Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 80-91)

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

1 FEBRUARY 2007

  Q80  Mr Love: From the Treasury's point of view, is decline going on further than it should be because they are all coming out from computer programmes?

  Mr Cunliffe: On that my view does not differ from Hector. The additional point I make is it has made the speed of change in financial markets much faster and, therefore, for us, as authorities trying to react, we have to raise our game to be able to react in real time much more quickly than you would have done before automation.

  Q81  Mr Love: You would agree with that?

  Sir John Gieve: Yes.

  Q82  Peter Viggers: Crisis management. If there is a crisis of operational disruption, the crisis is led by the bank, but if it is financial disruption, it is led by the FSA. Who decides which it is? I think I know the answer but I put the point to the Treasury.

  Mr Cunliffe: Actually what the Memorandum of Understanding says is that the tripartite will agree who is the lead on the crisis or particular aspects of the crisis. What very often happens is a crisis starts in one area and then it moves somewhere else and it starts to involve a different part of the financial sector. The tripartite would analyse what was happening and decide which institution should be taking the lead in the light of its responsibilities. A good example would be an operational crisis, something like a terrorist incident, where the Treasury would be very much in the lead in terms of co-ordinating what is happening between the broader public response and the financial sector, but if that started to cause problems in markets and elsewhere then that lead would pass over to the FSA because it would become a certain type.

  Q83  Peter Viggers: The Treasury would no doubt decide that. The 1996 Memorandum of Understanding says there will be a Standing Committee of representatives of the Treasury, Bank and FSA. The 2006 Memorandum of Understanding says the Standing Committee on financial stability is charged by the Treasury. The Treasury has, in fact, clawed back overall control, has it not? I am not saying it is wrong.

  Mr Cunliffe: I thought the original MoU was 1997. The Treasury has chaired the Standing Committee from the outset. The first chair was Sir Steve Robson, who was then the Permanent Secretary dealing with it, and that has not changed. I think the words reflect the enduring reality.

  Q84  Mr Gauke: We have high levels of household debt compared to income at the moment. We also have rising interest rates. Do any of you consider that is a threat to financial stability and, if so, what are you doing to mitigate that risk?

  Mr Strachan: It is very timely. That issue is covered in the Risk Outlook we published yesterday. We are quite clear that at present we do not see rising household indebtedness as a financial stability issue but I would not want to understate the fact that household indebtedness goes to a number of the other FSA's other responsibilities. In particular, the work we are doing around financial capability and financial awareness, in order to help consumers understand more about their own finances and the risks of taking on debt, is very much a priority for us at present.

  Q85  Mr Gauke: Before turning to the others on this question, you say the FRO addresses this. It states that "In an extreme scenario where consumers' credit quality deteriorated rapidly, we would need to liaise closely with the Treasury and the Bank of England to ensure that overall financial stability was not affected." What do you mean by an extreme scenario in those circumstances? How likely is that? How extreme is extreme?

  Mr Strachan: Extreme is a very low probability event. You are referring to one of our alternative scenarios that we have set out in the FRO. We have not defined "extreme" but clearly if the numbers of consumers in distress was rising, if the distress was extending from the unsecured borrowing market into the secured borrowing market and the housing market ever increasing, then at some point we would want to, as we do regularly anyway, share views with our tripartite partners as to the nature of the developments and whether we thought, at that point, there might be a threat to financial stability. It would be a situation we would be monitoring very closely as it developed.

  Q86  Mr Gauke: Is there anything further to add on the wider question of household debt?

  Mr Cunliffe: There is nothing to add on the financial stability judgment of the FSA. On the question of financial inclusion and financial capability, this does affect a number of households and the Treasury has a fairly large agenda to try to both develop people's financial awareness, how they take on debt and deal with the financial sector and products, and to try to improve the advice people get when they do run into debt distress. The last question is a macroeconomic one which we discussed at the time of the PBR. The FSA are assuming a large shock to employment and the economy to drive that. It is always a risk but not one of our central scenarios.

  Sir John Gieve: I draw a distinction. This is on our radar and always is, whether household or corporate debt get into an unstable state. The point is these are relatively slow burn things. You should be able to see it coming over a long period, therefore it is quite difficult to envisage how it would cause a sudden crisis in the operation of markets.

  Q87  Chairman: I gather from that it is not in your top 10 of worries.

  Sir John Gieve: It is on our top six if you look at the list.

  Q88  Chairman: The New York Federal Bank's president, Tim Geithner, was talking about Federal risk in the OTC derivatives. He is quoted as saying "Exposures are harder to measure because investments in credit derivatives contain embedded leverage where one's exposure to profit and loss is multiplied many times compared to the same investment in the underlying conventional security." The problem for central bankers, he says, is that embedded leverage has expanded phenomenally and does not appear on balance sheets so it is impossible to quantify embedded leverage across the financial services industry. In other words, no-one can be sure how much capital to set aside as insurance against these leveraged bets going wrong and whilst risk management techniques have improved they remain flawed in fundamental respects. Would you agree with that?

  Sir John Gieve: First of all, coming back to this area after several years, risk management has become a lot more professional, both at this level but also in the firms. Secondly, the question is: has it kept pace with the markets. I think, in some respects, it probably has not. Picking up one point Hector made, the valuation of some of these instruments is still extremely difficult and therefore it is difficult to manage around that. Tim is right in saying there is still quite a lot of work to do. Some of the measures which are very well established, like VaR and so on, are useful but clearly not the whole story which is why you have to do stress tests and so on.

  Q89  Chairman: So embedded leverage not appearing on balance sheets is a problem to central bankers as well as regulators.

  Sir John Gieve: I was not making a point about the accountancy profession and how they should treat it. I would put it a different way. Some of these are very highly geared bets and so there is more risk in them than some of the holders may realise.

  Mr Jenkinson: We do have a box in our Financial Stability Report in July which does talk about leverage. It does talk about embedded leverage and it does say that is more difficult to calculate but is something to monitor.

  Q90  Chairman: All your financial stability reports are coming out in April so it would be good to see a reflection of that debate, embedded leverage and hedge funds, so if you could take that message back.

  Sir John Gieve: We will definitely have a box on hedge funds.

  Q91  Chairman: This is the first occasion the Tripartite Committee has been to the Committee and I think it is a very worthwhile initiative for us and for you. It has been very helpful to us and I thank all of you for coming along. We nearly made 11.30 am but a little extra time does not do any harm.





 
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