Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 60-79)

SIR JOHN GIEVE, MR NIGEL JENKINSON, MR JON CUNLIFFE, MR CLIVE MAXWELL, MR HECTOR SANTS AND MR DAVID STRACHAN

1 FEBRUARY 2007

  Q60  Kerry McCarthy: But in a less regulated way.

  Mr Sants: They are presented in the market place in the same way as hedge funds are, and they can introduce variants around that whereby they can look at the components of the investment strategy and, as appropriate, introduce it into their other funds. The restrictions, just to remind you (and so we do not get confused), are on the marketing of products to UK consumers. There is no restriction on a company setting up a hedge fund utilising the various legal structures which hedge funds themselves utilise and, indeed, vice versa, a hedge fund could set up a conventional asset manager, indeed, some have done.

  Q61  Kerry McCarthy: That has made it clearer. Is the move into credit markets from equities significant or, again, is that just an example of their innovation?

  Mr Sants: I think there have always been different types of hedge funds in different spaces. As you rightly point out, when hedge funds started to develop they tended, in terms of their marketing strategies, to be focused on a particular area of which the most common classes, as you rightly identify, would tend to be equities (long and short equities), fixed income and credit, but there have always been operators in all these different segments. What, however, we have seen is growth in all these segments and we have also seen the development, as I have mentioned. As hedge fund managers develop into scale they tend to offer greater choice off their platform, and so you will see groups who previously maybe were only offering equity funds develop a credit product to sit alongside. We also see, and we have highlighted this as a potential risk, there is always the risk of what one might loosely describe as mission creep whereby a fund, which may be telling its investors it is primarily focused in a particular area because it might be concerned about maybe not achieving the returns that it is expected to or it hopes it will in that area, might be tempted to move into another area to seek to supplement its returns, and obviously that then raises issues of transparency with the investors as to whether they are fully informed as to the underlying strategy about the fund, and that is a transparency issue between the funds and the investors. We have highlighted the importance of the hedge fund community being clear with its investment communities about exactly the strategies that they are pursuing in the various product offerings that they have.

  Q62  Kerry McCarthy: It touches on the question of regulation. You say you have highlighted the importance of them being open with their investors, but to what extent do you have any regulatory powers over hedge funds?

  Mr Sants: I think it is important to be clear about this. We do regulate the fund managers who are based here in the UK. You tend to get odd comments around saying that hedge funds are not regulated. To be absolutely clear, the fund managers who are based here in the UK are regulated, and that includes our overall conduct regime. Our overall conduct regime obviously requires them to treat their customers fairly and act with integrity and honesty, and so forth. That conduct regime does apply to the managers based here in the UK.

  Q63  Kerry McCarthy: Amaranth was mentioned earlier, and this is again a question for the FSA but possibly for the Bank and the Treasury as well. What did you learn from the failure of Amaranth? What assessment did you make at the time whether it would pose a financial stability threat?

  Mr Sants: To be clear, the specific Amaranth fund which got itself into difficulty was not regulated by the FSA. We would not have direct insight, as a regulator, into the particular circumstances that occurred there. Any comments we make you have to look against the background that we were not actually the regulator for that specific fund. Having said that, as you rightly point out, you would expect us to properly consider the events there and to give consideration as to whether any lessons could be applied here in the UK as a result of what we understand happened in the Amaranth circumstances. When we look at what we understand happened there, we can reasonably say that our regulatory regime here is structured to take into account the type of issues which appear to underlie the problems which Amaranth got itself into. Of course having a regulatory regime which does focus on those particular risks does not always guarantee, and is not designed to guarantee because it is not a no fail regime, that individual fund managers will not get themselves into difficulty. It is certainly the case here in the UK, which is different to many other regulators around the world, which you will note from our various public pronouncements in response to the fact that it is a growing area which we rightly should be focused, on we have set up a dedicated supervisory group and have increased our supervisory engagement with the larger fund managers we do regulate who are based here in the UK. We now have an active supervisory programme in place with sematic visits with that group of larger funds. Of course in that visit programme we do focus on the control environment and the efficiency of stress testing and the types of mitigants that we would expect a well run fund to have in place to address the types of risks that we could envisage in the market-place. We do have a programme which is looking at those types of risk. As you would expect me to say, this is not a no fail regime. We are alert to these issues but individual firms would not get themselves into difficulties.

