Examination of Witnesses (Questions 1-19)|
1 FEBRUARY 2007
Q1 Chairman: Good morning and welcome
to our inquiry into financial stability. Can you identify yourselves
for the shorthand writer, please?
Mr Jenkinson: Nigel Jenkinson,
Director for Financial Stability at the Bank of England.
Sir John Gieve: John Gieve, Deputy
Governor of the Bank.
Mr Cunliffe: Jon Cunliffe, Managing
Director, International Finance, at the Treasury.
Mr Maxwell: Clive Maxwell, Director,
Financial Services, at the Treasury.
Mr Sants: Hector Sants, Managing
Director, Wholesale, Financial Services Authority.
Mr Strachan: David Strachan, Leader,
Financial Stability Sector Team and Director, Major Retail Groups
Division, Financial Services Authority.
Q2 Chairman: We have got double vision
for each institution, but if one person from your institution
can answer the questions, that will comply with our target of
finishing by half past eleven at the latest. The Memorandum of
Understanding has recently changed. What were the main changes
and why were they brought about?
Mr Cunliffe: It was changed, I
think, to bring it more up-to-date with the operating experience
of the years since 1997 and the changing circumstances. For example,
one of the main changes is that it now has quite a developed section
on business continuity operational risk and how the Standing Committee
addresses that, because that work very much developed after September
11. It also has some clearer statements, I think, of Bank and
Q3 Chairman: Sir John, I note the
memorandum changes the Bank's core responsibilities. In the original
memorandum it said that it was "responsible for the overall
stability of the financial system as a whole", but it now
"contributes to the maintenance of the stability of the financial
system as a whole". It would seem, on the surface, that the
Bank's role has been downgraded. Why has that happened?
Sir John Gieve: I do not think
the role has been downgraded, I think that the words capture it
better now. To say that we were responsible uniquely for the financial
stability of the whole system was an exaggeration.
Q4 Chairman: An awful lot of thought
should have gone into the Memorandum of Understanding in 1997.
Are you saying that there was less rigorous thought going into
that, Sir John? I want Sir John to answer that because it is a
bit of a flippant answer.
Sir John Gieve: I was not intending
to be flippant. I was trying to make a point.
Q5 Chairman: We want to get underneath
the surface, Sir John, just the same as we are trying to do with
departmental budgets. For example, we looked at the Home Office
the other day in the Spending Review. So give us thorough answers,
Sir John Gieve: I am sorry, I
was not intending to be flippant. Both the original statement
and this revised memorandum were agreed before I got to the Bank,
but the whole point of this memorandum is that the stability of
the financial system is, in fact, a joint function, if you like,
of the three parties to the memorandumthat is what it is
aboutso I think it was rather odd to say in the first one,
and I think it is an improvement to say in the second one, that
the Bank contributes to the financial stability but it is not
solely responsible for it.
Q6 Chairman: It seems a bit of a
change. Jon, can you enlighten us?
Mr Cunliffe: I would just make
three points. First, the memorandum was drafted before the Financial
Services and Markets Act had gone through and before the FSA was
formally established under its powers, so it was right to revisit
that. Second, we have learnt in the light of experience. Working
together on financial stability is an art, not a science, and
I think we have a better understanding now of how the institutions
fit together, but in 1997, when they had no experience of working
together, it was a new system. The third point I would make is
just to echo what John has said, which is that financial stability
involves no one organisation, it involves the Treasury, the FSA
and the Bank, and the way we operate together produces financial
stability. We each have distinct responsibilities and accountabilities
but the three pieces have to fit together, and I think it is particularly
an awareness of that that underlies this. We do not give the overall
responsibility for financial stability to the FSA or to the Treasury,
it really requires the three to work together.
Q7 Chairman: Can I ask one person
from each institution how, in your opinion, has the Tripartite
Standing Committee functioned and what is undertaken to try and
monitor the effectiveness of the Tripartite Committee?
