Bank of England

As the central bank for the United Kingdom, the Bank of England is at the heart of the UK financial system. Founded in 1694, the functions of the Bank have changed somewhat in response to historical events, but the primary goal of promoting and maintaining monetary and financial stability for the UK economy remains constant.

Bank of England History and Mandate

In the late 1600s, public finances in England were in tremendous disarray. No authority was in place to manage the distribution of currency throughout the country, and there was no means of guaranteeing the integrity or value of money once in circulation.

Several schemes were put forward to address these concerns, but it was a proposal by William Paterson to create a new central bank that won the most support. Initially, Patterson’s central bank plan was not looked upon favorably by the government of the day, but the need to finance an ongoing war with France finally forced Parliament to give its approval for the “advance of one million pounds on a perpetual fund of interest”.^[1]

Paterson managed to raise £1.2 million through the dispersal of shares in the new Bank of England. This money was immediately lent to the Government, and in return, investors in the Bank were incorporated as the “Governor and Company of the Bank of England”. The Bank of England officially came into existence through Royal Charter and began operations on July 27, 1694.^[2]

Development of a Currency System

Most of the Bank’s efforts in its first years was to service the Government’s needs for capital, but the Bank also took on tasks that served as a prelude to what we today would recognize as modern banking concepts. The Bank accepted deposits and issued banknotes verifying that the holder had deposits with the Bank sufficient to cover the amount specified on the note. In the early days, these banknotes were often issued in odd sums matching the actual amount on deposit – but this soon evolved into the practice of issuing notes in round amounts. ^[3]

This change helped facilitate the growing practice of accepting Bank of England notes as currency – prior to this, only gold coins (specie) were used as currency. The use of specie was an easy system to implement as the coins had an obvious intrinsic value due to the gold content itself (i.e. commodity money). However, carrying around precious metals proved to be not only inconvenient, it could be outright dangerous as thieves targeted individuals that they suspected may be carrying large purses!

Thus, promissory notes (i.e. representative money) - with a guarantee backed by the Bank of England entitling the bearer to redeem the note for gold – grew in favour. And with the backing of the Government, individuals and merchants felt reassured that the banknotes would be honoured by the Bank.

Bank Charter Act - 1844

There have been several changes to the original charter that created the Bank of England – you can review this information on the Bank of England website so we won’t look at each instance in this article. However there are a couple of critical changes that we will discuss as they are of particular importance, starting with the Bank Charter Act of 1844.

The Bank Charter Act as passed by Parliament contained two pivotal elements that laid the groundwork for a modern banking system. The first requirement of the Bank Act essentially formalized the Bank of England as the central bank by giving the Bank of England exclusive rights to issue promissory notes. All banks in England and those established in Wales were required to follow this rule, but banks in Scotland and Ireland were permitted to continue issuing their own notes and still do today. ^[4]

The second major change of the Bank Act required that any new notes issued by the Bank of England, must be fully backed by gold reserves held at the Bank. Fearing a repeat of the crippling inflation endured by the country during the Napoleonic wars that ended in 1821, Parliament insisted on tying bank notes to a gold standard. ^[5]

To ensure compliance with this regulation, the Bank was required to establish a separate department that is “wholly distinct from the general banking business of said Governor and company”.^[6] The Bank still produces a weekly summary report listing its assets and liabilities in what is known as the Bank Return Report. This report shows the consolidated balance sheet of the bank, but separates the total of its note issuing functions from other lines of business as first required in the Bank Charter Act of 1844.

The Bank of England Becomes a True Central Bank

While the Bank Charter Act created a de facto central bank and also ensured a safe and secure currency, the separation of these activities from retail banking limited the Bank of England’s ability to compete with other commercial banks that were rapidly growing in and around London. Rather than fighting for business in an increasingly competitive market, the Bank of England decided to further develop its role as a central bank.

This involved serving as a banker to the other banks, managing the nation’s gold reserves, and ensuring sufficient liquidity within the financial system. After providing emergency capital to keep several high-profile, privately-held banks solvent during a liquidity crisis in the mid 1800s, the Bank of England took on the formal role of a lender of last resort.

The Bank also began to impact interest rates by controlling the supply of money to the banking system. While the money supply and interest rate relationship was very limited at this time, the Bank had to keep interest rates high enough to ensure its gold holdings covered its outstanding notes. This is the earliest instance of the Bank of England using its control of the money supply to influence interest rates. ^[7]

Gold Standard Eliminated

Originally, it was silver – or “sterlings” – that served as the basis for the pound, but gold became the standard early in the 18th century. Germany also adopted gold as the basis for its currency around this time, and the shared use of a gold standard fostered a trade boom between the two nations. Ironically, it was the during the First World War that Parliament – just as it did earlier during the Napoleonic wars – suspended the gold standard mandate to meet the costs associated with the war.^[8] Despite fears of driving up inflation by issuing currency not backed directly by gold reserves, it was deemed necessary in order to increase the amount of currency in circulation.

