Bank of England

What is the Bank of England?

The Bank of England is the central bank for the United Kingdom. Also known as The Old Lady of Threadneedle Street, the Bank of England has been given increasingly more power and responsibility in recent years; thus increasing its role in levering London as a global financial center. Located in the heart of the UK's financial system, the Bank of England is responsible for managing the monetary and financial stability of the UK. The Bank of England's role in the UK markets can be seen very similar to that of the United States Federal Reserve. More on the similarities and differences between the Bank of England and the Federal Reserve will be discussed later.

History

The Beginning

The Bank of England was the result of the Glorious Revolution where William and Mary overthrew King James II to give power to the English Parliament.  The basis of the revolution was to create a government entity that was accountable to the people and would act in their best interests. 

In 1688, William and Mary successfully took control of the monarch.  However, they inherited a weak economy.  The new Monarchs quickly recognized the need to stabilize the economy that suffered from a poorly coordinated money and credit system.  The purpose of the centralization was two fold:  first it would mobilize national resources by ensuring consistency in money and credit conditions, second the political viability of the new monarchy would be solidified through a centralized stable economy.

 The Monarch and Parliament consulted with economists to determine an efficient way to create a central banking authority. William Paterson proposed a loan of £1,200,000 to the government. In return the subscribers would be incorporated as the governornment and the Bank of England with long term banking privileges included the issue of notes. Only £750,000 of these funds were ever deposited with the Bank and the rest was generated by Fractional Reserve Banking. The loan established a corporation, where the recipients controlled the assets provided by the loan under the title Governor and Bank of England.

Initial Functions

In 1694, the Bank of England was officially founded and received its Royal Charter.  The bank served as the governments account manager and managed the national debt.  The bank initially had two purposes, managing the national debt and stabilizing public finances.  The bank acted as the agent to issue and pay government loans, ensuring prompt payments to maintain a good credit standing.  In addition, the bank sought to stabilize public finances by establishing interest rate consistency and reducing service fees.  To aid in the stabilization of public finances the bank was open to the general public where it accepted deposits and issued notes.

Within in less than a century England became so dependant on the bank that its charter was renewed in 1781 and proclaimed the "public exchequer".  This designation officially recognized the Bank of England as the official account manager of the English government.  

Evolution of Currency

The bank initially backed the English pound with sterling gold.  The backed currency valued the pound specifically to how much gold sterling it could purchase.  The bank used this method of currency valuation because of its simplicity. Inflation rates were contained because the spending power is only the sum of the value of the gold in the economy. It also had 100% backing; if the currency were to become devalued the commodity represented by the currency still had an intrinsic value that was universally exchangeable. The final advantage to the commodity-backed currency was its designated par value.  A backed currency represents a specific amount of gold that it can be exchanged for, this enabled the bank and citizens to understand the value of their currency.  

Issues with the Backed Currency
In the late 18^th century, England found itself engulfed in the Napoleonic Wars,  the war effort consumed a great deal of the nations resources and the government was eventually forced to sell portions of gold reserves to help fund the war effort.  With a dwindling gold supply the English economy experienced a recession where the English pound had a lower purchasing power.  In attempts to control the gold supply, Parliament placed a ban on withdraws of gold form the bank.  This prevented citizens' form exchanging pounds for gold.  The restriction lasted until 1821.

In 1844, the Bank Charter act was passed requiring that the Bank of England issue notes that were only tied to the nations gold reserve. The bank was also required to distinguish its primary operational accounts into the account that issued the notes and the account that performed the daily operations. The funds of these two accounts were required to be separate and the bank published weekly reports for Parliament's oversight.

Creation of a Fiat Currency
In 1931, England officially left the gold standard and valued its currency based on government-backed securities.  England left the gold standard because of its lack of flexibility and sporadic economic growth. By the early 1900s the English empire began to discover vast gold mines in its African colonies. With the vast supply of gold, the economy began to grow at irregular rates and became sensitive to the amount of gold discovered and mined in Africa. To help control inflationary growth, England abandoned the gold standard. This enabled the economy to grow at a steady and sustainable rate. To this date England still values the pound via government backed securities.  Even though the bank no longer values the currency with gold, the entity is still responsible for managing and protecting the country's gold reserves.  

