The International Monetary Fund (IMF) conducts in-depth assessments of the financial sectors of the 32 most systemically important countries every five years. Yale faculty Sigrídur Benediktsdottir and Greg Feldberg participated as external experts in the 2022 review of the United Kingdom. They were the main authors of the technical note on systemic risk oversight and macroprudential policy, one of seven technical notes that the IMF produced for this FSAP.
The IMF’s previous report on the UK noted that the significant structural changes developed after the global financial crisis appeared to be effective but were too newly implemented to fully evaluate. Since then, Brexit and the COVID-19 pandemic have offered significant tests of the UK’s systemic resilience. According to Benediktsdottir and Feldberg—former financial stability officials at the central banks of Iceland and the United States, respectively—the UK remains a world leader in managing financial system risk. They recommended UK authorities maintain their strong focus on financial stability, augment their oversight of nonbank financial institutions, and continue to work through international channels to address data and oversight gaps in cross-border financial activities.
Q: How has the UK’s financial stability framework changed since the global financial crisis?
Greg Feldberg: In the immediate aftermath of the global financial crisis, the focus was very much on fixing the banks. There were important international agreements on new capital and liquidity standards. And individual countries reexamined and reoriented their oversight of the banks. In the UK that took the form of a central bank-driven model where the bank supervisor became part of the Bank of England (BOE).
In addition, perhaps the biggest lesson learned from the crisis was how much systemic risk can come from non-bank financial institutions such as investment banks, money market funds, and other asset managers. As a result of that new understanding, the BOE quickly put together a framework for how they were going to analyze those risks and established a regular surveillance program which was ahead of its time.
Sigríður Benediktsdóttir: The UK was at the forefront of making these changes. Their approach was somewhat different from other countries, though many have since gone in the same direction—either merging the responsible authorities or at least bringing monetary policy, financial stability, and microprudential policy closer.
The UK was one of the first countries to state that not only is financial stability something that the central bank needs to think about, but if at any point financial stability and monetary policy were not going in the same direction, the financial stability objective trumps monetary policy.
That grew out of a very acute awareness that monetary policy alone is not enough to maintain the stability of the financial system. Neither is microprudential supervision of financial institutions. To create a substantial bridge between them, as Greg said, the UK merged their banking supervisory authority with the BOE.
I was the director of financial stability in Iceland from 2012 to 2016. The UK was implementing many of these changes in that period. I followed them intently. Even from the outside it was evident that it was difficult. It was quite costly and painful for the Prudential Regulation Authority, the main bank and insurance supervisor, to first be made a subsidiary and then a department within the BOE. There were definitely fault lines, but they didn’t force it. That meant it happened slower than some would’ve hoped, but over time, the cooperation was able to grow. By the time Greg and I were doing interviews for the report, there were no fault lines. We were impressed. They even have a research section that focuses on issues that span supervisory and financial stability realms.
For every corner we looked into, they were doing as well as possibly could be expected and basically being a leader in the world for managing financial system risk.
Q: Merging two organizations isn’t easy. Neither is breaking down functional and informational siloes. How did the new structure deliver the seamlessness and effective information sharing you found?
Sigríður Benediktsdóttir: The new structure makes three committees responsible for the BOE’s key policy decisions. One focuses on monetary policy, another on financial stability, and the last on prudential authority. The governor of the BOE and the deputy governors for each of the three areas sit on all three committees.
“The deputy governor for financial stability is at the Monetary Policy Committee and Prudential Regulation Committee meetings to say, ‘Hey, don’t forget the financial stability aspects of what you’re doing.’”
Greg Feldberg: The overlapping membership means the deputy governor for financial stability is at the Monetary Policy Committee and Prudential Regulation Committee meetings to say, “Hey, don’t forget the financial stability aspects of what you’re doing.” And the same is true for each area of focus.
The structural connections extend beyond the three committees. The head of the Financial Conduct Authority (FCA), which is an independent agency comparable to the United States’ Securities and Exchange Commission (SEC), also sits on the BOE’s Financial Policy Committee.