  Sir John Gieve: As I said in this speech the Chairman has been commenting on, it was a very interesting episode because, in gross terms, the losses were almost as big, or even bigger in some ways, than LTCM which did cause real troubles in the financial markets. This did not create a crisis although it was very painful for Amaranth and the investors in it. The question is what comfort do we draw from that. I think you can draw a bit of comfort in that they were able to liquidate their positions smoothly within working markets, that the leverage turned out to be not as great as it was in LTCM, and so on. Does that mean all is well and we do not need to worry about big price changes, in this case in the gas futures market or other markets? There were a few special features of the Amaranth case which meant that it had a few things going for it which might not always be true, one of which was it was in a special market, and the other of which was the change that hit it was a positive change for the world economy, namely a reduction in prices. If you go back to 1998, you had some big negative shocks to the world economy, the default of Russia and so, which were associated with LTCM. I thought it was very interesting.

  Q64  Kerry McCarthy: If Amaranth had happened in the economic circumstance of 1998, potentially the fall-out would have been much greater and vice versa?

  Sir John Gieve: My conclusion is that it is positive because a lot of things worked well which allowed this big loss to be swallowed by the market. I do not think it should lead us relax our guard completely.

  Q65  Kerry McCarthy: It was a particular combination of factors.

  Sir John Gieve: Yes, there were some special factors.

  Mr Cunliffe: I will just make the obvious point. Hector has talked about lessons learnt and comparing the system of regulation to which Amaranth was subject to our own system. As far as the Standing Committee on risks is concerned, as it became quite quickly apparent that Amaranth was not going to pose a financial stability risk, either in its home market or internationally, we did not discuss the financial stability risk because it did not occur. That is the sort of thing, had a risk started, we would have picked up. On why was it different to LTCM, John is right that 1998 was a particularly stressed time in the world economy because of the Asian crisis and the Russian default, et cetera. The other point I make is its leverage was less. One of the things that is different now in relation to hedge funds and the way they are regulated, because they are regulated, is that a lot of the prudential regulators focus on this question of where leverage is coming from in the financial system. Of course LTCM was very highly leveraged.

  Sir John Gieve: One other thing about Amaranth is the fact that this was supposed to be a multi-strategy firm but it actually bet the whole fund, as it turned out, on one particular strategy. I think that has sent messages through the industry, to both the investors in hedge funds and to hedge fund managers themselves in terms of risk controls, transparency, and so on.

  Q66  Kerry McCarthy: In some ways that is more powerful than any attempts at heavy-handed regulation.

  Sir John Gieve: Market restraints are very important.

  Q67  Chairman: Could I just finish this? Sir Andrew Large, your predecessor, made a speech in Hong Kong a number of years ago, "Where is the Risk?" I was not able to get it before I came here. I tried the Bank of England website but failed this morning in that. On this issue of hedge funds, he gave the impression that we do not know where the risk is. You have discussed how hedge funds and complex derivatives parcel out risk and this can lessen the concentration of risk. I accept the liquidity brings the markets and the positive aspects but does it not also mean that you cannot see where the risks currently lie and, along with complex financial instruments, this opaqueness poses a risk in itself?

