3.1 The Bank of England

With the changes to the Bank of England’s responsibility for monetary policy in

1997, these powers (together with many staff) were transferred by the Bank of Eng-

land Act in June 1998 to a newly established Financial Services Authority (FSA), which

eventually became responsible for the supervision of all nancial intermediaries in 2001.

Banking, like most forms of nancial intermediation, is increasingly an inter-

national activity. Banks with headquarters in one country, for example, may operate

subsidiaries in many others. This poses a problem for supervisors, partly because

differences between national rules may lead to distortions in the pattern of banking

activity whereby banks concentrate certain types of business in those countries

where regulation is lightest, and partly because there is a danger that foreign sub-

sidiaries ‘fall between the cracks’ when it comes to supervision: the home authority

cannot exercise supervision in the host country, while the host country supervisor

may not feel a responsibility for foreign banks. Thus much activity in recent years

has gone into the international co-ordination of banking supervision. For example,

the capital tests imposed by the FSA are derived from the EC Capital Adequacy

Directive, 1996, while the EC Second Banking Co-ordination Directive, 1993, places

the responsibility for supervision of overseas branches on the home supervisor but

lays down rules to ensure the co-operation between home and host authorities. Thus

branches of banks with headquarters in other EU states are permitted to operate in

the UK on the strength of the licence issued in the home country. The general issue

of nancial regulation and supervision is discussed further in Chapter 13.

3.1.5Management of the national debt

Another activity which is sometimes the responsibility of the central bank is the

management of the national debt. In most years since 1945, the UK government has

run a budget decit and the national debt is the accumulation of successive annual

borrowings. At the end of 2003, the UK debt stood at £470bn or approximately

43 per cent of GDP.

Decisions have to be made therefore about both the funding of new, annual decits

and the renancing of that fraction of the existing debt which matures each year. Both

can be nanced in a number of ways, each with different monetary consequences.

For example, funds can be raised by sales of marketable debt (treasury bills and

government bonds) or non-marketable debt (National Savings products in the UK).

Within each of these categories, there are further decisions to be made. Treasury

bills generally have an initial maturity of ninety-one days and are therefore highly

liquid. Bonds may have an initial maturity of ve years or up to twenty-ve years.

A decision to issue mainly long-dated bonds, for example, means that the overall

maturity structure of the national debt is lengthened, as long-dated bonds form an

increasing proportion of the total. This might cause long-term interest rates to rise

relative to short and, since long-dated assets are less liquid than short-dated ones,

the supply of liquid assets will diminish relative to less liquid ones. The opposite

consequences will follow if the authorities fund the national debt by the issue of

short-dated bills. Lengthening the average maturity of the debt is confusingly called

‘funding’, while shortening it is unattractively called ‘unfunding’. If the quantity of

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Chapter 3 • Deposit-taking institutions

liquid assets, not just money, in the economy has any effect upon people’s willingness

to spend, then ‘unfunding’ could be one part of an expansionary part monetary

policy. ‘Funding’ would be associated with a tightening of monetary policy.

Once issued, bonds can be bought and sold and may pass through many hands in

the course of their lifetime. This means that the central bank, if it is responsible for

debt management, will have to maintain an up-to-date register of bond ownership

and make efcient provision for the payment of bond interest to current holders.

Debt management was one of the oldest functions of the Bank of England. But in

April 1998 it was transferred to a new Debt Management Ofce, an executive agency

of the UK Treasury. The reason for the transfer lies in the assumption that holders

of government bonds are ‘capital risk averse’. This means that they buy bonds partly

for the secure interest they pay and also in the hope that their prices will not uctuate

beyond narrow limits. But as Chapter 6 shows, bond prices mustuctuate (inversely)

with interest rates. A central bank whose primary function is the control of ination

must be free to change interest as often as it likes. The argument is that it might

hesitate to do that if it is also trying to maximise the sale of government bonds andit

believes that buyers might be frightened off by price volatility. Without responsibility

for debt management, the Bank of England has more freedom to set interest rates as

it thinks appropriate for its anti-ination policy.