Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1-19)



  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 FSA responsibilities.

  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, please.

  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 memorandum—that is what it is about—so 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 do—the 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 worked—we 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 Treasury—particularly 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 crisis—that 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 attending?

  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 since 1997?

  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 be true?

  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 stability?

  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 financial instability.

  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 movements—that is particularly the case for illiquid and complex instruments—and 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 the FSA?

  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 providers.

  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 all levels?

  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.

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