  Mr Sants: I would agree with you that one of the challenges, or arguably the biggest challenge, we face from the financial stability perspective is the fact that it is almost axiomatic that markets are getting ever more complex. As you yourself have said, recent historical experience suggests that one of the positives of the increased complexity of markets has been increased risk dispersion. It is really important to recognise the hedge funds have been a primary agent in that increased risk dispersion. Our point about the benefits hedge funds bring to the system is to indicate, on historical records to date, that ability to disperse risk has been a very major benefit to the market-place. I do not want, in any way, to underestimate the point you are making, which is as markets get more complex the available transparency to the regulatory community overseeing those market places is diminished. I would make the point that even if we could see all those risks and those trading positions—I think that is where you are coming from—at a given point of time, it is not in any way clear—and Callum McCarthy made this comment in a recent speech in December on hedge funds—that we could either do anything with that information or, given the moral hazard point, should want to have that information. Whilst it is reasonable to say that visibility of risk is on a declining trend due to complexity, it is not totally clear that increased visibility of risk would necessarily help regulate.

  Q68  Chairman: Surely that is a debate for more disclosure and more transparency.

  Mr Sants: What is reasonable to look at—and we have some initiatives in this space and we are working at doing more—is focusing particularly on counterparty risk. As you will be aware, we have increased transparency of that through a voluntary reporting scheme with the prime broking and investment banks. If you mean specifically transparency of individual trading positions in something approaching real time, I am not sure that would help the regulatory community.

  Q69  Chairman: Are there any areas of hedge fund operations you would prefer to know more about?

  Mr Sants: We are seeking to operate a proportionate regime and we do think our degree of oversight of the fund managers based in the UK within our FSA remit is currently broadly appropriate and proportionate.

  Q70  Chairman: You do not need to know more about most of them. Sir John, do you agree with that?

  Sir John Gieve: I would like to know quite a lot more about markets, particularly how new instruments will behave under different stress conditions. The opacity that worries me is not so much that there is not a database people can access to find out whether hedge fund A has a position or does not have a position, it is the opacity that is inevitable because we have a lot of new instruments and new players. We do not know, for example, coming back to one of Hector's points, quite whether the patterns of correlation which people are trusting and that have held up over the last five years will continue to hold up in the future. In a way, what I think is the most worrying point in this development is not that there is not a super database where people can check positions but that people cannot know exactly what risks they have taken on because they have not seen these products through a full cycle.

  Q71  Chairman: That answers the question. We are at one, at the end of this session, on that. Could I ask this final question very quickly? There has been a suggestion from the ECB for an international highly-leveraged institutions' credit register. Do you support such an idea and do you think it will happen?

  Mr Sants: As we currently understand the idea, I do not think we would currently support it. We would have to understand more about it.

  Sir John Gieve: This is an FSA lead but I agree.

  Mr Cunliffe: I think one needs to know more about it. Some of the problems that Hector mentioned, about trying to have a real time picture and what would you do with it, would be very tricky. We prefer to focus on this question of leverage and counterparty.

  Q72  Mr Love: Can I turn to private equity? Mr Sants, you have been quoted as saying "The default of a large private equity-backed company is increasingly inevitable." What would be the consequences of such a failure for stability?

  Mr Sants: I did say that but I think increasingly inevitable does not necessarily make it inevitable but highly likely. I also said, at the same time and which is still my view, that such an event, in our view, does not pose a particular risk to financial stability. In other words, what I was highlighting there is reflecting where we are in the cycle. It is clear that private equity deals are tending, quite understandably, to get larger, the degree of leverage is increasing and the terms of financing on which it is being achieved are getting more aggressive. It seems likely, at some point, either you have a failure of the syndication process around that funding in a particular deal, or the subsequent underlying investment gets itself into difficulty, and is not necessarily able to fund the funding structure that is being set up to support that investment. That happening could then lead to losses being incurred by the investors in that particular fund or the syndicating bank. We were highlighting the importance of being focused on that point and trying to maintain the appropriate disciplines. The fact that some individual deals may fail, either in syndication or subsequently, in no way necessarily poses a threat to overall financial stability. Obviously it is theoretically possible the set of circumstances could arise but that is not our central message.