Modern Evolution of the Bank
Movement away form commercial banking
From 1920 to 1944 the Bank of England began to move way from its commercial banking practices and began to focus primarily on its central banking functions.  Acting as a central bank accounts were restricted to the English government, other central banks, and private banks.  Individuals were no longer able to hold accounts at the bank.

Important Legislation
 In 1997, Chancellor Exchequer, Gordon Brown, gave the bank of England operational independence.  This enabled the bank to establish target inflation rates and set appropriate interest rates.  Being operationally independent form Parliament placed the bank on par with the United States Federal Reserve.  The Bank of England is still subject to oversight by Parliament, each year they must present a target inflation rate and explain deviations from the target inflation rate.    

The 1998 Bank of England Act changed the governing structure of the bank to consist of a Governor, two deputy Governors and sixteen directors.

Core Purposes

The Bank of England has two core functions, monetary stability and financial stability.

Monetary Stability

The objective of this area is to ensure the stability of the currency in terms of its purchasing in England and abroad relative to other currencies.  To meet this objective the bank examines real exchange rates and purchasing power parity.

Real Exchange Rate = nominal exchange rate*(Domestic price level/foreign price level)
Purchasing power parity = Domestic price level/ foreign price level
 
The Bank's objective in monetary policy is to ensure sustainable economic growth through low inflation rates.

To adjust the level of economic growth the Bank of England conducts open market transactions by trading government debt securities.  

To stimulate economic growth the Bank of England will purchase government backed securities, this introduces more English Pounds into the economy. The more English Pounds in the economy lowers the interest rate. With lower prevailing interest rates and an abundance of currency, consumers and investors will either spend their money or place their funds into high yielding equity instruments to help grow the economy.  In addition, businesses are encouraged to increase their operational capacities because of the low cost of capital. These expansions introduce new and improved products and provide valuable research and development.

To slow the economy down the bank will sell government backed securities; this transaction will extract English Pounds from the economy.  The fewer pounds in the economy means higher prevailing interest rates. Higher interest rates encourage savings via debt instruments across the economy. Consumers are less likely to purchase goods and services and more likely to invest in bonds and CDs. Business will be less likely to expand their capacity because of high capital costs and will either place excess cash in debt instruments or distribute it to shareholders via dividends.

Accountability
To maintain effective monetary stability the Bank of England has established protocol.  Each year the bank announces its annual target inflation rate and key issues in the economy.  Currently the inflation rate is 2% and the most pressing issue is the sub-prime mortgage lending.  To meet the inflation target and address the pressing economic issues the bank is vest with the power to set short-term nominal interest rates.

Financial Stability

To run effective monetary policy a stable and sound financial system must prevail.  The Bank of England acts to detect and reduce threats to the financial system as a whole.  If a crisis plagues the financial institutions of England, the Bank will appropriately adjust interest rates to maintain the fundamentals of the market.  The Bank of England also works with the Financial Services Authority and Her Majesty's Treasury to improve and ensure the infrastructure of financial institutions in England.  The Bank's most important contribution to financial stability is its ability to act as a lender of last resort.  The Bank of England describes the purpose as, "In exceptional circumstances, as part of its central banking functions, the Bank may act as "lender of last resort" to financial institutions in difficulty, in order to prevent a loss of confidence spreading through the financial system as a whole". This means the Bank acts as the key player in rational expectations, they want to make sure people still have confidence in the economy to encourage appropriate spending.

Information and Communication plays a fundamental role in financial stability. The bank reports deviations of 1% from the target inflation rate to Parliament.

