The Bank of England and the Financial Services Authority

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Table of Contents

Northern Rock and the Bank of England
Other functions of the bank of England
Other functions of the FSA
References

The casual observer who is confused about the roles of the Bank of England and the Financial Services Authority, (FSA), is in good company. While the two institutions have different mandates, developments that followed the troubles at Northern Rock created doubts about the clarity of the two institutions’ different roles. When the subprime crisis that originated in the US became a global problem that affected individuals and institutions in far away lands, the UK was not spared. Threats posed by the crisis to one of the UK’s leading mortgage companies, Northern Rock, led to a blame game that exposed the confusing nature of the roles played by the two main financial service regulators.

A brief history of the bank of England should help explain the different roles of these financial regulators. The bank of England, also known as The Old Lady, is quite ancient. It was started as a private enterprise in 1694 and was converted into a Central Bank in 1844 when the Bank Charter Act was passed (“Bank of England” 2007). Even after conversion into a central bank, the old lady remained a privately owned enterprise until 1946 when it was nationalised through an act of parliament. For many years the Bank of England performed the traditional duties of a typical Central Bank and was the sole regulator of the nation’s monetary affairs. Some of the duties performed by the Bank of England included the issue of currency notes, control of public debt and banker for the government (“Bank of England”). In addition, the bank played a supervisory role on the commercial banks and has been known as the lender of last resort – a financial institution at the risk of ruin can run to the Bank of England for bail out (Heffer, 2002). Heffer (2002) further notes that the control that the Bank of England exercised over the rest of the financial institutions made it a very important player in the life of the nation and even in government. Exercise of control over the rest of the financial institutions was granted as early as 1844 even though the bank was still a private enterprise. Not only did the bank of England exercise control locally, it did, and still does, “provide limited services to other central banks and other countries” (Heffer 2002).

While much legislation has been undertaken to regulate the activities of the Bank of England, the Tripartite Agreement of 1997 is what really defines the bank as it is today. This agreement was signed by three main players in the UK financial market – the Bank of England, the FSA and the Treasury (“The loudest bark” 2008). The agreement was actually a memorandum of understanding whose aim was to specify the authority that each body would hold. One of the most crucial changes that the agreement effected was the removal of the supervisory and regulatory role of banks from the Bank of England to the FSA (Buiter 2007). While this was a major reduction in the powers of the bank of England, the institution still remains a crucial player in the UK financial markets.

Today, the bank of England retains some of the crucial powers it has held over the years. One of these roles is the issue of bank notes for which the bank has a monopoly (“About the bank”). The bank also occupies a central place in the financial markets of the UK since it has the sole responsibility of setting interest rates. In addition, the bank is responsible for the management of the foreign exchange of the UK and is still the lender of last resort.

Northern Rock and the Bank of England

The current global crisis started in the subprime lending markets of the US but soon became a global crisis because the players involved were spread across the globe. The UK was not spared and one of the earliest casualties was Northern Rock. As one of the leading providers of credit and mortgage finance in the UK, Northern Rock was, like other providers of mortgage finance, negatively affected when the housing bubble in the US burst. The consequent credit problems that Northern Rock experienced forced it to seek the help of the Bank of England (“Northern Rock”). In September 2007, Northern Rock obtained liquidity support from the Bank of England to assist it stabilize its operations which were then threatened by the subprime crisis. While this support was supposed to aid the bank, the downside was that it caused panic among investors in the bank who then rushed to withdraw their savings from the institution. This further compounded Northern Rock’s already miserable financial standing and soon offers were being made to buy the bank. In the end, the bank was taken over by the government in February 2008 (“Northern Rock”).

The bail out and eventual nationalisation of Northern Rock helps explain some crucial functions of both the bank of England and the FSA. In offering liquidity support to Northern Rock, the bank of England was performing one of its traditional roles – the role of the lender of last resort. When banks face the instability caused by liquidity problems, they can turn to the Bank of England for support. The acrimony and blame game between the Bank of England and the FSA that followed the troubles at Northern Rock (“The loudest bark”) are indicative of the close relationship that the two financial regulators have in the management of the financial services of the UK. While the bank of England offers liquidity support, it requires the expert information that only the FSA possesses. One of the key responsibilities of the FSA is to regulate the financial markets (“About the FSA”). In its regulatory role, a function taken from the Bank of England in the 1997 agreement, the FSA “aims to promote efficient, orderly and fair financial markets” (“About the FSA”). To achieve this objective, the FSA supervises the financial markets to ensure that they meet the standards that it has set. The nationalisation of Northern perhaps best illustrates the supervisory role that the FSA plays. Prior to the nationalisation, two bids had been made on the bank (“Northern Rock”). The two bids failed to go through because neither of the bidders had a plan that was agreeable to the FSA on how the liquidity support that had been extended by the bank of England, which is taxpayer’s money, was going to be repaid in a period of three years (“Northern Rock”). This also explains the war of words between the FSA and the bank of England over Northern Rock. The FSA was accused of “failing to anticipate the crisis” – which it should have as the regulator of financial institutions – while the bank of England was accused of dithering over the provision of a rescue package – which it should offer as the lender of last resort (“The loudest bark”). The two institutions then, though carrying out different functions, must of necessity have a close relationship.

