We summarize reactions to the Bernanke Review from the Bank of England watchers community – a diverse group of academics, market economists, and business analysts who closely monitor and analyze the actions of the Bank of England. Key themes include the Review’s recommendations to retire the “fan chart”, increase the use of scenario analysis, and de-emphasize the central forecast conditioned on the market yield curve, as well as its critique of the Bank’s forecasting infrastructure. There is also extensive discussion of areas left unaddressed by the Review, including whether the Monetary Policy Committee should publish its preferred policy rate path, adopt a Fed-style dot plot, or give Bank staff ownership of the forecast.

This paper develops an operational framework for stress testing that evaluates financial sector vulnerabilities across a distribution of plausible macro-financial scenarios rather than a small number of predetermined stress paths. The approach identifies macro-financial risk factors of particular relevance to the system, or individual institutions, and scenario families that could drive them toward their worst outcomes (reverse stress testing). We illustrate the methodology for euro area banks. Overall, the framework provides policymakers with a structured way to evaluate the severity, plausibility, and narrative consistency of stress scenarios, enhancing the design and interpretation of supervisory and macroprudential stress tests.

This paper proposes an operational approach to stress testing, allowing one to assess the banking sector's vulnerability in multiple plausible macro-financial scenarios. The approach helps identify macro-financial risk factors of particular relevance for the banking system and individual banks and searches for scenarios that could push them towards their worst outcomes. We demonstrate this concept using a macroprudential stress testing model for the euro area. By doing so, we show how multiple-scenario stress testing can complement single-scenario stress tests, aid in scenario design, and evaluate risks in the banking system. We also show how stress tests and scenarios can be optimized to accommodate different mandates and instruments of supervisory and macroprudential agencies.

We build a semi-structural New Keynesian model to study the drivers of macroeconomic tail risk (‘GDP-at-Risk’). Our model features three key nonlinearities: an effective lower bound on nominal interest rates; a credit crunch in bank loan supply when bank capital depletes; and deleveraging by borrowers when debt service burdens become excessive. These nonlinearities can interact to amplify GDP-at-Risk: for example, when debt burdens rise sufficiently, this increases the risk of debt deleveraging but also that of a credit crunch and hitting the effective lower bound. We use the model to study various UK recessions and document the amplification potential driven by the prevailing levels of headroom vis-a-vis the effective lower bound, the bank capital constraint, and the debt service burden threshold. Furthermore, we simulate a persistent inflation shock to analyse how these interactions might operate at this juncture.

This paper explores monetary-macroprudential policy interactions in a simple, calibrated New Keynesian model incorporating the possibility of a credit boom precipitating a financial crisis and a loss function reflecting financial stability considerations. Deploying the countercyclical capital buffer (CCyB) improves outcomes significantly relative to when interest rates are the only instrument. The instruments are typically substitutes, with monetary policy loosening when the CCyB tightens. We also examine when the instruments are complements and assess how different shocks, the effective lower bound for monetary policy, market-based finance and a risk-taking channel of monetary policy affect our results.

In this paper, we survey the rapidly developing literature on macroprudential stress-testing models.The scope of the survey includes models of contagion between banks, models of contagion within the wider financial system including non-bank financial institutions such as investment funds, and models that emphasise the two-way interaction between the financial sector and the real economy.Our aim is two-fold: first, to provide a reference guide of the state-of-the-art for those developing such models; second, to distil insights from this endeavour for policy-makers using these models.In our view, the modelling frontier faces three main challenges: (a) our understanding of the potential for amplification in sectors of the non-bank financial system during periods of stress, (b) multi-sectoral models of the non-bank financial system to analyse the behaviour of the overall demand and supply of liquidity under stress and (c) stress testing models that incorporate comprehensive two-way interactions between the financial system and the real economy.Emerging lessons for policy-makers are that, for a given-sized shock hitting the system, its eventual impact will depend on (a) the size of financial institutions' capital and liquidity buffers, (b) the liquidation strategies financial institutions adopt when they need to raise cash, and (c) the topology of the financial network.

We find that deep contractions have highly persistent scarring effects, depressing the level of GDP at least a decade hence. Drawing on a panel of 24 advanced and emerging economies from 1970 to the present, we show that these effects are nonlinear and asymmetric: there is no such persistence following less severe contractions or large expansions. While scarring after financial crises is well known, it also occurred after the deep contractions of the 1970s and 1980s that followed energy price shocks and restrictive monetary policy to combat high inflation. These results are very robust and have important implications for policy making and macro modelling.

