Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 20-39)



  Q20  Chairman: We did visit the Bank's Court, and at a later date we will have them in, but do the Court get information on your deliberations in the Tripartite Committee?

  Sir John Gieve: Yes, we do report to them, obviously, on this part of our work. We do a quarterly report on financial stability, or we are about to start one, which covers both where we have got to in our assessment and what we have been doing about it. For example, we are reporting this month on the pandemic exercise which the tripartite authorities carried out to Court.

  Chairman: You mentioned the search for yield, and in your report you say that has been supported by a favourable economic background and a low volatility environment, but it has driven down the returns from traditional low-risk investments, encouraging investors to look towards less well understood, and potentially riskier, asset classes. The issue of transparency is an important one. If you could you incorporate that into your answers on hedge funds and credit derivatives when we come to that later, I would be grateful.

  Q21  Mr Gauke: Can I ask representatives, again, from each institution, how do you each measure your success in ensuring financial stability?

  Mr Cunliffe: It is extremely difficult to have a quantitative measure in that sense. The UK financial system and the global financial system have been stable for a number of years, but causality is difficult to prove and I would not take that as a measure of the success of the tripartite. I think we look to the success of the things that we are doing. In a way, one is trying to measure the success of the outputs rather than assuming the outcomes, and there I think I look for whether we have a systematic process in the Tripartite Committee for comparing risk assessments, for bringing new information in and for having discussions when there are differences of assessment to make sure we all understand what is going on; whether we are able, through joint discussion, to identify gaps in action that we might take to mitigate and whether, between the authorities, we can agree which authority is best placed within its own responsibilities to take that sort of action; whether our tests work—Hector made the point that our tests are a measure of how well we work together—and what the market thinks of them and how we deal with actual incidents.

  Sir John Gieve: I suppose we look at this on two sides. One is: "What is the state of financial markets? Are markets liquid? Have there been crises?", and so on, where the record is pretty good. The other is: "What is our contribution to that?" What we try to do, apart from the things Jon has mentioned, is to get some feedback from markets as well as from other governments, other central banks, on whether the analysis that we are doing and publishing is helpful, is moving, and understanding financial markets, and so on.

  Mr Sants: From our point of view, to add to, rather than repeat, what has already been said, clearly the FSA has particular responsibilities for interacting with individual firms. One way of judging whether we are being successful with regard to the financial stability question, using the sort of analysis I have offered earlier out of the FRO, is to try to identify what we might think would be a likely driver of the causes of financial instability and also, consequently, what the right sort of mitigants would be and then to have a look within the individual firms and their frameworks as to whether they are properly addressing those sorts of issues. Without repeating myself on the earlier risks, if you then take a view, for example, that relative to market infrastructure clearly we need a robust operational capacity, business continuity planning with regard to event risk or, for example, with regard to operational efficiency, we need a robust operational platform, then we can measure are the firms making progress in those areas. So we have a benchmarking survey, which we do publish, with regard to operational preparedness. We clearly monitor the degree of settlement efficiencies in the market, and we have had a number of initiatives recently jointly, particularly with the Fed, with regard to credit derivatives, and there is more work to be done, may I say. So we can monitor, as it were, both the success of the firms in putting in mitigants and the external issues, particularly with regard to financial risk. Similarly, we will be talking there about mitigants being stress tested, and we have done work with firms both to encourage and improve stress testing. One of the bigger themes of our FRO is the need for stress-testing to be improved further. We have made visits to firms to see what sort of level of progress they are making. Of course, more generally, it should not be forgotten, it is easy to deep-dive into the detail. Of course, a core mitigant with regard to financial stability is the overall robustness of the financial sector, the quality of the balance sheets and the general strength and the ability of the institutions to withstand financial shock, which, of course, we are addressing through our overall prudential regime. So, as it were, from the bottom up you can build some pretty good data points, assuming you have picked out the right drivers. Of course, there is always a risk—it is a complex business—that the drivers will not necessarily be the ones that you have focused on, and that should all supplement the top down comments made by my colleagues here.