Structure within the Bank

The Bank of England is structured in a way that focuses on its two core purposes.  The Bank of England is organized into four main operational areas: Monetary Analysis and Statistics, Markets, Financial Stability, and Banking Services.  The role of the Monetary Analysis and Statistics division is to conduct research and analysis of current and prospective developments in the UK and international economies. The analysts in these groups prepare reports for the Bank of England of the current monetary and economic situation in the UK and of the outlook for inflation and growth.  The Markets division is responsible for managing the Bank of England's balance sheets, managing the UK's foreign exchange reserves, and for delivering financial market analysis and intelligence in support of the Bank of England's monetary and financial stability objectives.  The Financial Stability division works closely with the FSA to detect risks to the structure and functioning of the UK financial system and to develop measures to strengthen the financial infrastructure at home and abroad.  Finally, the Banking Services division provides banking services to the Government and other customers, principally central banks and other financial institutions.  To take a closer look at the structure of the Bank of England click on BOE structure

Other Functions

In addition to acing as the authority on Monetary Policy the Bank of England is in charge of minting English Pounds.

The English Pound comes in £1, £2, £5, £10, £20, £50.

There is also a fractional pound system called pence.   There is a 1p, 2p, 5p, 10p, 20p, 50p.

An interesting fact is that the current monarch is always on the currency.  While important historical figures such as Adam Smith and Charles Darwin, rotate their appearances on currency.

Important People in Bank of England

The Bank of England is headed by The Court of Directors who make all bank strategy decision outside of monetary policy which is the responsibility of the Monetary Policy Committee whom the Court of Directors also have some oversight. The head of the Court of Directors is the governor, currently Mervyn King. He is assisted by two deputy governors, Rachel Lomax - (who focuses on monetary policy) and John Gieve - (who focuses on fiscal policy). The Court also consists of 16 non-executive members who are experts in their respective fields and assist with the direction of the BOE. These members are appointed by the monarch.

Who Banks at the Bank of England?

The English Government

The Bank of England is in charge of managing the government accounts.  When the government collects tax revenue, the Chancellor Exchequer takes the revenues and deposits them into the government accounts at the Bank of England. In addition to making deposits at the Bank of England, the English government uses the accounts to withdraw funds to pay for social welfare programs. The bank acts as an authority to make sure the accounts remain in good standing and that there is enough money to fund the social welfare programs.  In addition to monitoring the deposits and withdraws of the English government the bank also manages the national debt.  The bank is in charge of making payments to bond holders and is responsible for maintain appropriate amounts of financial leverage.

Central Banks

Banks such as the United States Federal Reserve and the European Central Bank may also hold accounts at the Bank of England.  These bodies have accounts at the bank because they hold government backed English bonds.  The bank of England houses the principal payment and then repays the investor in the form of coupons over the bond's life.  Because the payment is prorated over the life of the bond, the other central banks hold receivable interest accounts at the Bank of England.

Private Banks

Private Banks in England hold reserves at the Bank of England. This validates the currency issued by the private bank and ensures the solvency and security of the bank for investors.  The Bank of England can further control the money supply by setting explicit reserve to deposit ratios. This requires a bank to hold a specific amount in reserve at the Bank of England relative to the number of deposits at the Bank.  Requiring the Banks to hold reserves at the Bank forces them to have accounts in which they make deposits. Multiple deposit creation stems from Private Banks holding accounts at the Bank of England. When one party makes a deposit, the bank can loan a certain percentage of the money to other investors as long as it maintains its required reserve to deposit ratio.  Excess funds are invested in additional areas designated as appropriate investments by the Financial Services Authority.

Interaction with Parliament

The Bank of England is accountable directly to the Parliment by the House of Commons Treasury Committee. The BOE's annual reports are laid before Parliment before being made public for review.  The main interaction between the two institutions is through the Monetary Policy Committee.  The MPC meets with House of Commons Treasury Committe to discuss current monetary policy as well as when new member are being appointed to the MPC.  The Treasury Committee holds no statutory power to veto MPC policy, but does have power of choice when new members are being appointed to the MPC.