Distinguishing between risk and uncertainty, this article draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modeling and regulating the financial system. We find that: simple methods can sometimes dominate more complex modeling approaches for calculating banks’ capital requirements, especially when data are limited or underlying risks are fat-tailed; simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; when combining different indicators to predict bank failure, simple and easy-to-communicate “fast-and-frugal” decision trees can perform comparably to standard, but more information-intensive, regressions. Taken together, our analyses suggest that because financial systems are better characterized by uncertainty than by risk, simpler approaches to modeling and regulating financial systems can usefully complement more complex ones and ultimately contribute to a safer financial system.

Borrower-based macroprudential policies, such as limits to loan-to-value and loan-to-income ratios, have grown in popularity in the last decade globally. An understanding of their effects, both intended and unintended, is continuously evolving. In this Note , we discuss the macroeconomic channels though which such measures, like all economic policies, can both benefit and impose costs on the economy. System-wide benefits of such measures arise predominantly through the taming of housing-credit cycles, which lower both the probability and the severity of financial recessions, as well as avoiding resource misallocation. Such crises have been shown to have particularly harmful effects, are followed by slow recoveries and can have persistent adverse macroeconomic effects. The macroeconomic costs of such measures operate through liquidity constraints on renters, and reductions in consumption and construction activity that may arise through dampened house prices and expectations. These macroeconomic costs are more likely to be short-term, and less likely to affect the productive capacity of the economy in the long-run. ,

We show that the effects of financial conditions and monetary policy on U.S. economic performance depend nonlinearly on nonfinancial-sector credit. When credit is below its trend, an impulse to financial conditions leads to improved economic performance and monetary policy transmission works as expected. By contrast, when credit is above trend, a similar impulse leads to an economic expansion in the near term, but then a recession in later quarters. In addition, tighter monetary policy does not lead to tighter financial conditions when credit is above trend and is ineffective at slowing the economy, consistent with evidence of an attenuated transmission of policy changes to distant forward Treasury rates in periods of high credit. These results suggest that credit is an important conditioning variable for the effects of financial variables on macroeconomic performance.

The global financial crisis has been the prompt for a complete rethink of financial stability and policies for achieving it. Over the course of the better part of a decade, a deep and wide-ranging international regulatory reform effort has been under way, as great as any since the Great Depression. We provide an overview of the state of progress of these reforms, and assess whether they have achieved their objectives and where gaps remain. We find that additional insights gained since the start of the reforms paint an ambiguous picture on whether the current level of bank capital should be higher or lower. Additionally, we present new evidence that a combination of different regulatory metrics can achieve better outcomes in terms of financial stability than reliance on individual constraints in isolation. We discuss in depth several recurring themes of the regulatory framework, such as the appropriate degree of discretion versus rules, the setting of macroprudential objectives, and the choice of policy instruments. We conclude with suggestions for future research and policy, including on models of financial stability, market-based finance, the political economy of financial regulation, and the contribution of the financial system to the economy and to society.

A decade on from the global financial crisis, is a macroprudential reaction function emerging and is it sensible? We address this question in two parts. First, we assess the responsiveness of the countercyclical capital buffer (CCyB) and housing tools to developments in the risk environment. We find that both tools are tightened in response to rapid household credit growth, with a one standard deviation increase approximately doubling the probability that tools are tightened in the following year. CCyB use also responds to rapid house price growth and low equity market volatility. Second, we compare the weight policymakers have given to different risk indicators with the indicators’ predictive power over severe recessions in the past, as measured by the “GDP-at-risk” framework. In practice, countries have tended to overweight household credit relative to its GDP-at-risk weights and put too little weight on other indicators, including households’ debt service ratios and corporate credit growth. While the risk indicators we consider can explain around 30% of variation in the CCyB, their explanatory power over housing tools is much more limited. This may indicate that housing tools are in part put in place as structural guardrails rather than to address current vulnerabilities.

How can macroeconomic tail risks originating from financial vulnerabilities be monitored systematically over time? This question lies at the heart of operationalising the macroprudential policy regimes that have developed around the world in response to the global financial crisis. Using quantile regressions applied to a panel dataset of 16 advanced economies, we examine how downside risk to growth over the medium term, GDP-at-Risk, is affected by a set of macroprudential indicators. We find that credit booms, property price booms and wide current account deficits each pose material downside risks to growth at horizons of three to five years. We find that such downside risks can be partiall y mitigated, however, by increasing the capitalisation of the banking system. We estimate that across our sample of countries, GDP-at-Risk, defined as the 5th quantile of the projected GDP growth distribution over three years, on average deteriorated by around 4.5 percentage points cumulatively in the run-up to the crisis. Our estimates suggest that an increase in bank capital equivalent to a countercyclical capital buffer rate of 2.5% (5%) would have been sufficient to mitigate up to 20% (40%) of this increase in medium-term macroeconomic tail risk.