Sigríður Benediktsdóttir: Think of the head of the SEC walking into the Fed to join in on major policy meetings. It’s not going to happen.
Greg Feldberg: They really have the Financial Policy Committee taking the lead when it comes to financial stability issues. After the Brexit vote, investors rushed to withdraw their money from commercial property funds over concerns about the valuation of underlying assets. Several of these funds shut down redemptions temporarily.
This was an issue for the FCA, which supervises property funds. But because there was also a potential financial stability issue, the Financial Policy Committee had both the FCA and the BOE present their cases on how to regulate the funds going forward. After weighing the different arguments, the Financial Policy Committee made a recommendation, which the FCA was responsible for carrying out.
Sigríður Benediktsdóttir: The Financial Policy Committee has really broad power to point out a potential systemic risk and the relevant authority must address it or explain.
That isn’t to say the Financial Policy Committee can just do whatever to maintain financial stability. There are strict rules about evaluating and transparently acknowledging the costs on the real economy of any proposed policy measures. Still, they really have broad powers to maintain financial stability.
Q: How does it compare to other models?
Greg Feldberg: The Financial Stability Oversight Council in the U.S. is unwieldy and only has a couple of real powers. If they identify a sector that might be creating financial stability risk, they can suggest that a regulator take action. It’s just not as strong a mechanism as you have in the UK.
Sigríður Benediktsdóttir: In the U.S., almost all decision-making around systemic risk is based on stress tests because that’s what the legislation following the global financial crisis allowed regulators to do. There was very little in the way of other improvements. The UK does stress tests too, but they rely on them less because they have so many other avenues to use.
I don’t think the U.S. ended up with the optimal institutional structure for decision making, which has led to limited policy options. In the long run I think that might be costly.
Greg Feldberg: To be fair, even with less authority the Financial Stability Oversight Council has demonstrated that if a dedicated treasury secretary and the heads of the relevant agencies work together it is possible to make proposals. We’ve only seen proposals so far, but, especially in the area of non-bank financial institutions, a lot has happened in the last couple years in the U.S.
Q: The UK has set up a robust structure, but it’s still part of a global financial system. Crises cross borders. How has the UK addressed that?
Greg Feldberg: Perhaps the biggest surprise for us in this exercise was the UK’s acknowledgment that they need to rely on international coordinating bodies to set policies around systemic risk. It’s a bit of a shock when London, one of the most important financial hubs in the world, highlights the reality that no country can go it alone.
Sigríður Benediktsdóttir: Most of the pound-denominated money fund industry is offshore, so it’s hard for the UK to simply dictate what will happen.
Greg Feldberg: Yes, it’s based largely in Luxembourg and Ireland. The UK can only regulate a small fraction of those asset managers. That necessitates working with other countries. Now that they’re not part of the European Union, coordination gets more complicated, but they emphasized its importance many times in our interviews. One way they do that is through thought leadership.
Sigríður Benediktsdóttir: The UK was still in the European Union as they were developing these financial stability frameworks, so they were also leading all of Europe in this shift through the European Systemic Risk Board. And the BOE convened financial stability authorities from around the world to make sure the knowledge and understanding underlying these frameworks were shared widely.
Q: Was the financial shock at the start of the COVID pandemic a true test of the new measures?
Greg Feldberg: In March of 2020, the risks were genuine. We saw a lot of the same things happening as we saw in the global financial crisis. Governments and central banks, including the Federal Reserve and the BOE, responded very quickly. As with the global financial crisis, fortunately, their responses prevented us from seeing how bad it could have been.
Sigríður Benediktsdóttir: During the COVID shutdown, assets that were completely liquid and almost money-like prior to the crisis all of a sudden became not money-like and not as liquid, which impacted those markets severely.