  Q73  Mr Love: If I could go on to further quote you, and you can tell me whether this is accurate or not, and I am paraphrasing. Such defaults have negative implications for lenders, purchasers of the debt, which you have mentioned, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy. We have already touched upon excessive leverage, which I think is a concern here especially with interest rates rising. Someone in the American market suggested that private equity groups were attempting crazy deals. Is there not a concern that the direction in which private equity is going could well lead to some of the difficulties that you expressed in that comment?

  Mr Sants: As I am sure you appreciate, we need to distinguish, and this is a bit akin to the hedge fund discussion a moment ago, between the general concept of private equity and the terms under which private equity deals are being done. Certainly the concern of the FSA, rightly given our remit over the financial sector, is particularly to focus on the issue of the terms and basis under which the financing is occurring. We absolutely have said that, as I have just re-capped. We do recognise that leverage is rising and that risk is increasing around the financing terms of individual private equity deals and that some of those may, in consequence, fail. As I have just said, and as you rightly quote me there, clearly theoretically—and we are now into the business of risk and probability and impact—if the deals were to be large enough and there were to be interconnecting ramifications with the funding institutions, for example if the investment banks themselves were not properly anticipating the consequences of such a failure, that could be a transmission mechanism for an impact on the wider financial system. Our judgment clearly, not wishing to repeat myself, is currently that does not look that likely, not least because the deals are not yet at a size that in any way looks like it would threaten the overall UK financial stability. It is interesting that in the States, which may be the point you are trying to draw out here, deal sizes have been rising. We have had commentators talk about deals moving more into the US$50-100 billion size, which is significantly bigger than deals we have seen here in Europe to date. It seems reasonable to assume, as we tend to see conversions over time in markets, that we will see deal sizes getting ever larger here in the UK. Possibly over the very long term some of these risks you are talking about will come further up the risk map, if you will, or there will be areas that undoubtedly the FSA should be focused on. Again, that is my earlier point about hedge funds. In response to the fact that we absolutely do think it is part of our obligation to keep an eye on developing trends and changing structures in the financial market, we have set up a dedicated group with specialisms in private equity, particularly in these large leveraged transactions, to make sure that we can properly monitor developments. As a long-term trend that we need to be very focused on, I completely agree with you. As a short-term driver for financial stability, we do not see that as a current major risk.

  Q74  Mr Love: There has been this drift upwards in the American market in particular. We are told constantly in the newspapers that the Americans are sniffing around Europe for similar types of deals. Is that something you, at this point in time, are concerned about?

  Mr Sants: From the FSA standpoint, addressing the financial stability mandate, that is not something we would currently be concerned about. Do we think, which is reflected in the comments I have already made, that individual investors and individual banks should be focused under the terms under which they are doing their current deals? The answer to that is yes.

  Q75  Mr Love: Can I move on to a term which has been used on a number of occasions so far in this discussion, the "search for yield". I want to ask each of you what you mean or understand by the term "search for yield" and what your concerns are arising from it.

  Sir John Gieve: The search for yield is shorthand for the position in which the premium offered for taking risk is reducing in a number of respects. Interest rates, especially long-term interest rates, are fairly low. People want to get a better return. They are willing to take on extra risk, for example, by buying a debt which is of a lower than investment grade. You have seen a narrowing of the gap between the AAA investment-rated bonds and other bonds. Why is this a matter of concern? The potential is there will be a snap back to more normal historical levels which will change asset prices and some people may find themselves exposed to losses. That is the fundamental worry.

  Q76  Mr Love: There were a lot of people going around saying it is the benign macroeconomic environment created by central banks, the low interest environment you talked about. Do you accept some responsibility for this narrowing of risk?

