9  All speeches are available online at www.bankofengland.co.uk/speeches  9  (ii)  Forward looking stress tests of the Bank’s financial exposures  If the first case study illustrated an example where risk was already being actively evaluated, my second illustrates a completely new area of activity. The concept of enterprise-wide stress tests has transformed private sector thinking on risk management in recent years, driven in many cases by central bank regulators. The Bank of England conducts an extensive annual supervisory stress testing programme in the United Kingdom – and I note with interest the discussions taking place elsewhere in this conference on the potential to expand such exercises well beyond 11  banks, something we have also been considering . But, ironically perhaps, the Bank of England has not until very recently applied such techniques to its own balance sheet. That made sense when large-scale balance sheet expansions were expected to be rare and highly idiosyncratic. But the more permanent shift in the Bank’s firefighter role illustrated in Chart 5 suggests we need a more sophisticated, agile forward-looking way of evaluating the risks we might face, and (importantly) the resources required to deal with them. Development of a suite of stress tests has therefore been a core part of the early work of the new second line team. To shape this work, key judgments are required on ‘the 3 ‘S’s’: Scope, Scenarios and Severity. Scope describes the range of facilities that the Bank might be called upon to use.
It seems that one trend is towards disintermediation and a more important role of capital markets, gaining ground to banks, in a global financial system that will probably end up being smaller and more attuned to the size of the global economy. Another trend points to a reduction of financial linkages between national financial systems, as BIS banking statistics, for example, are starting to show. Here, the role of Central Banks’ policies and operations, as well as regulators is crucial, as they must walk a fine line in promoting domestic financial stability without falling into the nets of protectionism, something that would be indeed damaging for growth and prosperity. As we all know, the risk of fragmentation and re-nationalisation of the financial system has materialized at the European level, in the unique institutional context of European Monetary Union; and the solutions to overcome this situation are changing the foundations of the euro. Each of the three sessions which make up the programme will focus on a particular perspective on how the new trends are shaping the global financial system. The crisis and the policy response – in the areas of financial regulation and monetary policy – are generating new patterns of funding, new players and changes in capital flows across global markets. Those issues will be reviewed in the initial session. As I mentioned before, the euro area has to deal with a severe crisis which has led to the fragmentation of the European financial system.