Mr Cunliffe: If I start off for
the Treasury, I think it has functioned well. It is true, and
I say this thankfully, we have not had to test it in a major crisis,
but it has come through a number of events, like the July bombings,
like September 11, like problems with individual institutions.
Part of the Standing Committee's objective is to increase co-operation
and information flow between the authority, so part of it has
grown over time through the experience of working together, and
we have become more systematic in what we have done. I would say,
examples of how we monitor its success: we monitor what the industry
thinks of, for example, the exercises that we dothe recent
business continuity exercise we followed up with a questionnaire
of those participants, we followed up on the July bombing event
by asking the market how they thought arrangements had workedwe
hold conferences with the market to get their views on these issues,
and the general view seems to be that the co-ordination and co-operation
have worked well and, indeed, other countries have adopted it.
Sir John Gieve: I was briefly
on the Standing Committee in the Treasury in 2001 and I think,
in the last five years, coming back to it, the thing that strikes
me most is that it has become more systematic in its assessment
of risks. It does that better. It has become much more systematic
in doing exercises, both within the tripartite group and with
the market, on financial crisis exercises but also operational
crisis exercises. I suppose the third thing, coming back to your
first question, which is a reflection of the change here, is that
there is a better understanding and acceptance of each other's
roles. Perhaps when the original MoU and the original Standing
Committee were set up we were still feeling our way on exactly
where the boundaries were.
Q8 Chairman: Hector, if you answer
for the FSA can you take in question one as well? Was your influence
over the past few years significant in ensuring the change in
wording the Memorandum of Understanding?
Mr Sants: We certainly do believe
that currently the process functions well. I think, in terms of
supporting that, what is definitely key, from our point of view,
is the type of feedback that we get through both some of the actual
events that have occurred and, more critically (because they in
a way have been more demanding hypothetical incidents), the actual
testing that we have done. We do get extensive feedback from the
market. Obviously we are speaking to firms on regular basis, so
we are not just getting feedback through our lessons learned exercises
and documentation around our tests, but we are also getting informal
feedback from our one-on-one conversations with market participants,
and the general flavour that we get from that is a perception
that we are doing a good job. In terms of the MoU from the FSA's
point of view, I think we do feel, both through the MoU and, in
a way, echoing some of the earlier comments, more importantly,
through regular interaction with the Bank and the Treasuryparticularly
through the tests, though, critically, we do all understand better
what our relevant roles are and, particularly at the operational
level, how it would all fit together in the event of a crisisthat
testing it all works is actually the real way to get into the
guts of whether it is functioning properly rather that the particulars
of the memorandum; and the fact that we have done tests in the
last year or two which previously had not been done, I think,
is critical to us feeling that it works better.
Q9 Chairman: Would one of you answer
the question. Why do only deputies normally sit on the Tripartite
Standing Committee, not principals?
Mr Cunliffe: Because in normal
times the role of the Committee is to share assessments, exchange
information, look at litigation. There is a fair amount of technical
work there. The minutes of the Committee are then sent up to principals
and it is possible to have a discussion with principals on that,
as sometimes happens, and, of course, any of the three principals
could call for a meeting whenever they choose.
Q10 Chairman: The memorandum contains
a section saying that principals may sit as a Standing Committee
at times of crisis. How often has the Committee met with principals
Mr Cunliffe: Luckily, as I said,
we have not had a crisis to deal with, so it is really a question
of testing. We recently carried out a test at principals' level
to look at a crisis and some of the things that would occur and,
on the basis of that, we decided to run a full-level test with
deputies and principals in the first quarter of this year.
Q11 Chairman: So it is has met once
Mr Cunliffe: It has met once formally
at principal level to test the crisis, yes.
Q12 Peter Viggers: What really happened,
surely, is that the Labour Government came in with a landslide
majority in 1997 and in came a great clunking fist with one big
idea and, as a result of that, making the Bank of England independent,
we had this Memorandum of Understanding in 1997. Paragraph two:
"The Bank's responsibilities. The Bank will be responsible
for the overall stability of the financial system as a whole."