  Q22  Mr Gauke: As Mr Cunliffe pointed out, there has not been a financial stability crisis since these arrangements were set up. What would you say if someone said, frankly, the tripartite arrangements have not made any difference to that, it is more a matter of luck, that you can each do your separate work in your own silos and, as long as you do that all right and the world economy is ticking along all right, really it has not made any difference? What would be your response to that view?

  Mr Cunliffe: I think my response would be that one has to try and prepare for the future even though you do not know what the future will hold. Some of the events that we prepare for are low probability but very high impact events, but they are significantly low probability, very much in the tail of the probability distribution. Nonetheless, we do need to prepare for them, we do need to find ways of trying to see whether we could work together well and co-operate. If you look at the interactions between us—take, for example, the issue of communication to the market in the event of a terrorist incident or pandemic flu—it is a clear case where the authorities need to work together because communication is one of the tools you use to manage a crisis. If we all worked in our silos with our responsibilities without this formal structure for co-operation and co-ordination, you could argue that we cannot prove that it has made a difference that we work that way, but I think it would be dangerous for the future. I chaired the Deputies' Committee, which enjoyed an earlier existence, through the incidents of September 11, and am trying now to imagine what would have happened had we not had the committee, but I think, in terms of communication and relations with other governments and other authorities and just co-ordinating in areas where the FSA, the Treasury and the Bank had interests, it would have been much more difficult without the structure.

  Q23  Mr Gauke: Can I ask each of the organisations what resources are devoted to financial stability, looking at numbers of staff, expenditure, et cetera?

  Sir John Gieve: Directly we have a division under Nigel of about 100 people working on financial stability issues. That includes a team of, I think, around 10 who work on financial crisis management. As to business continuity work, we have a single team covering the external responsibilities and our own preparations internally within the Bank, and there are about 15 people in that.

  Mr Cunliffe: We have 75 people in the Treasury who work on the financial sector generally. We do not pull out financial stability issues specifically in each area. A lot of the different teams have financial stability responsibilities. Then we have six or seven people who have specific responsibilities for financial stability and operational stability and supporting the Tripartite Committee.

  Mr Sants: The direct co-ordinating team, which is David's team, has some 15 or so people in it, but, of course, in our case, the type of issues that we are addressing, the ones I have just set out, are also part of our day-to-day activity. So, in that sense, you could say that effectively all our staff engaging with the larger institutions who are central to the financial system are party to this overall initiative.

  Q24  Mr Gauke: Let us move on to prudential regulation. Sir John, from the perspective of the Bank of England, no longer the prudential regulator for banks, how do you ensure that you have still got the information gathering skills and expertise to ensure that any interventions you ever make are successful? How close is your ear to the ground, given that you are no longer the regulator of banks?

  Sir John Gieve: Firstly, Hector has talked about the exchange of information between the FSA and the Bank. We would rely on the FSA's sources of information and, indeed, we collect some of their information for them through various surveys that the Bank runs, so there is an exchange of information that way. We do not try and replicate the sort of relationship that supervisors have with individual banks. That has moved to the FSA. However, our markets division, which deals with the money markets and foreign exchange markets on a daily basis, obviously has day-to-day contacts and we have developed over the last few years a more systematic market intelligence function based in that division which tries to get round and talk to the main players in a variety of other financial markets, and we think that that gives us a supplement, if you like, to the information that we get from the FSA and elsewhere.

  Q25  Mr Gauke: To what extent is prudential regulation about stopping financial stability crises and to what extent do you feel that you have got control over prudential regulation, (because obviously a lot of that is determined at a European level) to address any concerns that you might have?

  Mr Sants: David looks after our main UK banks. Perhaps he might answer.

  Mr Strachan: The essence of prudential regulations is probably twofold: firstly, to make sure that the firms that we regulate have adequate capital and, secondly, to make sure that their risk-management systems and processes are robust. Clearly, both of those go to help reducing the likelihood of any financial crisis arising and, indeed, the work that we are doing on stress testing that we have commented on publicly goes right to the heart of both those areas, the capital strength and, indeed, the quality of the systems and controls; so the two are closely linked.

  Q26  Mr Gauke: Are you satisfied that the instruments that you have at your disposal are sufficient as far as financial stability is concerned?

