Paul Fisher: Financial markets, monetary policy and credit supply Speech by Mr Paul Fisher, Executive Director for Markets of the Bank of England, Member of the Monetary Policy Committee, to Richmond University, London, 2 October 2013. *  *  *  Thank you for having me back at Richmond University. In this lecture today, I aim to review the behaviour and development of financial markets over the past year, including the period of heightened volatility since May and the introduction by the Monetary Policy Committee of explicit forward-looking monetary policy guidance in August. I will also assess the working and impact of the Funding for Lending Scheme over its first year of operation. Developments in financial markets When I spoke to you a year ago, financial markets were still scarred by the crisis years and there remained a number of significant downside tail risks to the global economy. Contacts were citing: the risks of a breakup of the euro-area; the possibility of a “fiscal cliff” in the US; a slowing in China, alongside already weak growth in the advanced economies; and tensions in the Middle East – especially around the Straits of Hormuz. But those tail risks were seen to be offset in large part by the commitment of central banks to respond. The ECB had announced its Outright Monetary Transactions programme and had been interpreted as publicly committing to do whatever it takes to keep the euro-area together.
Issuers, though, transferred much of the risk and did so comprehensively, as they needed to demonstrate that they had transferred risk irrevocably before they could get capital relief. But in the absence of adequate monitoring, originators could chase volume at the expense of lending standards. 5  See for example, the Bank of England Financial Stability Report, October 2007. BIS Review 93/2008  7  27 Therefore, two elements at the heart of the benefits of financial innovation – the ability to pool and transfer risk – contributed to an endogenous increase in the level of underlying credit risk. 28 There is also a potential incentive problem arising from the separation of legal ownership from economic exposure – although this is at the moment a possible difficulty for the future. Credit default swaps transfer the risk of economic loss to the seller of protection but the right to trigger covenants or put a firm into administration remains with the underlying asset holder. A protected asset holder, therefore, has little incentive to monitor a company closely and trigger covenants or force it into administration at the first signs that its business may have become unsustainable. And the seller of protection lacks an alternative legal remedy. Companies may therefore continue to operate for longer than they did in the past once they get into trouble. So, the use of credit default swaps may reduce the probability of default but increase loss given eventual default.