The Treasury then fought back, "My God, what have we done?",
and in 2006 you have a totally different idea. "The Bank's
responsibilities", under the revised Memorandum of Understanding:
"The Bank contributes to the maintenance of the stability
of the financial system as a whole", one of its two core
purposes. That is what happened, surely, Sir John?
Sir John Gieve: I was not around
negotiating the first one. Jon was, so he can tell us.
Q13 Peter Viggers: That has got to
Mr Cunliffe: I have to say, it
is not a version of events I recognise at all. I think the initial
Memorandum of Understanding was a way to try and bring three authorities
together when we realised they each had a piece of financial stability.
I would say, I think it is ahead of its time. All European countries
have now followed this. It is becoming in the financial stability
forum, if you like, "advanced technology", but financial
stability is not an easy issue. As you work at it, you understand
more of it. The FSA at that point did not have its full powers
under the Financial Services and Markets Act. We did not have,
for example, the operational issues that we have now. The framework
has evolved over time to reflect the responsibilities and give
a better understanding of how we act in a crisis. Of course, from
1997 to 2006 the financial sector, both nationally and internationally,
has changed enormously. So I would regard it as the evolution
of what I think is a good idea, an idea that has been adopted
by many other countries.
Q14 Peter Viggers: Can I ask the
lead witness from each of your groups, how would you define, in
simple terms, financial stability? What are you seeking with financial
Mr Cunliffe: I think you are seeking
to ensure that the financial system can operate, can play the
role that it needs to play in the economy as a whole.
Sir John Gieve: I think it is
easier to define financial instability actually; and the instability
that we are concerned about is a loss of functionality in the
financial system which would damage the wider economy because
it no longer functioned to bring savings and investment into balance
or to transmit money effectively round the system.
Mr Sants: I have not got a lot
to add to that last comment other than maybe just to elaborate
that probably the two main transmission mechanisms for the financial
market place impacting on the real economy would probably come
either through operational infrastructure disruption or through
market movements and subsequently, therefore, financial instability.
That is the mechanism by which the financial market place would
transmit a shock into the real economy which would then create
Q15 Peter Viggers: Can I ask each
of the three of you, please, to characterise the current environment
for financial stability? What are the principal risks at the moment?
Mr Cunliffe: It might be best
for the FSA and the Bank of England to start with that, because
the FSA has recently done an analysis and the Bank has published
its Financial Stability Review.
Mr Sants: As I am sure you have
seen, we published our Financial Risk Outlook this morning. The
central comment in there, which is repeated in a variety of different
terms of phrase but, broadly speaking, is that the view of the
FSA is that currently (and obviously "currently" is
a key word) risks to financial stability are relatively low? We
are saying that in our annual review but we are making the point
that, if anything, the directional trend here is one of increased
risk rather than decreased risk, not least of which just the statistical
fact that markets have been pretty benign, and that does tend
to led to an increase in risk being taken by financial participants.
If I was asked to expand a little bit further on that in terms
of the potential risks which could lead to financial instability,
if you would like me to elaborate on that, I would make the point
in passing with regard to the FRO that that looks at the risks
to the FSA, not specifically risks to financial stability. If
I was to pull out of the FRO some key points, I would come back
to some of my earlier comments. We really group them under two
headings, which is "risks to market infrastructure"
and then "financial market risks". As you can see from
the material, in terms of risks to market infrastructure we have
pulled out three particular ones: genuine external event risks,
of which we would have two subcategories, pandemic and, regrettably,
terrorism, but also here we would talk about operational risks
within the market place, particularly derivatives; and then, under
the financial market risk category, I think we would broadly pick
out a couple of themes, one under the strap-line which is called
the "search for yield", which is the tendency of financial
market participants to look for ever greater returns, which is
a challenge when markets have been benign, and that can lead them
to place risk in areas which carry risk in the event of sudden
market movementsthat is particularly the case for illiquid
and complex instrumentsand I think the other area within
this category of financial market risks that we want to highlight
is, clearly, we have been seeing increased correlation between
various components of the financial market place between various
asset categories, and of course the risk of that is that market
participants are not fully thinking through the consequences of
that correlation having increased and are turning to model their
trading strategies and hedging techniques on historic correlations
which have been a lot wider and therefore provide greater opportunity
for risk dispersion, and that carries through into a whole series
of possible consequences. So, that gives you a bit of a flavour
of the potential risks we are talking about, but, as I say, we
have made an essential assertion there that currently we feel
the risk is relatively low for the forecast period of the document
in front of you.
