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Bank of England may toughen stress tests as economy rallies

Wednesday, July 29, 2015 - 16:45
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Bank of England policymakers expect the recent plunge in oil prices will weigh a bit on British inflation in the coming months but said it remains unclear if the impact would be lasting.

[LONDON] The Bank of England may consider using stress tests of differing severity to assess the resilience of the financial system as economic booms turn to busts, said Deputy Governor Jon Cunliffe.

A harsher scenario would be used as economic growth accelerates and risk builds up in the system, Mr Cunliffe said in a speech in London on Tuesday. When the economy weakens and there is less risk in the system, and looser bank lending is required, a softer scenario could be used, said Mr Cunliffe, who has responsibility for financial stability.

"At present we are using stress testing to help us judge how resilient the banking system is to different severely adverse, but plausible, scenarios," Mr Cunliffe said. "A development of this approach would be to use stress testing more countercyclically." Regulators are seeking to broaden their view of the financial system after the crisis showed how risks can build unseen, creating feedback loops and contagion that can cause seemingly solid institutions to collapse. They are turning their attention to potential crises outside the banking system in institutions such as insurers and asset managers, and examining economic scenarios that may cause banks to lower their guard when making lending decisions.

The asset-management industry has grown by 60 per cent since 2003, and is now a similar size to the commercial-banking system, Cunliffe said.

"This will probably be one of the new frontiers of macro (and micro) prudential regulation," Mr Cunliffe said. The BOE's Financial Policy Committee "is exploring whether there are significant risks from changes in these markets." The thrust of regulation since the crisis has been blamed for slowing economic growth as authorities have insisted that banks retain more capital.

Mr Cunliffe cautioned, however, that "we should not imagine that there is some recent halcyon world of banks supporting the real economy to which we can quickly return if the regulatory straitjacket is loosened." The financial system was "badly distorted" in the run-up to the crisis, and a "major adjustment" is now required in banks' business models.

While the BOE accepts that rules will need to be refined and reviewed, the temptation to trade financial stability for growth should be resisted, Mr Cunliffe said.

"The implementation of the detailed reforms will inevitably throw up unforeseen effects in particular places and where it is justified we will need to revisit issues," he said. "But we should be careful about talking about turning back the overall regulatory dial or trying to trade off the risk of financial instability for short term growth."

Separately, in the text of a speech issued on Tuesday, BOE Chief Economist Andy Haldane said there are "incentive problems" at companies, particularly banks, that mean short- term gains are prioritised over the long-term view.

"Challenges to the shareholder-centric company model are rising, both from within and outside the corporate sector," he said. "Some incremental change is occurring to trim these branches. But it may be time for a more fundamental re-rooting of company law." The comments follow Mr Haldane's remarks last week, when he said companies are investing too little because of payouts to investors. "Companies are almost eating themselves, taking their internal funds and distributing that to shareholders rather than investing," he said on BBC television.

"Ultimately, if you change the structure of the system, the incentives, that's got to be better for everyone," he said.

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