Ensuring a sound and stable financial system is another important central banking function - important in its own right and vital to the efficient conduct of monetary policy. The Bank of England has long recognised this and for many years sought informally to ensure that banks and other City financial institutions were financially sound and well-run. But it had no legal basis for doing so until the Banking Act 1979 gave it power to authorise and supervise all deposit-taking institutions. (Building societies, however, were supervised by The Building Societies Commission.) The Banking Act, which was updated and strengthened in 1987, provided that an institution wishing to take deposits from the public (that is, to conduct a banking business) in the UK had to gain prior authorisation from the Bank and submit to the continued supervision of its activities by the Bank. Under European legislation this did not apply to the UK branches of banks incorporated in other European Economic Area (EEA) states. These are regulated by their home state authority. Including EEA–regulated banks, there are some 540 banks currently authorised in the UK.

Recent legislative changes mean, however, that the Bank of England no longer has the responsibility for the supervision of the banks. When the 1998 Bank of England Act came into force on 1 June 1998, this responsibility was transferred to a new organisation called the Financial Services Authority (FSA). The FSA is now responsible for the supervision of individual organisations while the Bank remains responsible for the overall stability of the financial system.

In October 1997, a Memorandum of Understanding between the Bank, the Treasury and the FSA was agreed. This formalises the allocation of responsibilities for regulation and financial stability in the UK. It makes provisions for the establishment of a high-level Standing Committee which meets regularly and provides a forum in which the three organisations can develop a common position on any problems which may emerge. The Bank has established an internal Financial Stability Committee which is responsible for overseeing the Bank’s work in monitoring and improving the stability of the financial system as a whole. This Committee also develops policies for dealing with any problems which may arise.

The part of the Bank which is responsible for ensuring the stability of the financial system is called the Financial Stability Area. The role of this area is to identify and analyse developments in the structure, functioning and regulation of the financial system that are relevant either to the stability of the system as a whole, or to its efficiency and effectiveness in meeting the needs of the customers. The Financial Stability Area co-operates closely with the FSA through information-sharing arrangements with the new regulator.

Where a threat to the stability of the financial system is perceived to be present, the Bank may intervene to stand between an intermediary and the market place in order to facilitate payments and settlements which might otherwise not be completed. The Bank can also consider acting as lender of last resort in the rare situation where the failure of one institution could bring down other (otherwise viable) institutions. This function may involve the Bank lending money to the failing institution to prevent its failure and hence to stop repercussions of its collapse from spreading through the banking system. This safety net exists to protect the stability of the financial system as a whole and not to protect individual institutions or their managers and shareholders.

The use of the Bank’s lender of last resort function must be carefully justified in terms of the damage that would result to the financial system and the wider economy if intervention did not take place. This is because the lender of last resort role requires the use of public money and can also encourage excessive risk-taking (and hence financial fragility) if institutions believe that they will be bailed out whenever they experience difficulties. These risks mean that the Bank and the FSA should always co-operate closely when a problem emerges, and inform the Treasury through the Standing Committee provided for in the Memorandum of Understanding. The Bank also needs to satisfy its Court of Directors that any risks it accepts are manageable (in relation to the size of the Bank’s capital) when they are to be carried on the Bank’s balance sheet.

As part of its responsibility for ensuring the stability of the financial system, the Bank analyses developments in foreign financial markets and their impact on the banking sector. The Bank is represented on a number of international supervisory committees and has close links with supervisory institutions outside the UK.

Reproduced by kind permission of the Bank of England