  Sir John Gieve: I have only been there a year so I am not going to claim credit for macroeconomic stability, although I suppose I was partly in the Treasury when this great stability started. I think the macroeconomic stability has been a factor in this and it has been a very successful period in the West. I suppose our worry is that people may be refining a little bit too much on that, and what Mervyn King calls the "nice decade" may actually be unusual even in a world in which the macroeconomic policy is being well run.

  Q77  Mr Love: Without creating turbulence, how do we deal with this flattening of risk, not pricing risk properly, which we see emerging?

  Mr Cunliffe: The first thing I would say is low interest rates globally and low yields look very low by historic standards but of course one does not know, there is no certainty, that interest rates should be at a certain position. There could be all sorts of reasons why interest rates are low, and there are benefits to having global rates low as far as firms and investment are concerned. Part of that issue is not just to do with central banks and how central banks happen to be operating at present. It is noticeable that even those central banks who have gone in a tightening cycle across the world raising interest rates, generally low long rates have persisted more than you might think. A lot of it is to do with excess of savings over investment opportunities in the world economy. It is to do with large reserve accumulations in Asia and now in oil producers. You have a lot of money looking for an investment home, looking for opportunity, and that pushes yields down. One does not deal so much with the problem, one deals with ensuring that the people who are taking these risks, who are looking for high yields and who have changed the pricing of risk in the investments they take, regularly stress test and examine what they would do if rates were to snap back so that they are proofed against it. There are lots of trades, for example the carry trade which is often talked about, where people need to do those tests to be sure they are robust to those changes.

  Q78  Mr Love: What about carry trades? What about some of these riskier investments that everybody accepts in principle are risky but do not seem to be priced in that way by the market at the present time? What is the FSA doing to alert those involved in this activity to do better?

  Mr Sants: You rightly identify it is not our role to directly manage individual firm's trading strategies. What is critical, and clearly the focus of our attentions as a regulator, is to seek to ensure they have proper systems and controls and proper risk management systems. There are two key components I would like to re-emphasise which have both been mentioned before, and one is a comment which we made in the FRO today. One of the features of the shorthand term "search for yield" is also people looking to utilise a greater variety of trading instruments than they did before and that does push them into illiquid and, in many cases, OTC markets. One particular risk we do want people to be focused on is the valuation point and the importance of having good valuation systems which seek to, as best they can, make sure that these portfolios of illiquids are properly valued. Secondly, and most critically—and I know you have heard this a lot already today but it is an absolutely essential mitigant for firms to be focused on here—is the ability to scenario test stress tests. It is tied back to our capital regime but it is critical that people stress test effectively. We do believe stress testing in the industry is much improved. We believe the introduction of the CRD regime is further increasing the focus in that area. Having said that, as we said before, and we have had some special papers on this topic, we think there is still more work to be done. It is drawing the extension between stress testing, to give you a layman's feel, maybe looking back at historical events and saying "If that happened, what would happen to our set of positions at the current time", but also overlaying that type of analysis with the more extreme question, which we think senior management should be properly focused on, which is under what conceivable circumstances would this financial institution get itself into difficulty. That type of stress testing is a somewhat different one to running historical scenarios. We do think more work can be done in this area so we recognise progress.

  Q79  Mr Love: Can I ask all three of you one final question about these new and complex financial instruments? A lot of this is done by computer and so the old heard instinct we have talked about in financial markets has been replaced by this thing they call black box investing when it is all done through computers. You are in the market and out of the market not based on whatever sentiment there is in the market but based on whatever the programme tells you about these complex instruments. Does that have ramifications? We have talked, in previous declines in the stock market, about this and the influence of computer programmes. Is that a worry for you? What should we be doing about it if it is a worry?

  Mr Sants: There are two types of automated risk here: one is about modelling, which we have covered already; and the second point, which is maybe what you are principally alluding to, is more to do with exchange-traded instruments and the ability of automated systems to execute large volumes of trades in very short periods of time. That is a risk we do believe exchanges and intermediaries should be focused on and we clearly believe they should have proper systems and controls in place to manage that risk.


 
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