there is just sufficient liquidity in the economy.

Managing foreign reserves

The Bank of England also manages the UK foreign exchange reserves to ensure that the country settles its international debts.

There is a special ‘account’ in the Bank of England – called the Exchange Equalisation Account (EEA) which is a fund that can be used to purchase currencies to help stabilise the value of sterling, especially in the event of any unexpected shocks.

The EEA holds the UK’s reserves of gold, foreign currency assets and International Monetary Fund (IMF) Special Drawing Rights (SDRs) [3].

Providing banking facilities

The Bank also provides banking facilities to the high street banks - all credit banks in the UK must keep an account with the Bank of England. The Bank also provides facilities to the UK government, which keeps its accounts with the Bank.

Lender of last resort

The Bank also acts as lender of last resort, which means that, given a liquidity shortage in the banking system the Bank of England will provide funds ‘as a last resort’.

This is an important function in that confidence in the financial and monetary system depends upon the expectation that institutions will not become insolvent. Players in the financial system are highly interdependent, and one bank insolvency can trigger others. The danger with this is that it can create moral hazard, with inefficient banks expecting to be 'bailed out'.

Issuing notes and coins

Finally, the Bank is responsible for controlling the issue of new notes and coins.


Inflation

What causes inflation?

Inflation
Investment spending

What determines export spending?

Investment
Supply-side policy

How effective is supply-side policy?

Supply-side policy

[1] The price of bonds, and the return on them - the yield or interest rate - is inveserely related.

[2] Exchange Equalisation Account: report and accounts 2019-20f

[3] Ramsden, D;  Speech by Deputy Governor for Markets and Banking, The Monetary Policy Toolbox in the UK, Society of Professional Economists, October 2020