Other functions of the bank of England

The Bank of England plays a central role in the financial markets of the UK as it has been given statutory duties that impact on all financial institutions. One of the roles that the bank undertakes that puts it in the very centre of financial dealings is its control over banking interest rates. As part of the 1997 agreement, the bank was given the duty of setting the official interest rate in the UK. Working with the Chancellor of the Exchequer – who sets the inflation target – the bank then decides the interest rate that will meet the set inflation target. Once the interest rate has been set, the bank uses it to lend money to banks and the rest of the financial institutions. The bank then not only sets the rate but, as a player in the financial markets, also influences the rates at which the rest of the banks lend money (“About the bank”).

Through its control over interest rates, the bank of England is also able to influence the monetary policy. The interest rate determines the level of inflation in the economy and through manipulating it the bank is able to meet the targets that the government sets. In addition, the bank sets the rate at which the sterling pound is exchanged with other currencies. Through its Monetary policy Committee, the bank not only sets the official exchange rate but also participates in the foreign exchange market as a player and sometimes represents its customers. Control of the exchange rate influences prices on the international market and the bank can use the rate to influence trade. Another major function of the bank is maintenance of market stability. This is a broad function but its main aim is to create confidence among the public, investors and other players in the financial market that the economy is stable and sustainable and therefore reduce the risks associated with dealing in unsafe markets. As part of its market stabilization role, the bank identifies areas that could pose financial risks and provides solutions. The liquidity support offered to Northern Rock is an example of this stabilization role. Moreover, the bank produces various publications that provide information on the financial markets in the UK. The publications cover financially important topics such as inflation in addition to explaining the bank’s operations (“About the bank”).

Other functions of the FSA

The FSA, in regulating the financial markets, attempts to fulfill one if its major functions which is the creation of market confidence. Playing a similar role to the bank of England in this respect, the FSA is supposed to operate like a big brother to the financial institutions. It is expected to create market confidence by being the holder of information that is critical to the proper functioning of the financial markets and to use that information to raise the alarm before things go awry. That is why the FSA was seen to have failed in its role by not anticipating that the subprime crisis was going to affect Northern Rock. In a recent case, the FSA carried out investigations on HBOS when rumours did the rounds that the company had asked for a bank of England bailout as a result of which HBOS share prices fell dramatically (“HBOS”). FSA reassurances about the liquidity of HBOS did not assure a largely skeptical public which has yet to come to terms with the credit crunch. In addition, the FSA has a statutory duty to promote public awareness about the operation of the financial markets. Here again, the FSA’s role is similar to that of the Bank of England which also educates the public on financial matters through its various publications. Another crucial duty given to the FSA is protection of consumers. The nationalisation of Northern Rock followed doubts developed by the FSA about the ability of the bidders to repay taxpayers’ money. Moreover, the FSA is mandated to be on the look out to prevent financial crime. As the policeman of the UK financial markets, the FSA is supposed to find out and seal the loopholes that would enable criminal minds to use the financial markets to propagate crime (“About the FSA”).

The FSA and the Bank of England play a controlling role in the UK financial markets and co-operation between the two is mandatory as the actions of one institution affect the actions of the other. The bank is able to act with speed and confidence when its source of information is the FSA. The investigative capacities that the FSA has are beyond the bank and the former will share in the blame or credit that the latter acquires after effecting policy decisions.

References

About the bank, Bank of England.
About the fsa, Financial services authority.
Buiter, W 2007, ‘Responsibility without information: the bank of England as lender of last resort’, Maverecon – Willem buiter’s blog.
HBOS, Wikipedia the free encyclopedia. Web.
Heffer, S 2002, ‘Time to sell the old lady’, New Statesman, vol. 127 no. 4367, p. 30+.
Northern rock, Wikipedia the free encyclopedia. Web.
‘The bank of England’ 2007, The Columbia encyclopedia, 6^th ed., Columbia university press, New York.
The loudest bark 2008, Financial world.

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The Bank of England and the Financial Services Authority

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