Examination of Witnesses (Questions 20-39)|
1 FEBRUARY 2007
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 workHector
made the point that our tests are a measure of how well we work
togetherand 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 riskit
is a complex businessthat 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
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 ustake, for example, the issue of communication
to the market in the event of a terrorist incident or pandemic
fluit 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
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
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
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 inthe 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 forthhistorically, 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, secondthe point that
Hector just mentioned about interest rates running unusually relatively
lowcompared 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 marketsand, again,
this is not just the hedge funds, it is just as much the investment
bankshave 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
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
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.