In 1925, while serving as Chancellor of the Exchequer, Winston Churchill attempted to re-introduce the gold standard. However, it was determined by 1931 that this approach was no longer in the best interests of the economy and the gold standard was officially eliminated in the UK.^[9] From 1931 to today, the UK currency system is entirely fiduciary, meaning that there is no underlying commodity linked directly to the currency. No longer tied to the requirement of having gold reserves sufficient to the value of notes in circulation, the Bank must only receive a resolution from Parliament approving their request in order to issue additional notes.

Bank of England Act - 1998

The 1998 Bank of England act built upon the operational independence granted the Bank one year earlier when it was given responsibility for setting interest rates to meet target inflation rates. The 1998 Act made changes to the Bank’s governing bodies and structure intended to establish a new accountability framework and greater transparency into the Bank’s operations.

The provisions for this Act include: ^[10]

• Formalizing the policy objectives for the Bank of England:
  • To maintain price stability
  • To support the Government’s economic policy (including objectives for growth and employment)
• Establishing the Monetary Policy Committee to formulate the Bank’s monetary policy
• Assuming responsibility for monetary policy
• Transferring the responsibility for supervision of the nation’s banking system to the Financial Services Authority
• Producing an annual report to go before Parliament
• Producing a list of actions for the Monetary Policy Committee and publishing of minutes of all meetings

Bank of England Accountability

In 1997, the Bank assumed responsibility for the implementation of England’s monetary policy and, like other countries with independent central banks, works with the government to establish economic and fiscal targets. The Bank then has wide-ranging autonomy to manage the nation’s financial system according to the agreed-upon fiscal policy.

Autonomy does not mean a lack of accountability however, and accountability to government is maintained through the office of the Chancellor of the Exchequer. The Bank must provide periodic reports and updates and is ultimately accountable to the Chancellor and Parliament as a whole.

The current monetary policy includes an inflation target of 2% and the Bank must provide notification if actual results fall outside the mandated targets. While it is understood that inflation rates will fluctuate throughout the course of the year, the Bank is required to inform the Government if the target is missed by 1% or more for any given quarter. This notice takes the form of an open letter to the Chancellor.

Sample Letter

The Chancellor, on behalf of the Government, will respond with a remit addressed to the Governor that reaffirms the expectation of the Government.

Sample Remit

Note also that the Government reserves the authority to override the Bank and impose interest rate changes if it is deemed to be a national crisis, but this would be a very rare event indeed.

Executive Committees

The Court of Directors

The Court of Directors – often referred to simply as “the Court” – was created by the 1998 Bank of England Act. The Court serves as the executive branch of the Bank and it’s duties are to manage the Bank’s business and operations; it does not however, formulate monetary policy directly.

The Court is led by the Governor and two Deputy Governors and are assigned to five year terms by the government. As well, sixteen non-executive directors – also assigned by the government – are added to the Court for three year terms. All appointments are renewable at the government’s discretion.^[11] The current Bank of England Governor is Mervyn Allister King – the list of all Bank of England executives is available on the Bank of England website.

The Monetary Policy Committee (MPC)

Monetary policy for the Bank of England is the responsibility of the Monetary Policy Committee, or the MPC. This committee consists of the Governor, two Deputy Governors, two Bank Directors, and four other members appointed by the Chancellor of the Exchequer. The Government sets yearly price stability, growth, and employment targets and it is the Monetary Policy Committee’s responsibility to formulate the monetary policy in the name of the Bank of England.

The MPC must meet at least once a month and minutes of the meetings – as well as any actions planned by the MPC – are published two weeks after each monthly meeting. The MPC also publishes the Inflation Report every quarter which outlines the MPC’s projections for inflation and economic output.^[12]

NedCo

While the MPC has jurisdiction for monetary policy, it is subject to review by NedCo. This committee - comprised of the Directors not part of the Executive or serving on the MPC itself – is the primary review mechanism holding the MPC to account.

