Mervyn King: Banking – from Bagehot to Basel, and back again Speech by Mr Mervyn King, Governor of the Bank of England, at the Second Bagehot Lecture, Buttonwood Gathering, New York, 25 October 2010. *  *  *  I am indebted to Stephen Burgess, Philip Evans, Andy Haldane, Andrew Hauser, Vicky Saporta, Jenny Scott, Paul Tucker and especially to Iain de Weymarn for their useful comments and suggestions on earlier drafts. 1. Introduction  Walter Bagehot was a brilliant observer and writer on contemporary economic and financial matters. In his remarkable book Lombard Street, Bagehot brought together his own observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique of central banking as practised by the Bank of England and a manifesto for how central banks could handle financial crises in future by acting as a lender of last resort. The present financial crisis dwarfs any of those witnessed by Bagehot. What lessons can we draw from recent and current experience to update Bagehot’s vision of finance and central banking? Surely the most important lesson from the financial crisis is the importance of a resilient and robust banking system. The countries most affected by the banking crisis have experienced the worst economic crisis since the 1930s. Output is somewhere between 5% and 10% below where it would have been had there not been a crisis.
By affecting the transmission mechanism, financial innovation is also a challenge for the conduct of monetary policy  A good knowledge of the mechanisms through which monetary policy affects the economy is of crucial importance for central banks. Financial innovation affects these mechanisms both by altering the channels through which monetary policy operates and by changing the overall impact of monetary policy decisions. But the magnitude of the changes and the precise effect due to financial innovation at a time when other factors such as globalisation are at work are not well known. At the present juncture research shows that financial innovation tends to strengthen the interest and exchange rate channels whereas it appears to weaken the credit channel. -  Financial innovation certainly contributes to stronger wealth effects and thus probably also to strengthen interest rate channel 7 . This can be explained as follows : •  Financial innovation fosters faster dissemination of information and its more rapid incorporation into financial market prices. This is of course particularly true for monetary policy decisions and can therefore increase the effectiveness of monetary policy, particularly via the interest rate channel 8 . •  Financial innovation contributes to an increased holding of financial assets by lowering transaction costs and facilitating arbitrage, hedging, funding and investment strategies. •  Financial innovation often relies on stronger leverage, increasing the effect of interest rate change by the central bank.