Current Target Inflation Rate

As discussed earlier, one of the Bank of England's objectives in monetary policy is to maintain price stability. This price stability derives itself from low inflation. Low inflation is key to a country that wishes to achieve sustainable economic growth over a long period of time. Each year the Chancellor of the Exchequer announces the yearly target inflation rate. Currently the target inflation rate for the BOE is

                                                                                                    2%

At this 2% inflation rate level, the BOE believes it can maintain constant economic growth while also maintaining price stability. The annual rate of inflation is based on the Consumer Price Index (CPI). This 2% target is a goal set by the BOE and by no means necessary does this gaurantee that the existing rate of inflation in the UK will be exactly 2%. The real inflation rate in the economy is very volatile and always changing. Therefore, through the changes of interest rates, the BOE will attempt to move the existing inflation rate towards the 2% target.

The Bank of England Museum states that besides famine and war the most detrimental and harmful occurence that can happen in a society is high inflation. This hightened sense of awareness of inflation mirros the Bank of England's policies regarding inflatoin. Any time the target inflation rate is missed by more than 1% (inflation below the 2% target is just as bad as inflation above the 2% target), the Governor of the Bank of England, in this case Mervyn King, is required to write an open letter to the Chancellor explaining why inflation is above/below the target and must state what the BOE hopes to do to get the inflation rate back to the inflation target. In other words, the Bank of England is very serious and open about it's current level of inflation and hopes to enlighten the populace on its seriousness and deadliness if not kept under control.

Bank of England's Relationship with other Regulatory Bodies

The Bank of England works closely with two other regulatory bodies, Her Majesty's Treasury (HM Treasury) and the Financial Services Authority (FSA), to ensure monetary and financial stability.

HM Treasury

The HM Treasury is the economic and financial ministry of the United Kingdom. This government body was organized by Henry I in 1126  and carries out many of the economic policies enacted by the Bank of England.  Its primary objective however is revenue collection, which is carried out in the form of taxes. HM Treasury is accountable to the Parliment.

FSA

The Financial Services Authority is and independent body that regulates the financial services industry in the United Kingdom. According to the Financial Services and Markets Act 2000, the FSA has four statutory responsiblities:  

• Market confidence
• Public awarness
• Consumer protection
• Reduction of financial (white-collar) crime 

The Financial Services Authority is governed by a board of directors, appointed by the HM Treasury.  The Bank of England works with the FSA to ensure consumer confidence in the economy by closely monitering the financial climate. The BOE and FSA share the common goal of making the British economy more efficient and ensuring that the United Kingdom remains a global financial center.

Bank of England vs. The Federal Reserve

The Bank of England shares many simularites and a few differences with its American counterpart, the Federal Reserve system.

 Similarities

The most obvious characteristic shared by both is that they serve as Central Banks for their nations. Central Banks have a huge impact on economies because they set monetary policy, and in times of crisis act as a lender of last resort. Setting monetary policy, another responsibility shared by both, is often made through adjusting interest rates.  In the United States, the Federal Reserve system (the Fed) manages monetary policy by adjusting the federal funds rate which is the rate of interest banks are charged for borrowing from the Fed.  In the United Kingdom, their is a nominal interest rate that is set by the BOE which has an equally large effect on its economy as the U.S. economy. Overall, both institutions are very similar in how they operate, yet there are a few key differences.

Key Differences

The Bank of England has in the past been a more transparent organization than the Fed.  Mainly the BOE is very open with its reasons for changing interest rates or target inflation rates. As mentioned earlier, if the BOE is unsucessful in implimenting its proposed changes, an open letter must be written stating reasons for the failure.  The fed operates in more privacy. Often, little reason is given as to why a certain stance has been taken by the organization. The chairman of the Federal Reserve board of govenors, currently Ben Bernanke, is known as the second most powerful man in the world in part because there is so much discression given to the Fed.  Another more subtle difference is that the BOE share much of its regulatory power with the FSA and HM Treasury. In the United States, the Fed is solely responsible for regulating banking.

