The financial system has weathered the latest shocks, Bank of England Governor Andrew Bailey told the Istanbul Economic Forum, but resilience cannot be taken for granted. Banking systems remain well capitalised, funding stress is absent, and markets have absorbed significant increases in sovereign bond yields in an orderly way, which he credited to the post crisis reforms. The vulnerabilities he named are specific: sovereign debt markets, credit markets and asset valuations could crystallise together, and the rapid expansion of financing connected with artificial intelligence has created new exposures.
The deeper argument is about frequency. Covid, Russia’s invasion of Ukraine and the Middle East conflict each disrupted supply, they followed one another with unusual speed, and a more multipolar world in which economic policy is an arena for geopolitical competition may produce disruptions more often. A negative supply shock pushes inflation and output in opposite directions, the textbook response is to look through a one off price level increase, and that is possible only if inflation expectations stay anchored; when shocks arrive in quick succession, a recent history of higher inflation makes people expect more of it, which is the risk sequencing creates.
Fiscal policy gets the same treatment. Lower growth and repeated shocks weaken public finances while raising pressure for support, higher borrowing costs and weaker growth lift debt ratios, and if markets doubt the trajectory, yields rise further and tighten conditions on their own. Countercyclical fiscal policy gets harder to sustain as the debt stock ratchets up with each shock.
On market structure, Bailey said government bond markets were once dominated by price insensitive long term investors and are now intermediated far more by leveraged investors, while traditional demand for long duration debt has declined with pension changes and ageing populations. Absorption capacity has risen, but so has fragility: leveraged positions unwind rapidly, losses trigger margin calls and forced selling, the buyers are more price sensitive, and the same funds hold leveraged positions across several countries, so deleveraging can spread between markets. His remedies were greater central clearing, appropriate minimum haircuts and stronger risk management, alongside credible monetary and fiscal frameworks. On his own framework he was explicit: an unwavering commitment to returning inflation to target, scepticism of unconditional promises about future interest rates, and clear explanation of how policy would respond under different conditions.