In other words, it stems from an increased acceptance of paying a certain price over the short term in order to reduce the risk of a particularly unfavourable outcome later on. However, the question remains of what this “something” that can dampen the build-up of imbalances could be. Should we deploy the weapons of the policy rate, of regulations or of a combination of the two? The answer to this question largely depends upon the view taken of the efficiency of the policy rate and regulations respectively as regards dampening excessive credit growth. It also depends upon the consequences arising for inflation and the real economy in various time perspectives if the policy rate or regulation, respectively, are used. Both the policy rate and regulations have their advantages and disadvantages. The policy rate is a blunt instrument in so far as it impacts all lending in the economy, which can be seen in the two interest rate equations for companies and households, respectively. It can require decisionmakers to make difficult choices and is a tough challenge to communicate. It is probably quite difficult to explain that the policy rate is being increased to safeguard stability in inflation and the real economy further ahead, even though everything looks good in a more short-term perspective. This task is not made any easier when policy rate increases impact sectors in which credit growth is not deemed to pose any problem. At the same time, the very bluntness of the policy rate is one of its strengths compared with regulations.
The first agreement on liquidity between the Bank of England and private banks occurred in 1947, and involved a requirement to hold a minimum liquid assets ratio of thirty-two percent (lowered to twenty-eight percent sixteen years later). The regime prevailed until 1971, when the Competition and Credit Controls Act (CCC) introduced a minimum reserve ratio of twelve and a half percent. The CCC had two objectives: first it was intended to strengthen control over monetary policy, by creating a solid money base to underpin it; second, it aimed to unify restrictions on banks to strengthen competition in the industry. The minimum reserve ratio was designed with this aim in mind, and this perhaps took priority over any desire to impose prudential liquidity reserves. While CCC undoubtedly liberalised the UK banking sector and thus supported improvements in competition and efficiency, it led to a fall in very high quality sterling liquid asset holdings of UK banks, as shown in Chart 4. After twice lowering the minimum requirement, the Bank of England finally replaced the reserve ratio regime with the cash ratio deposit regime in 1981, which did not directly require a minimum level of liquid assets. The Sterling Stock Liquidity Regime (SLR) in 1996 focused on holding sufficient liquidity to meet a particular severe cash flow funding stress.