  Mr Strachan: We have a risk-based capital framework which will be enhanced by the introduction of the Capital Requirements Directive, we have the ability to use supervisory review, impose additional requirements when we think that is necessary and we have got the rules and requirements in place that enable us to do the work that we need both from a prudential standpoint and a financial stability standpoint.

  Q27  Mr Gauke: Sir John, could I now move on to issues relating to monetary policy. Clearly, you, in particular, have a dual role as a member of the MPC. To what extent in your role as a member of the MPC do you bring a financial stability angle to the discussions and how important is that to the discussions of the MPC?

  Sir John Gieve: The financial system is a key part of the transmission mechanism for monetary policy, and that is one reason why the Central Bank cannot step away from a concern for financial instability. The two go together. But the sort of issues that I am talking about in the Standing Committee are essentially about systemic risk and the risk of instability incidents and crises. We tend to be talking about, if you like, the tail end of the distribution, the improbable events; whereas naturally in the MPC in normal times we are talking about the balance of risk but we are broadly focusing on what is most likely to happen. What I would say on the MPC is that, of course, I bring my knowledge and the work we have done on the financial sector to the table, but I do not see that as in normal times determining how I vote because it is a different question that I am addressing.

  Q28  Mr Gauke: Does it work vice versa? Is your knowledge of the monetary position and the thinking of the MPC helpful in understanding financial stability risks at all?

  Sir John Gieve: Yes. If you look at the risks that we have identified, one of those is global imbalances, another is the low level of risk-premium within interest rates and so on. Those are macro-economic facts, and we are looking at them from both points of view. So I think there is a synergy between the two and, of course, on the Financial Stability Board of the Bank, which produces the report, are the executive members the MPC. So, yes, there are many common features. For example, if you are looking at why the money supply has grown so rapidly over recent years, one thing you will notice is that most of that unusual growth has been in the financial sector, and so having an understanding of what the structural change is in the financial sector is relevant both to the monetary analysis and to the risk analysis.

  Q29  Chairman: Thank you. Before I go on to Kerry, each of you, what would you currently regard as the top three risks to financial stability? Hector, I will start with you.

  Mr Sants: I think, on balance, given the fact that whilst the probability might be difficult to predict, the impact would clearly be high. I think that potential types of external events which would then drive through to financial stability (and I have obviously already touched on the ones that we particularly highlight in the FRO) would have to be, I think, at the top of the list currently. Having said that, as a small rider, as I also mentioned earlier, clearly it seems reasonable to forecast that financial market conditions will get more difficult just because of the length of time we have been in this relatively benign period, so that relative importance of market events, I think, will rise over the coming months.

  Q30  Chairman: Give us, at the end, the top three. Just make it simple for us?

  Mr Sants: The top three. If you take them at the very high level, number one is infrastructure disruption, I think number two is the possibility of correlation changes reverting back towards the norm that has not been properly anticipated by market participants, and in a way linked into that, so it is partially three, would be a widening out of credit spreads going back towards more norm, and that is also linked into the structural change in volatility. So, it is really market conditions going back to the norm.

  Q31  Chairman: Presumably correlation changes to the norm means that economies can dip. Is that another way of saying that?

  Mr Sants: I am sorry.

  Q32  Chairman: "Correlation changes to the norm"—what does that mean in ordinary language? The TV is on here. People are going to be watching at three o'clock in the morning. They want to know exactly what you are saying?

  Mr Sants: What we are saying is that at the moment, if you look at the financial world in terms of the different types of instruments that are out there that financial market participants can trade in—the highest level equities, fixed income and physical assets, commodities, and then, of course there are subclasses of those depending on the way the structures have been developed convertibles, credit derivatives and so forth—historically, if you measure the degree to which they will move in parallel or move in a predictable way, these classes have been reasonably widely dispersed. So, if there was a movement in one, it was not necessarily the case that the other one would go down as well. What you are observing in financial markets is, as liquidity is increased and the number of participants has increased and the number of vehicles participating in the underlying assets has increased, these classes of assets have moved more in tandem. The risk of that, of course, is that if something happens in one part of the system it will now affect the whole of the system more quickly, and maybe with a greater impact, than it would previously have done.