There was a run in the gilt bond market. That market is extremely well run and usually very efficient. Because of that gilt bonds are used in short-term transactions. The economic shock at the onset of the pandemic led to margin calls becoming very prevalent; that affected the market. Due to lessons learned from the global financial crisis, the BOE was really swift in going into the market and restoring market functions.
Q: How do you set up systems that not only guard against a recurrence of the last crisis but are also able to respond to new risks?
Greg Feldberg: There are only so many different services that we need the financial system to provide: in particular, credit, liquidity, and risk-sharing. The role of the financial stability oversight folks is to keep track of whoever is delivering those services and what potential risks there could be in those services.
The challenge is that the financial system is always evolving quickly. One of the key lessons learned in the global financial crisis was to pay attention to those changes. If they’re doing it right, then they’ll always notice the changes, respond, and everything will be okay. That’s the theory. It’s way too optimistic to think it will always work.
But the BOE is ahead of the curve. In addition to looking at the risks in bank and nonbank arenas, they have also examined new challenges that don’t fit into easy categories. For example, they have examined the potential financial stability risks from climate change and cryptocurrencies.
Sigríður Benediktsdóttir: Please don’t use that word. Call it crypto. It’s not a currency. It’s not an asset. We should not use those terms and they should not be allowed to advertise using them either.
Greg Feldberg: You’re right. I strongly agree. For Sigga and me, stablecoins are maybe one of the scarier parts of this new crypto world because they represent a promise, but there’s nothing like a regulated bank or money fund showing what the assets are to back up your deposit.
Sigríður Benediktsdóttir: We see cryptos and asset-referenced tokens (stable currencies) as mostly just payment systems, rather than assets, currencies, or anything else. The benefit to the financial sector and the real economy from this innovation will be in payment systems technology and competition. Competition is pushing central banks and nations to upgrade their payment systems, which is very good.
However, with these kinds of things, you always have to go to the basics. Asset-referenced tokens (stablecoins) are just rebrandings of checks or debit cards. In exchange for holding assets for you they give you a token just like a bank or money market fund would give you a checkbook or debit card. That makes it either a deposit-taking institution or a money market fund. If it’s a deposit-taking institution, it has to have deposit insurance to protect depositors. And as soon as you have deposit insurance, you have to regulate and supervise the deposit-taking institutions for moral hazard behavior. Otherwise, we’re going to end up back in the 1800s U.S., where we had multiple banks with multiple currencies and then multiple runs.
We learned then that if people, in good faith, deposit money and then all of a sudden lose it, that’s costly both for the economy and it has significant social costs.
Greg Feldberg: The BOE has set out very high-level principles around crypto which say crypto and stablecoins shouldn’t get special treatment. If a stablecoin is involved in payment systems, it should be overseen just like any other payment system. To the extent that a stablecoin is creating a money-like liability or asset, it should be supervised as a commercial bank deposit would be supervised. There’s work to be done moving from the BOE’s analysis and principles to actual oversight.
Q: What recommendations did you make based on your research?
Greg Feldberg: Our biggest specific policy issue was around risks coming from non-bank financial institutions. There are still data gaps around asset management funds’ leverage, liquidity, and risk. When there’s a liquidity mismatch, as we saw following the Brexit vote when investors all wanted to redeem their shares in property funds while the underlying assets, commercial buildings, are relatively illiquid, that mismatch can be severe and dangerous during periods of financial instability.
The Bank of England put out principles for how to manage the risks in 2019. COVID played into delaying their full implementation. We want to see them stick to those principles.
Along those lines, non-bank financial institutions are taking a bigger and bigger share of the financial markets, we hope that the focus and the resources dedicated to managing the associated financial stability risks will grow in tandem with that.
Sigríður Benediktsdóttir: Overall the financial stability setup is so good and so efficient that the political authorities have started to add projects on their list of responsibilities—things that may not fully fall under financial stability like financial market competitiveness. That is something Greg and I warned about. The financial stability objective is so important and complex that there shouldn’t be additional priorities for the Financial Policy Committee, even if they are presented as secondary.