Bank of England policymakers will use their new regulatory powers to prevent credit bubbles being blown by forcing banks engaged in riskier lending to shore themselves up with more protective capital when warning signs appear from the economy, according to a draft policy document.
Under reforms of the banking system working their way through parliament, the Bank of England's Financial Policy Committee will be given regulatory control over the industry that is currently held by the soon-to-be defunct Financial Services Authority.
In a draft policy document, the BoE outlined how it would use its new regulatory powers to prevent any future financial meltdown akin to the collapse seen in 2008, which the British economy may not recover from for a decade.
One of the new powers will be the sectoral capital requirement (SCR), which gives the BoE freedom to change buffer rules for specific sub-sectors, such as residential property, as and when it sees fit.
This should give the BoE flexibility to adapt its rules quickly and stave off any meltdown by forcing banks to better protect themselves against specific exposures, assuming it heeds warning signs fast enough.
Another power will be countercyclical capital buffer (CCB), which sees regulators raise their capital requirements when credit grows more quickly than GDP, halting a bubble before it bursts.
"The use of these tools will improve the ability of the financial system to withstand shocks," said the BoE's draft policy document.
"The CCB applied to UK exposures and SCRs will be zero when the FPC judges that current and future threats to financial stability in the United Kingdom are low.
"When threats to stability emerge, the FPC would be able to raise the CCB or SCRs, requiring banks to have a larger capital buffer to absorb unexpected losses when the 'cycle' turns."
There will be an impact on the UK's economic growth if these two tools are deployed successfully, said the BoE.
"In the medium term, if these tools are successful in reducing the likelihood and severity of financial crises, their use is likely to boost the expected level of UK GDP," said the draft report.
"In the near term, while historical experience is limited, the best available studies point, on average, towards only a modest negative impact on near-term growth if the CCB is tightened, particularly if the outlook for inflation weakens such that monetary policy can be used to cushion the impact on growth."
The BoE also warned that it would have to rely on its own judgement on when to deploy CCB and SCR as "no single set of indicators can ever provide a perfect guide to systemic risks, or to the appropriate policy responses".
"To support its judgement, the FPC will monitor a wide set of information, varying over time depending on the emerging risks, including both market and supervisory intelligence, and 'stress tests' of banking sector resilience," said the BoE.
Among the indicators it will use as smoke-signals from the financial sector is the size of residential mortgage deposit requirements.