37 An additional mechanism that creates amplification is that if and when these risks do materialise, market participants begin to doubt the solvency of even banks that are resilient. This is a form of what economists call ‘Knightian’ uncertainty (Knight, 1921); Caballero and Krishnamurthy (2008) present a model based on this concept. 38 In his classic paper on policymaking under uncertainty, Brainard (1967) argues that it will generally be optimal to use all instruments available when pursuing particular targets. This result holds provided the tools have less-than-perfectly correlated impacts on the target. In these circumstances, while any given tool may prove ineffective, it is less likely that their combined use will be. There is, therefore, an insurance benefit to using multiple tools in moderation. 39 Under the Bank of England Act 1998, as amended by the Financial Services Act 2012, the Bank of England has a statutory objective to protect and enhance the stability of the financial system of the United Kingdom. Subject to achieving this primary objective, the FPC must also support ‘the economic policy of Her Majesty’s Government, including its objectives for growth and employment’ (Section 9C(1) of the Bank of England Act 1998). 40 The first signs of that can be seen in the work being conducted internationally and domestically to study and address risks around asset management, market liquidity and derivatives. For example, the FSB published a policy recommendation in January that funds’ investment strategies should be consistent with their redemption terms, see Financial Stability Board (2017).
34 Constancio (2014) argues that “It seems unacceptable that macro-prudential authorities would passively watch the development of a bubble in housing prices and other asset prices, comforted by the idea that the banking sector is prepared to weather the storm and that the central bank would deal with the painful aftermath. The crisis showed that the amount of risk endogenously generated by a financial cycle spinning ‘out-of-control’ dwarfs the ‘mopping up’ ability of fiscal and monetary policy due to fiscal capacity limits and the zero lower bound on nominal interest rates. In matters of financial instability, prevention is always better than cure”. 35 The FPC recommendation on the loan-to-income (LTI) flow limit is that the PRA and the FCA should ensure that mortgage lenders do not extend more than 15% of their total number of new residential mortgages at LTI ratios at or greater than 4.5. The FPC recommendation regarding mortgage affordability is that when assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, Bank Rate were to be 3 percentage points higher than the prevailing rate at origination. For further detail, see for instance Bank of England (2014) for a documentation of the Bank of England’s 2014 housing market measures. 36 See Bank of England (2016).