The bank bites the bullet

Whatever disagreements they may have had, the message from the Bank of England and the Treasury recently has been clear: financial stability will once again be placed at the centre of the Bank's activities.

Since operational independence was granted a decade ago and the responsibility for banking supervision was passed to the Financial Services Authority, the Bank's vestigial responsibility for financial stability – ensuring orderly markets and preventing systemic risk – was clearly secondary to its work in setting interest rates and controlling inflation. Indeed, in the Memorandum of Understanding between the tripartite authorities – Bank, FSA and Treasury – the Bank is only required to "contribute" to financial stability.

During the credit boom the Bank' s research teams produced report after report illustrating the dangers in colourful graphs with blood curdling gradients, and the Bank's officials warned of the dangers – to little avail when the credit crunch arrived and Northern Rock collapsed. If financial instability was appearing on the horizon, the Bank had no legal, statutory obligation to do anything about it, except perhaps to speak out. Now, in the reforms to the Bank announced by Chancellor yesterday, it will be obliged to act, and given the tools to do so.

The Bank may have lost a deputy governor, but it has gained clarity. The court of the Bank, its governing body, will be streamlined and a new committee of court – the Financial Stability Committee – set up to supervise and advise on policy. This innovation must have been unwelcome to some in the Bank. Its very existence looks like an admission of failure. The resignation of Sir John Gieve, the deputy governor for financial stability, also seems a thinly disguised exercise in scapegoating. The Governor and his two deputy governors are supposed to have statutory security of tenure under the Bank of England Act: the essence of independence. The rumoured horse-trading that led to this and an interlocking web of quid pro quos does not look like a proud, independent central bank setting its own course. Of all the sub-deals, the most valuable win for Mr King may well be the promotion of his protégé, Charlie Bean, to be deputy governor for monetary policy. The perception that independence has been eroded matters greatly.

Still, given all that, the Bank seems to have effectively tamed and internalised the FSC. It will, crucially, be chaired by the Governor and have an advisory rather than executive role – it will "guide" the Bank, in Mr Darling's phrase. In that, it will differ markedly from the Monetary Policy Committee. Less encouragingly, there will be no definition of "financial stability", merely a "high-level statutory objective". Perhaps, like an elephant, you don't need to define it because you know what it is when it hits you. Yet there might be an unhelpful assumption that the Bank's job is to prevent market crashes, and thus market booms, rather than deal with the consequences of such inevitable events.

The Chancellor says that the Bank will have "an improved framework for the provision of liquidity, through alterations to disclosure rules". The Special Liquidity Scheme, as Mr King has hinted in the past, will become more permanent.

There is also doubt about who might be on the new Court/Financial Stability Committee. Mr Darling has promised more detail "in due course" on how bankers and market professionals can avoid conflicts of interest. Some seasoned observers have suggested that it would not be appropriate to have any current market practioners on the FSC, and those recently retried from the scene might make a better choice. There's more agreement on who shouldn't be there. Michael Fallon, deputy chairman of the Treasury Select Committee, says: "People with senior commercial experience – national and international bankers. None of the three people at the top of the Bank of England are bankers – one is an economist and the other two are civil servants." His colleague, Mark Todd, is more forthright: "I would gently say that civil servants at the end of their careers on such committees have been criticised in the past. We need people with an active engagement in practical and technical issues."

As importantly, for the Bank, its long struggle to reform the law on failing banks has been won. The Special Resolution Regime would have eased the Northern Rock crisis, and perhaps averted nationalisation. The FSA retains its "sole" role as banking regulator, and the right to trigger the Special Resolution Regime – but the Bank can request firm-specific evidence from the FSA, and it is not clear when the Bank will, informally, become involved in the rescue of a distressed institution. All involved agree that "responsibility without power" and duplication of regulation are to be avoided. There are other problems.

The Bank of England's advisory committee of top City lawyers, the Financial Markets Law Committee, warned the Government in April that its reforms threatened to undermine confidence and make another Northern Rock more, and not less, likely. They found that uncertainty about when the Special Resolution Regime would be triggered and how commercial creditors would be treated could cause a wholesale run on a troubled bank. The FSA and City law firms are working on the issue of "close-out netting", which ensures that, if a bank becomes insolvent, its derivatives positions with other banks are terminated and any monies owed are paid. The Treasury's proposals do not sufficiently set out the position of netting under the special regime, increasing the credit risk to counterparties. It could deter non-UK banks from doing business with British lenders. If a British bank were rumoured to be in trouble, there could be a rush to withdraw funding. After all, the root cause of Northern Rock's problems was not retail withdrawals but the earlier wholesale run as other banks stopped lending to it. As ever, the devil is in the detail.

How the US Treasury plans to strengthen the powers of the Federal Reserve

The Federal Reserve should be given urgent new powers to oversee the activities of Wall Street's biggest investment banks, the US Treasury secretary, Hank Paulson, has said.

The pivotal role of the Fed in propping up the financial system was revealed in the fall of Bear Stearns, and the central bank must be given oversight of the firms it may now be called on to bail out, he said.

"We should quickly consider how to most appropriately give the Fed the authority to access necessary information from highly complex financial institutions and the responsibility to intervene to protect the system so that they can carry out the role our nation has come to expect – stabilising the overall system when it is threatened," Mr Paulson said in a speech.

Since the Fed brokered the takeover of Bear Stearns by JPMorgan in March, it has been acting as lender of last resort to securities houses, a role the Fed usually only plays for the wholesale banking system.

Financiers have been debating if the Fed's position as lender of last resort to securities firms should be permanent. Academics argue it is too late to pretend that the Fed is not ultimately responsible for ensuring Wall Street securities firms are protected.

Stephen Foley