How will the Financial Policy Committee work?

written by Paul Chisnall on 23/03/2012

Today the Bank of England’s new Financial Policy Committee revealed more details of how it would carry out its responsibility to ensure financial stability in the UK economy.

Arguably the FPC's greatest power will be its ability to advise and influence, to anticipate potential risks to the economy. But it will also have other specific powers which fall into three categories: 

• those that affect the balance sheets of banks and other financial institutions;
• those that affect the terms and conditions of loans and other financial transactions; and
• those that influence market structure.

The FPC will be publishing quarterly reports which will be watched closely. But while its equivalent on the monetary side - the Monetary Policy Committee - reports on a single, specific indicator for monetary policy (the inflation rate) there is no similar, single indicator for financial stability. The FPC will therefore be expected to exercise a greater degree of judgement when identifying possible threats to financial stability. As such, it will have a greater responsibility to explain any actions it considers necessary to prevent threats materialising.

In the jargon, this is macro-prudential regulation. At the micro level, the regulatory focus is properly on the detailed supervision of financial services firms. Macro-prudential regulation has a much wider remit, including assessment of asset prices and the supply of credit in the economy, and therefore requires regulators to be aware of all possible threats to financial stability. To be successful, therefore, macro and micro approaches to regulation must complement, not duplicate each other.

Macro-prudential supervision must consider the wider financial system and drivers of financial instability. For instance, as banks face ever greater regulation, risks may migrate to the unregulated sector. The FPC's remit to monitor risk is across the entire financial system and it will have the ability to recommend to the new regulator – the Prudential Regulatory Authority - a widening of the regulatory parameter if it sees a need.

Practical experience of how these might work is limited: the UK is leading the way on macro-prudential regulation. But as a priority we are urging the FPC’s approach to be governed by five principles: 

• a preference for simplicity;
• the need for transparency;
• an element of predictability;
• proportionality; and
• international coordination and reciprocity.

The international point is significant. The FPC will be required by European law to take account of the potential implications of its actions on EU-wide financial stability. The European Systemic Risk Board will be watching.