The Bank of England was established in 1694 to act as a debt manager for the government and originally operated as a private bank. After being nationalised in 1946, overall policy remained under the control of government until 1997 when it was granted independence.
The Bank of England has two main roles; monetary policy and financial stability. The most well-known aspect of bank activity is its role in setting interest rates for the United Kingdom, although financial stability is equally important in overall management terms.
Is the Bank of England Independent?
The Bank of England has full operational independence surrounding its decision-making and this has been the case since 1997. It is, however, responsible to parliament and members of the bank are required to testify to the Treasury Select Committee on all aspects of operations.
The bank Governor also has to write a letter of explanation to the UK finance minister (Chancellor) if the inflation target is consistently missed by falling outside a 1-3% range.
It is very important to note that the government sets the inflation target and the Bank of England is then tasked with meeting this target. It is entirely within the government’s powers to set an inflation rate lower or higher than the current 2% and the bank would have to comply with meeting this target even if it disagreed with the change.
Monetary Policy Operation
The bank is mandated to deliver low and stable prices, which is defined, at present, as achieving an annual inflation rate of 2% as defined by the Consumer Prices Index.
The bank adjusts monetary policy in order to reach the inflation target. This can be achieved by adjusting the level of interest rates or, following the financial crash, engaging in quantitative easing through the purchase of government bonds.
Any changes in the policy are agreed through the Monetary Policy Committee (MPC) and these changes in interest rates have a substantial market impact.
The MPC is comprised of nine members; five of these are Bank of England appointed representatives, including the Governor and Chief Economist. The other four members are external appointments from business and finance. These four members have initial three-year terms, which can be extended.
Following recent changes in legislation, the MPC now holds eight meetings per year. Following the meetings, there is an announcement of any changes in policy and interest rates. There is also a summary of the bank’s assessment of conditions and underlying trends in the economy. The minutes from the meeting are also released with the voting decisions of all committee members. Policy decisions can be made on majority votes and the Governor can be out-voted by other members.
Four times a year, the bank produces an inflation report, which outlines its economic outlook and medium-term projections on growth and inflation levels. The inflation reports are an important element in determining decisions on monetary policy. The BoE Governor also holds a press conference following the inflation report that increases the market impact.
Bank of England Speeches
External and internal members of the MPC make speeches during their time in office. These are often important in setting out their thoughts on the economy and potential trends in interest rates. These comments are often significant in moving markets with the speeches from the Bank Governor notably important, especially when the Governor is looking to signal a change in policy direction.
The Bank of England produces a number of economic data releases relating to credit, money and the housing sector. In general, these are not the most important data releases, with the ONS (Office for National Statistics) data usually having a bigger impact; however, data on lending and mortgage approvals can have a significant impact.
The second element to the bank’s mandate is financial stability.
From 2013, new legislation required the Bank of England to indentify, monitor and take action to remove systemic risks and enhance the resilience of the UK financial system.
Financial Stability Functions
- Reinforcing confidence in money
- Acting as a lender of last resort in times of financial stress
- Promoting the safety of financial organisations
- Removing risks to the financial system
- Supervising financial market infrastructure
- Resolving failed institutions
Achieving Financial Stability
The bank looks to maintain an adequate supply of credit to the economy through the financial system.
A crucial aspect of this work is to ensure than bank hold sufficient capital. In the event of a severe economic downturn such as the 2007/08 financial crash, under-capitalised banks quickly run into solvency issues and risk collapse. This was major weakness during and following the financial crash and the Bank of England can order banks to raise additional capital to bolster their balance sheets.
The Bank has the powers to order banks to put capital into reserves to prevent them being used for credit creation. This is an important policy tool when there are fears of overheating, especially in the housing sector. Conversely, when the economy is in danger on contracting, capital can be freed-up to boost potential lending.
The BoE also has the powers to impose restrictions on lending to the household sector by, for example, putting a ceiling on mortgage lending as a ratio of incomes or putting additional curbs on lending.
The Bank of England also monitors levels of household debt in the context of any threat to stability.
Prudential Regulation Authority (PRA)
The PRA is part of the Bank of England and takes charge of regulating and supervising 1,700 financial firms including banks, building societies, insurers and investment firms.
Bank Stress Tests
The Bank of England runs stress tests every year in order to test the resilience of commercial banks. Various simulations are used to illustrate a severe and extreme financial shock to the economy such as a deep recession, severe decline in equity markets or a crash in the housing sector. Simulations then determine the extent to which bank capital is depleted and whether the banks would remain solvent. If the banks are deemed to be vulnerable, they are ordered to strengthen their capital base.
The Bank of England can demand improvements in risk controls within the banks.
Financial Policy Committee
Changes in financial policy are sanctioned through the Financial Policy Committee (FPC). The composition of the FPC is similar to that of the MPC and is also chaired by the Governor. In addition, there are six internal appointments and four external members. The FPC announces its policy decisions, although there is a delay to protect the banking sector and minutes of the meetings are also produced. The FPC also produces a quarterly financial stability report.
Global Central Bank Co-operation
The Bank of England needs to ensure there is sufficient liquidity in the financial system and will co-operate with other global central banks to ensure liquidity is maintained. There will also be frequent discussions with heads of other global central banks to boost co-operation, especially when financial markets are extremely volatile.