Bank of England Governor Andrew Bailey Discusses Challenges, Mentions CBDCs: “Digital money is about the technology of delivery”

Andrew Bailey, Governor of the Bank of England, recently delivered a speech in which he commented on the major issues the UK faces, and tried to set out how they “fit together and the challenges they give rise to.”

Baily said that in recent weeks, they have seen the “crystallization” of problems in a few parts of the banking industry.

He pointed out that this is “against a background of a necessary sharp tightening in monetary policy to bring down inflation from levels that are much too high.” He explained that all of this has “to be set against the most serious global pandemic for at least a century and the most serious war in Europe since 1945.”

He went on to draw a set of conclusions and propositions from what is currently going on.

He added that the post crisis reforms “to bank regulation have worked.”

He further noted that he does not believe the nation faces a “systemic” banking crisis. When he looks at the UK banks, they are “well capitalized, liquid and able to serve their customers and support the economy.”

According to Bailey, this positive assessment of financial stability “is important for monetary policy.”

In the case monetary policy set by the MPC should be able “to respond to the macro implications of any dislocation to credit markets to the extent that they influence the outlook for inflation and thus deviations of inflation from target, just as the MPC conditions its policy decisions on asset price and balance sheet developments on all other occasions.”

He also mentioned that it is natural. But, what they have not done – and should not do – is in any sense aim off their preferred setting of monetary policy “because of financial instability.”

He clarified that this has not happened.

He claims that outcome “depends on having institutional structures governing decisions on monetary policy and financial stability.” Internationally the picture “remains more mixed on the latter,” Bailey claims.

He continued:

“Let me next move on to the first stage of what I will call developments in money. Many central banks, the Bank of England included, are now implementing Quantitative Tightening (QT), the reversal of the Quantitative Easing (QE) we had previously used.”

He revealed that QE has “worked through its effects on interest rates and asset prices more generally.”

Those effects “are temporary and their size is state contingent, being larger in times of crisis and market upheaval.”

He added:

We can think of QT likewise, except that we are deliberately implementing it gradually, and not in stressed times. It is not an active tool of monetary policy, but any effects it does have will be captured in the normal way of monetary policy setting, through realised financial conditions.”

He also mentioned that what he has described relates to the use of the central bank assets in order “to deliver monetary policy goals.”

The liability side of the balance sheet is key “to monetary policy setting too, through the setting of interest rates.”

He clarified that liabilities also “play a key Financial Stability role, since the level of reserve account balances held by banks at the central bank is a crucial part of their holdings of liquidity.” He pointed out that before the financial crisis, “the level of liquid assets, including reserves, was much too low, and this contributed to the scale of the financial crisis.”

He went on to “draw the next set of conclusions and propositions.”

He explained that both sides of the central bank balance sheet matter for their dual objectives of monetary and financial stability. He added that “what is less often said is that post financial crisis, irrespective of QE, a larger central bank balance sheet would have been needed to restore the safe stock of reserves and liquidity buffers.”

According to Bailey, it follows, therefore, “that we will not shrink central bank balance sheets to what they were pre-crisis. But at the moment we don’t know with any precision where that level of reserves will be, or what the composition of the assets backing those reserves will be.”

He also mentioned that one factor “bearing on the equilibrium reserve level question depends on the future mix of banks’ liquidity protections, as measured by the Liquidity Coverage Ratio. Take the major UK banks as an example.”

He added:

“Currently, they have an aggregate LCR of 149% which means a total liquidity buffer of £1.4 trillion. That buffer comprises £910 billion of reserves and cash and £489 billion of other high quality liquidity assets, mainly government bonds. As QT proceeds, that mix will change as reserves decline.”

He also noted:

“We can’t assume that, going forwards, the current answer on the total size of liquidity protection is the correct one. We saw with Silicon Valley Bank that with the technology we have today – both in terms of communication and speed of access to bank account – runs can go further much more quickly. This must beg the question of what are appropriate and desired liquidity buffers that create the time needed to take action to solve the problem.”

He added that “more interesting is the creation of so-called ‘stable coins’ or digital currency, which purport at least to be money as a means of payment.”

But, as we have seen, “they do not have assured value, and in the work we have done at the Bank of England we have concluded that the public should expect assured value in digital money, and confidence in this is needed to underpin financial stability. For stable coins to function as money they will need to have the characteristics of, and be regulated as, inside money.”

Meanwhile, a lot of work is going on “to assess the future of digital money, including Central Bank Digital Currency (CBDC).”

He also mentioned:

“Digital money is not new. Digital money in the form of commercial bank deposits and commercial bank reserves at the central bank have existed for many decades. What is new is the idea of broadly available retail digital money. But, this evolution of digital money is about the technology of delivery; it has not ripped up the script of inside and outside money. The question for us all should therefore focus most on is whether we think there will be a demand for retail digital money in the future? And, here we should not suffer a failure of imagination.”

He added that the US authorities “have announced a review of their deposit insurance system.”

And in the UK, the Bank is also “considering improvements to our approach to depositor pay-outs for smaller banks which do not have Eligible Liabilities.”

He also noted that their work “has thus far focused on the speed of pay-outs.”

This is important, but we also “have to recognize that the growth of non-bank finance has led to the significant expansion of the landscape of systemic risk since the crisis.”

He also mentioned:

“There is a challenge of breadth and depth in the NBFI world. It is a very large and disparate landscape with many activities and entities. As a result, we have to survey a lot of ground to look out for risks. But in order to understand these risks, we need to get into the detail, hence the depth issue. LDI was a good case study of this. The LDI fund world comprised 85% of the larger so-called segregated funds, and 15% of the smaller pooled funds. Our stress testing work focused on the 85%, but the problem arose in the 15%.”

He continued:

“In some ways the issues around NBFI bear a striking resemblance to ages old challenges in finance, such as leverage, and inter connectivity with other parts of the financial system, creating the scope for spill-overs and systemic consequences. But the heterogeneity of the landscape means that there is no single magic number for leverage as we have with banks, and the inter connectivity can be hard to map, reflecting the recent incidents.”

This helps to explain “why at the Bank of England we are conducting a system wide stress exercise involving non banks as well as banks to help us to map out the risks.”

This is “inherently a cross-border issue. So, we must make progress internationally.”

According to Bailey, this is “what the Financial Stability Board work program is focused on, and why it is so important. It is also crucial that individual countries take forward and implement these reforms. While the solutions are global, delivering them will necessarily be local.”

He concluded:

“Finally, there is an important point to pull out of a number of these issues. A common outcome of a shift in the balance from inside to outside money (either through CBDC or banks holding larger reserves at the central bank) or increasing the broader liquidity buffers of banks and non-banks could be to create a constraint on lending and investment in the real economy. For the UK economy this would go against the need to finance investment to support stronger potential growth, from its current weak level.”

He believes that this constraint “would not appear if the counterfactual was an unstable financial system because solving that instability would have to be the priority.”

He added that “in a more stable world public policy must still determine the best use of tools – for instance, advocating ever tougher stress tests and larger liquidity buffers in an attempt to cover future Black Swans is not obviously preferable to having tools by which central banks can make temporary and targeted interventions, as we did last October.”

This underlines his earlier point “that strong institutions of prudential policy (macro and micro) are important to enable these decisions to be made.”

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