Bank of England's Role In Levering London as a Global Financial Center

The Bank of England has been able to maintain positive economic growth, low inflation, and financial stability since being given operational independence in 1997. This period of economic stability has provided a solid foreground for London to become THE global financial capital of the world. The Bank of England will be able to lever London as a global financial centre in the future through the following ways:

• Determine a reasonable minimum market interest rate that will encourage spending but also saving. This will in turn affect inflation rates and exchange rates.
• Determine the target inflation rate and growth rate which will in turn determine how much investment will come to England.
• Get involved in the financial markets by becoming the lender of last resort to companies that could serve as a threat to the market as a whole.

The Bank of England is one of the main reasons why London is a global financial center today and the BOE will continue to play a pivotal role in determining whether this continues in the future.

Bank of England Museum

Bank of England Museum Website

Located in the Bank of England on Threadneedle street, the Bank of England Museum tells the story of the Bank of England from its foundation in 1694 to its role today as UK's central bank. Open Monday through Friday from 10:00am - 5:00pm, the museum contains many historical displays discussing past banknotes, famous people, and how the Bank of England came to be what it is today. It also features many informative intercactive videos discussing monetary and fiscal policy and a quite intriguing video which gives the history of inflation and the possible threats in poses on a society.The Bank of England Museum also features a display case of 59 gold bars each worth around 168,000 pounds.

After a visit to the Bank of England Museum not only does one come away with knowledge of what the Bank of England is and what it acutally does but one is also able to see the major differences between how the Bank of England goes about its work with respect to how the Federal Reserve goes about its objectives. On the outside they both wish to achieve economic stability and long term growth. But it is through things like the Bank of England Museum and the yearly proclamation of the target inflation rate that the Bank of England can be seen as much more transparent than that of the Federal Reserve, who does much of its work in secrecy leaving the markets, the academia world, and the populace questioning their next move. 

We believe the Bank of England's tranparency and willingness to be open about its policies is one major reason why London has acceled to be THE global financial center in the world today. The Bank of England Museum is just one of the ways that the Bank of England maintains a constant visiblity to the people.

Bank of England's Effect on the Exchange Rate

The Bank of England plays a very important role in determining the direction of trade in and out of the UK through their control of interest rates. A decision to change interest rates by the Bank of England will effect exchange rates either positively or negatively. Let's go through an example to illustrate just how this works

Example - Due to a lack of sustainable growth in UK markets, the Bank of England decides to lower interest rates to encourage consumer investment and spending. This decision is an example of expansionary policy and will effect the exchange rate between the UK and other countries. Assume the US interest rate remains stagnate, what is the effect on the exchange rate between the US and the UK? What is the effect on the strength of the dollar and the pound?

Answer - When thinking about this quesiton you should remember the formula:

       *Change in exchange rate (£/$) = UK inflation - US inflation*

Because the Bank of England demonstrates expansionary policy through a lowering of interest rates, the UK inflation will increase (supply of money has increased) while the US inflation will stay the same. An increase in UK inflation implies appreciation of the dollar with respect to the pound and thus the exchange rate becomes more favorable for people living in the United States and less favorable for UK citizens looking to trade with the US. In the end an increase in UK inflation because of a decrease in interest rates not only has a major effect on global trade but also effects study abroad students like us who buy goods from other countries.

The Bank of England Effects YOU

Believe it or not, YOU SHOULD CARE ABOUT THE BANK OF ENGLAND. I know it's hard to believe, but this institution plays a very important and vital role in determining many variables that affect you each and every day.  

• The Bank of England determines interest rates which we have just seen effect inflation and in turn affect the value of the dollar and the value of the pound. This effects the price at which you and I are able to buy goods in England and abroad. A change in policy by the Bank of England could determine whether you buy that Big Mac for 2.8£ or .99£ .
• The Bank of England directs the monetary and fiscal policy in one of the world's largest economies, that of the UK.
• In addition to the above bullet point, in today's global economy a period of downfall in one country will most likely in some way affect the economy of other countries. In this case, if the Bank of England mistakenly lets the UK economy fall into a recession, most likely the US economy will suffer and you will see an impact in your everyday life.

Therefore, in today's global economy it should not be surprising that the Bank of England plays almost an equally important role in shaping a US citizen's life as the Federal Reserve.