Examination of Witnesses (Questions 80-91)|
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
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
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
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
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
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