Applying these tools to central banking operations is both easier and harder than in the private sector. Easier, because there is no tension between profit and risk: central banking operations are always designed with risk in mind from the start. But harder, because the events in which central banks are called on to act often lie in the very tails of the distributions, making it hard – often impossible – to calibrate risk tolerance using historic data. And many of our operations are not discretionary, but reflect policy imperatives: so binding risk limits which, if applied, might cause a policy to be aborted mid-course, have little chance of success. At the Bank of England, we have responded to these challenges in three ways. First, we have adopted a risk tolerance that, though qualitative in nature, recognises the importance attached to the safeguarding of public resources and the priority placed on ensuring that policy decisions are always made in full knowledge of the financial risk implications. As I have described, maintaining monetary and financial stability – the Bank’s policy mission – can sometimes mean we have to take on material levels of risk ourselves. But where we do that, we should take on no more risk than is necessary, and we should do so with our eyes open, conscious too of the tradeoffs between financial and non-financial risk.
It also sits at the base of a particularly steep waterfall: since any loss in a lending operation would be expected to be met, first by a solvent firm’s own resources, second by the central bank’s collateral haircuts, and only then by its capital. Any loss beyond that implicitly falls to the government, as the ultimate owner of the central bank (Chart 6). Chart 6: The central bank capital waterfall  banking system  Central bank balance sheet  General Government  Probability  Self-insurance  Haircuts Capital  Risk-sharing with the Treasury More severe losses  Central banks across the globe differ in how they divide up this pie. In the UK, the Bank of England operates with a relatively low level of capital, and has few means of rapidly replenishing that capital if it is depleted (Chart 7). As a result it has tended to rely heavily on UK government indemnities for its larger operations, such as the quantitative easing example I gave a few moments ago. The Bank’s measured leverage ratio is 11  All speeches are available online at www.bankofengland.co.uk/speeches  11  just 1%, reflecting the fact that it supports a balance sheet of around £ on less than £ of equity. 12  But the ratio for its non-indemnified balance is materially higher, reflecting the significant role played by indemnities.