Ultimately, NedCo is responsible for reviewing how effectively the Bank’s monetary policy addresses the goals established by the government. A summary of NedCo’s functions include:

• Reviewing the Bank’s performance with regards to its objectives
• Determining the extent to which the objectives have been met
• Reviewing the Bank’s internal financial controls
• Determining remuneration and pensions for the executive members of Court
• Reviewing the procedures followed by the Monetary Policy Committee
• Ensuring sufficient regional data has been collected for the purpose of formulating monetary policy
• Determining the terms and conditions of the members of the Monetary Policy Committee who are appointed by the Chancellor of the Exchequer

NedCo works closely with separate Audit, Risk, and Remuneration committees to thoroughly review the Bank’s internal controls and practices. Reports from these committees are included as part of the Bank’s Annual Report which must be produced for government review.

Operational Structure of the Bank

There are four main operational divisions within the Bank of England to carry out day-to-day functions. These divisions were created as part of the changes introduced with the 1998 Bank of England Act and consist of the following: ^[13]

• Monetary Analysis and Statistics
• Markets
• Financial Stability
• Central Services

Monetary Analysis and Statistics

The Monetary Analysis and Statistics division provides the statistical information required by the Bank to determine and implement monetary policy. Staff economists research and analyze current conditions within the UK economy and other global economies in order to produce the Quarterly Bulletin and the Inflation Report. Both documents are used by the Monetary Policy Committee to determine future inflation and growth predictions. ^[14]

Markets

The main objectives of the Markets division include:

• Conduct open market operations in the money markets to implement the Monetary Policy Committee’s interest rate decisions
• Ensure sufficient liquidity in the financial system
• Manage the country’s foreign currency reserves

The Markets division also contains a Risk Management team that identifies and manages risk with respect to the Bank’s financial operations.

Financial Stability

The Financial Stability division is closely aligned with HM Treasury and the Financial Services Authority under the Memorandum of Understanding. The Financial Stability Board identifies and prioritizes potential risks to the UK economy and develops action plans to neutralize these risks. The Financial Stability division also contributes to the monetary policy process through the issuance of the Financial Stability Report.

Central Services

The Central Services division consists of several specialty groups that provide support functions to the Bank. Everything from computer maintenance to legal services falls within this category.

The Bank’s Agencies

Much like the Federal Reserve uses a series of regional reserve banks to get input from across the country, the Bank of England maintains twelve “Agencies” throughout the United Kingdom. Each Agency has two primary responsibilities – gathering feedback regarding the state of the local economy for the area they represent, and serving as representatives of the Bank of England.

Typically, Agencies visit each of their business contacts on a yearly basis and while specific, privileged information is kept confidential, information may be summarized and forwarded to the Monetary Policy Committee in a report known as the Bank of England’s Summary of Business Conditions”.

Monetary Policy Goals

The Government has established a target annual inflation rate of 2% for the British economy. This target takes into account the understanding that too little inflation – an indication that the economy is stagnant and not growing – is just as detrimental as too much inflation. Additionally, a 2% rate of growth provides favourable conditions for economic growth while maintaining price stability and supporting strong employment levels.

With these growth targets in mind, it is the responsibility of the [www.bankofengland.co.uk/ Bank of England] – or more precisely – the Monetary Policy Committee, to formulate and implement a monetary plan that maintains this 2% inflation rate.

Chancellor of the Exchequer

As the Government’s financial minister, the Chancellor of the Exchequer – or simply the “Chancellor” – is responsible for generating all required revenues for the government, as well as over-seeing how those revenues are spent. Each year, the Chancellor delivers a budget speech to the House of Commons which outlines the Government’s financial plans for the year. The Bank of England, through its Monetary Policy Committee, is expected to formulate a monetary plan that supports the budget goals.

The Chancellor is considered second only to the Prime Minister in terms of political power. Indeed, several Chancellors – including Winston Churchill and current Prime Minister Gordon Brown – have used the office of the Exchequer as a springboard to the office of Prime Minister.

Monetary Policy Announcements and Public Notices

The Monetary Policy Committee holds two-day policy meetings every month. These meetings usually take place on the Wednesday and Thursday following the first Monday of each month. Interest rate decisions resulting from these monthly meetings are announced at 12:00 noon on the second day of the meeting and complete meeting minutes together with the voting record of the MPC members are made public on the Wednesday of the second week after the meeting.

Each quarter, the Bank publishes its Inflation Report. This report was first produced in 1993 and contains detailed analysis and inflation projections for the next several quarters. The Bank’s Monetary Policy Committee uses the information in this report as the basis for interest rate decisions.

The report contains the following sections:

• analysis of money and asset prices
• analysis of demand
• analysis of output and supply
• analysis of costs and prices
• assessment of the medium-term inflation prospects and risks

The Inflation Report is an important artifact and provides insight into possible trends. Very often MPC members will note concerns or potential problems that they intend to watch, but do not yet feel intervention is required. This should be a clear warning to all investors that if the trend is not reversed in time for the next Monetary Policy Committee meeting date, then some form of action by the Bank is inevitable.