  Q33  Chairman: So there is a bit of a herd mentality?

  Mr Sants: Yes, there is a risk of a herd mentality, and this where the phrases of "crowded trains", for example, come from.

  Q34  Chairman: We are getting there. Plain English, Jon.

  Mr Cunliffe: First, in plain English, choosing three is difficult because I do not see that there are three pre-eminently above the broad spread of risk that Hector managed. If you ask me to mention three in addition to Hector, I would say, first, event risk, either coming from an event like pandemic flu or a terrorist incident, second—the point that Hector just mentioned about interest rates running unusually relatively low—compared to the last 50 years spreads between different assets are unusually lower and one is concerned about how the sector would manage if that corrects, and the third, not a direct risk but something that is a concern that we are working on, is how internationally we would manage the impacts of a financial crisis because, of course, the international aspects of the financial sector have always been there but the global financial sector is integrating more and more rapidly.

  Q35  Chairman: You would say you handled the Asian crisis quite well in 1998, would you not?

  Mr Cunliffe: Yes, I would say that, but I think the financial crisis that came out of that was limited very much to Asia. There was a big impact on what we call the international financial architecture, but there are questions about how we would handle very improbable low probability but very high impact events of institutions that operate in a number of developed markets.

  Q36  Chairman: Sir John.

  Sir John Gieve: In terms of events, I think it is the pandemic and geopolitical crisis of one sort or another. In terms of what that produces: a sharp turn in the credit cycle, a widening of spreads and therefore a change in asset prices. The third thing, I suppose, is the "untestedness" of the new derivatives markets when that happens.

  Q37  Chairman: On that "untestedness" in the new derivatives market, I note your speech at the Hedge 2006 Conference in October when you said that the Bank of England had looked at the last financial stability report in July and identified six main sources of vulnerability in the financial system, and the growth of hedge is not one of them. Nor, I believe, would it have been in the next six. So hedge funds, credit derivatives, is not in the top 12 of sources of financial vulnerability.

  Sir John Gieve: Yes, what I went on to say was that, nonetheless, hedge funds come in 40 times or more in the FSR, so they are a new factor in the financial markets. The point I was trying to make was that the spreading of risk, of which the growth of hedge funds has been one part, is in itself a positive in many ways in terms of financial stability because it allows the key players at the centre of the financial system, whose failure would have very widespread consequences for the economy, to off load some of their risk. But as I have just said, the fact that the derivatives markets—and, again, this is not just the hedge funds, it is just as much the investment banks—have grown and developed very rapidly in clement times and the fact that those have not been tested in a genuine downtown and a point of turn of the credit cycle means that we face some risks, because none of the players know quite how they will behave. The risk that they will behave differently is what Hector has talked about.

  Q38  Chairman: On the surface, it surprises me. It reminds me of Sir Humphrey telling his minister that he is making a brave statement since it is not in your top 12 risks. I note the ECB saying that an idiosyncratic collapse of a key hedge fund or a cluster of small funds would be in the same category as a possible bird flu pandemic as the types of shocks that could trigger fresh disruption in financial markets. What I am asking you to reflect on is: would it not be in your top 12?

  Sir John Gieve: I have not got a top 12, so I cannot give you the full list. I have got a top ten, actually, and it is not in those, and I do not think it would be on the next two, because I do not think it is the existence of the hedge funds or the fact that hedge funds may lose a lot of money, as Amaranth did, that is, if you like, the vulnerability in the financial system as a whole. Certainly they are players and if there was a crisis certainly there would be hedge funds involved in it, but the fact that hedge funds have become more prominent I do not think myself is one of the major risks.

  Q39  Chairman: My questioning has been around complexity and opaqueness, and it is on that issue that I want to keep going. You would not reassess your top ten, let us be modest, so you would not have that in there. Nigel, do you want to speak?

  Mr Jenkinson: We have clearly identified, as Hector indicated earlier, the question of the search for yield, the question of the unusually low premium for bearing risk, and market characteristics which have given rise to that in recent years is on our list but, as Sir John indicated, it is not the existence of hedge funds per se that is on our risk list, it is more the question of market conditions in general.

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