In March this year, inflation rose to 3.1% and I wrote an open letter to the then Chancellor explaining why and what we were doing about it. Over the past 12 months, we have raised Bank Rate by one percentage point. And, notwithstanding some claims at the time of the open letter, inflation has since fallen back quite sharply, mainly as retail gas and electricity prices have stopped rising and, more recently, fallen. CPI inflation was, in August, a fraction below the 2% target. The challenge now for the Monetary Policy Committee is to keep it there. The current turmoil in financial markets is not over. Conditions have eased a little – share prices have recovered and interbank interest rates have fallen back. Indeed, spreads between interbank rates and anticipated central bank interest rates are now lower in the UK than in the euro area or United States. But for the moment, some markets remain virtually closed. And even as they re-open, there will not be a return, I hope, to the excessive risktaking – and associated rapid expansion of credit – of the past few years. With investors more wary of risks, banks will find it harder to raise funds. So credit will not be so readily or cheaply available to businesses and households. As we said in August, pressures on capacity mean that output growth needs to slow moderately over the next year or so if we are to continue to meet the inflation target.
At the same time, regulators have continued to bulk-up their own resources in the face of a rising tide of regulatory rules. Ultimately, these costs are borne not by regulators or regulated firms, but by general taxpayers and bank customers. These come in the form of higher taxes, lower savings rates and higher lending rates. If system stability can be achieved in simpler ways, these are deadweight costs to society. (b) The unlevel playing field A second unintended consequence of the move to a model-based regulatory framework is that it has tended to work in quasi-discriminatory ways. In particular, it has tended to discriminate both between small and large banks and between new entrants and existing incumbents in the amounts of capital they are required to hold even against identical exposures. The reason for this is that small or new entrant banks will generally adhere to Basel I or simple standardised approaches for measuring risk. In general, they will have neither the data nor the technology to support internal model approaches. But simpler, standardised approaches tend to require much higher amounts of capital than internal model approaches. Indeed, this was a design feature of Basel II. Chart 8 demonstrates those differences among the major UK banks for a selection of portfolios. For an identical corporate exposure, a small bank on Basel I or a standardised Basel II approach holds, on average, twice as much capital as a large bank using models. For retail mortgages, these differences are larger still.