Q16 Peter Viggers: I am grateful
for that. May I ask each of you please, if you can, very simply
to spell out your own field of responsibility in controlling risk?
Mr Cunliffe: The Treasury is responsible
for the overall framework, the legislative framework, that governs
the powers of the Bank of England and the FSA and elsewhere. We
are responsible for reporting to Parliament, in the event of a
crisis, on the way in which the crisis has been handled, although
I assume Parliament would also want to talk to the authority specifically
responsible, the FSA and the Bank of England, and, of course,
we are responsible for decisions around, in extreme circumstances,
the use of public money to support institutions in the financial
sector. We are responsible for international negotiations around
financial regulation and the setting of financial regulation legislation
through Brussels which then comes into UK law. Also, and I think
the revised MoU tried to bring this out, in the event of what
I have to call an event risk, say from terrorism or pandemic flu,
then the Treasury has the responsibility of ensuring coherence
between what is happening in the financial sector, what action
is taken in communications and what is happening in the broader
public sector around public services and how an incident of that
sort is run.
Q17 Peter Viggers: And the Bank?
Sir John Gieve: The Bank's responsibility
and role derives from its responsibility for setting interest
rates and implementing monetary policy, its role in overseeing
the payment systems, and its operational role as banker to the
banks and, therefore, the provision of overall liquidity to the
market. It also, because it has a depth of economic expertise,
has a role in identifying and analysing the sources of vulnerability
in the global economy. I broadly share Hector's assessment of
the risks but our publication, if you like, tends to home in on
the broader economically-based risks in the financial system.
Q18 Peter Viggers: Thank you; and
Mr Sants: I think the FSA's powers
and responsibilities are clearly set out in the Financial Services
and Markets Act, but, broadly speaking, I would characterise those,
as they are in the MoU, as the responsibility for supervision
of firms and institutions within the financial sector, both on
prudential and conduct issues, also, of course, their authorisation,
and, probably particularly relevant in the context of the discussion
here, of course, regulatory policy and supervision does cover
the need to promote proper and appropriate operational platforms
to deal with potential operational disruption. So it covers the
need to ensure sufficient and adequate business continuity arrangements
being in place within those firms that operate within the financial
sector, and I use "firms" in a loose phrase because,
of course, it covers recognised exchanges and other infrastructure
Q19 Peter Viggers: Would the Bank
and the FSA say a word about the practical manner in which you
co-operate? How do you share information? Do you have staff exchanges
from time to time? Do you have a happy working relationship at
Mr Sants: I am happy to reassure
you on those points, is the headline answer. To the particular
question, we have a number of different mechanisms to make sure
we regularly exchange information on an informal basis; we have
made sure we have built up the right level of contacts in all
the working level committees and, in practical terms, in terms
of people picking up the telephone. We do capture that in an annual
review of our relationships to make sure that we have not got
any gaps there and that all the individuals in the organisations
feel the information is flowing freely, and, in particular to
your question of data exchange, yet again, as set out in the MoU,
we do exchange data and we clearly make sure that we are working
together towards a common goal. I genuinely believe that all our
practical level participants do feel that. As I have mentioned
before, we feel the market place gives us positive feedback on
the way we interact.
Sir John Gieve: Obviously at a
senior level, Hector or David attend our Financial Stability Board,
I am a member of the FSA Board, Callum McCarthy is a member of
the Bank's Court, so there is interaction at every level.