How Monetary Policy Is Implemented

The Bank uses open market operations to control the money supply and influence interest rates within the financial system. As the nation’s central bank, the Bank of England provides the funds required by the commercial banks to meet their end-of-day transaction obligations. Because transactions must be settled at the close of business each day, banks and other financial institutions that do not have sufficient reserves on hand, turn to the Bank to borrow the funds needed to cover their outstanding obligations.

The Bank of England is the sole provider of these short-term funds and can set the interest rate at which it will make funds available. Obviously, interest rate costs are passed on to the commercial banks’ clients in the form of interest charges for mortgages and other loans. When the central bank lending rate – also referred to as the dealing rate – changes, an adjustment is made by the banks to their lending rates. It is this relationship between the dealing rate and the commercial rates that enables the Bank of England to influence market interest rates.

For example, if inflation is creeping above the target rate, the Bank may hike the dealing rate it charges to the commercial banks in a bid to slow down spending, thus bringing inflation back to an acceptable level. Because the banks must pay a higher interest to access these cash reserves, this cost will be passed on to consumers in the form of higher borrowing costs almost immediately. ^[15]

In addition to commercial interest rates, the Bank of England lending rate also affects other financial instruments including stocks and bonds. Generally speaking, an interest rate increase will be seen in a negative light by both the stock and bond markets, while the currency market often sees interest increases as a positive sign as the value of the currency may rise in value against other currencies.

The Bank normally puts out two invitations each day – one at 9:45 A.M. and one at 2:30 P.M. – to provide opportunity for its open market counterparties (i.e. banks and other financial institutions) to borrow funds. The Bank may also issue a 3:30 P.M. invitation if it appears that overnight market rates are likely to deviate too far from the Bank’s intended threshold. Funds borrowed in the two earlier invitations are made available without requiring collateral, but if financial institutions borrow money at the 3:30 invitation, they must place an equal amount of securities up as collateral.^[16]

London Inter-Bank Offered Rate (LIBOR)

Financial institutions in the London banking system can also turn to the inter-bank lending market to lend or borrow capital as required to meet liquidity needs. The rate that loans are offered in this overnight market is referred to as the London Inter-Bank Offered Rate, or LIBOR.

Bank of England Financial Policy Objectives

In October of 1997, a Memorandum of Understanding was drafted specifically to outline the responsibilities and relationships between the Bank of England, Her Majesty’s Treasury, and the Financial Services Authority (FSA). An agreement in this document created a standing committee that works to ensure the three organizations work together to manage the economy and financial system. This Memorandum, which was updated in 2006, confirmed that the Bank of England would continue to be responsible for the financial system as a whole, while the Financial Services Authority would supervise individual banks and other financial institutions.^[17]

Role of the Financial Services Authority

The Financial Services Authority is an independent, non-government body charged with regulating U.K.-based financial services, markets exchanges, and firms. The FSA’s underlying principles are to “promote efficient, orderly, and fair financial markets and help retail financial service customers get a fair deal”.^[18]

While not a government body, the FSA is accountable to the Treasury and Parliament. The Treasury appoints a Board consisting of a Chairman, a Vice-Chairman, a Chief Executive Officer, three Managing Directors, and nine non-executive directors. Operationally, the FSA is independent of direct government intervention and is funded entirely by the commercial firms that it regulates.

Related Links

Governor Mervyn King Biography

Commentary - Bank of England and Northern Rock Bank

Bank of England website

Financial Services Authority website

Monetary Policy Committee Meeting Dates

References

1. ↑ The Early History of the Bank of England - Harvey E. Fisk
2. ↑ Bank of England website
3. ↑ Bank of England website
4. ↑ The Early History of the Bank of England - Harvey E. Fisk
5. ↑ A History of Sterling - The Telegraph
6. ↑ Bank Charter Act - 1884
7. ↑ Bank of England website
8. ↑ Bank of England website
9. ↑ Bank of England website
10. ↑ HM Treasury Press Release - April 23, 1988
11. ↑ Bank of England website
12. ↑ Bank of England website
13. ↑ Bank of England website
14. ↑ HM Treasury website
15. ↑ Bank of England Open Market Operations: The Introduction of a Deposit Facility for Counterparties - William A. Allen, Bank of England
16. ↑ The Bank of England's Monetary Policy - Geoffrey M. B. Tootell, England Economic Review, 2002
17. ↑ Financial Services Authority website
18. ↑ Financial Services Authority website