How well equipped are today’s macroprudential regimes to deal with a rerun of the factors that led to the global financial crisis? To address the factors that made the last crisis so severe, a macroprudential regulator would need to implement policies to tackle vulnerabilities from financial system leverage, fragile funding structures, and the build-up in household indebtedness. We specify and calibrate a package of policy interventions to address these vulnerabilities—policies that include implementing the countercyclical capital buffer, requiring that banks extend the maturity of their funding, and restricting mortgage lending at high loan-to-income multiples. We then assess how well placed are two prominent macroprudential regulators, set up since the crisis, to implement such a package. The US Financial Stability Oversight Council has not been designed to implement such measures and would therefore make little difference were we to experience a rerun of the factors that preceded the last crisis. A macroprudential regulator modeled on the UK’s Financial Policy Committee stands a better chance because it has many of the necessary powers. But it too would face challenges associated with spotting build-ups in risk with sufficient prescience, acting sufficiently aggressively, and maintaining political backing for its actions.

We present a model for assessing how the UK’s system of market-based finance — an increasingly important source of credit to the real economy since the financial crisis — might behave under stress. The core of this model is a set of representative agents, which correspond to key sectors of the UK’s financial system. These agents interact in asset, funding (repo), and derivatives markets and face a range of solvency and liquidity constraints on their behaviour. Our model generates ‘tipping points’ such that, if shocks are large, or if headroom relative to constraints is small, lower asset prices can cause solvency/liquidity constraints to bind, resulting in forced deleveraging and large endogenous illiquidity premia. We illustrate such an outcome via a stress scenario in which a deteriorating corporate sector outlook coincides with tighter leverage limits at key intermediaries. Our findings highlight the key role played by broker-dealers, commercial banks, investment funds and life insurers in shaping these dynamics.

We present a framework for measuring the evolution of risks to financial stability over the financial cycle, which we apply to the United Kingdom. We identify 29 indicators of financial stability risk, drawing from the literature on early warning indicators of banking crises. We normalise and aggregate these indicators to produce three composite measures, capturing: leverage in the private nonfinancial sector, including the level and growth of household and corporate debt, as well as the United Kingdom’s external debt; asset valuations in residential and commercial property markets, and in government and corporate bond and equity markets; and credit terms facing household and corporate borrowers. We assess these composite measures relative to their historical distributions. And we present preliminary evidence for how they influence downside risks to economic growth and different horizons. The measures provide an intuitive description of the evolution of the financial cycle of the past three decades. And they could lend themselves to simple communication, both with macroprudential policymakers and the wider public.

We provide a framework for assessing the build-up of vulnerabilities to the U.S. financial system. We collect forty-six indicators of financial and balance-sheet conditions, cutting across measures of valuation pressures, nonfinancial borrowing, and financial-sector health. We place the data in economic categories, track their evolution, and develop an algorithmic approach to monitoring vulnerabilities that can complement the more judgmental approach of most official-sector organizations. Our approach picks up rising imbalances in the U.S. financial system through the mid-2000s, presaging the financial crisis. We also highlight several statistical properties of our approach: most importantly, our summary measures of system-wide vulnerabilities lead the credit-to-GDP gap (a key gauge in Basel III and related research) by a year or more. Thus, our framework may provide useful information for setting macroprudential policy tools such as the countercyclical capital buffer.

We have entered a world of conjoined monetary and macroprudential policies. But can they function smoothly in tandem, and with what effects? Since this policy cocktail has not been seen for decades, the empirical evidence is almost non-existent. We can only fix this shortcoming in a historical laboratory. The Radcliffe Report (1959), notoriously sceptical about the efficacy of monetary policy, embodied views which led the UK to a three-decade experiment of using credit policy tools alongside conventional changes in the central bank interest rate. These non-price tools are similar to policies now being considered or used by macroprudential policymakers. We describe these tools, document how they were used by the authorities, and craft a new, largely hand-collected data set to help estimate their effects. We develop a novel empirical strategy, which we term Factor-Augmented Local Projection (FALP), to investigate the subtly different impacts of both monetary and macroprudential policies. Monetary policy innovations acted on output and inflation broadly in line with consensus views today, but tighter credit policy acted primarily to modulate bank lending whilst reducing output and leaving inflation unchanged.