House of COMMONS









Thursday 20 September 2007



Evidence heard in Public Questions 1 - 149





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Oral Evidence

Taken before the Treasury Committee

on Thursday 20 September 2007

Members present

John McFall, in the Chair

Mr Graham Brady

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

Mr George Mudie

Mr Mark Todd

Peter Viggers



Witnesses: Mr Mervyn King, Governor of the Bank of England, Sir John Gieve, Deputy Governor Responsible for Financial Stability, Mr Paul Tucker, Executive Director for Markets, Ms Kate Barker, External Member of the Monetary Policy Committee, and Dr Andrew Sentence, External Member of the Monetary Policy Committee, Bank of England, gave evidence.

Q1 Chairman: Governor, good morning to you and your colleagues and welcome. Can you introduce your colleagues for the shorthand writer, please?

Mr King: On my immediate right is Sir John Gieve, Deputy Governor for Financial Stability. On his right is Kate Barker, one of our External Members on the Monetary Policy Committee. On my immediate left is Paul Tucker, the Markets Director at the Bank, and on his left is Andrew Sentence, another of our External Members.

Q2 Chairman: Governor, you will recollect that the idea for the meeting arose from your suggestion that we consider the August Inflation Report. Obviously this meeting has been given added relevance by recent developments so in that context we are grateful for the paper you sent me last Wednesday 12 September. In that letter of 12 September you told us that providing extra liquidity at longer maturities - in your words - undermines the efficient pricing of risk by providing ex post insurance for risky behaviour and that you would conduct such operations only if there were strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future". However, yesterday you conducted such operations. What has changed in the past seven days?

Mr King: I think the events of last weekend and the impact on the confidence that people have in the banking system generally could have been shaken by the scenes that were seen on television. I do not think there is any fundamental reason to doubt that but, as I said in the statement I sent to you, the balance of judgment between how far you extend liquidity against a wider range of collateral on the one hand and being concerned to limit the moral hazard on the other, to limit the ex post insurance, is a judgment that we are making almost daily in the febrile circumstances of the time. The operation yesterday was carefully designed and judged. It does not give ex post insurance, it is limited in size, it is limited in amount to each individual bank, and that provides a strict limit on the extent to which there is some ex post insurance, so we have balanced the concerns about moral hazard against the concerns that arose at the beginning of this week about the strains on the banking system more generally.

Q3 Chairman: Your critics would say, Governor, that if you had undertaken the same steps as the ECB and the Fed then we would not have had the Northern Rock problem?

Mr King: Could I set out my explanation for why I do not think that is an argument that I accept. After the events in August, which essentially closed the markets in asset-backed securities, Northern Rock was then a company with a highly illiquid set of assets. Its assets comprised essentially mortgage-backed securities and plain mortgages which have not yet been securitised. The markets in those assets were closed. Northern Rock tried to sell some of those assets, not just to the UK banking system but overseas as well, without a great deal of success. The real problem facing Northern Rock has been that the assets side of its balance sheet suddenly became highly illiquid, and one has to ask the question who would have lent or who would have bought the assets from Northern Rock? Well, they tried and did not find any buyers. At that point I think it was clear that in one form or another Northern Rock required as a backstop a lender of last resort. The natural place to look for a lender of last resort is the central bank. You could ask whether the market could have been the lender of last resort for Northern Rock. I think the only circumstances in which that would have been feasible would have been when we had gone back to normal circumstances and banks had already financed the taking back onto their balance sheets of the conduits and vehicles that they now expect over a period to take back onto their balance sheets and were once again in a frame of mind to be willing to lend to others who had illiquid assets. To do that I think would have meant to inject a massive amount of liquidity in order to get back then to where we were in July. The Federal Reserve and the ECB have gone nowhere near that far at all. So the question is how could the market have been an effective lender of last resort to Northern Rock? In these circumstances it is natural to regard the central bank as being the lender of last resort. In a minute I would like to go on to explain what were the problems that arose in our trying to be lender of last resort.

Q4 Chairman: Let me ask a question, if you like what the ordinary person in the street is asking: Governor, how did we get to a situation where the effort put into rescuing Northern Rock is the equivalent of screaming "Fire!" in a crowded and darkened cinema where everybody rushes for the door and there is sheer and absolute panic, all as a result of one company maybe having a bad business model? I want to extend the questions to Mr Tucker who is the Executive Director of Markets and also to Sir John Gieve who has the responsibility for financial stability. How did we get there?

Mr King: Can I just answer that first and explain how we got there. You are quite right to be concerned about shouting "Fire!" in a crowded cinema. One of the major considerations during August was there was no reason to believe that it was inevitable that Northern Rock or any other bank would get into difficulty. There were clearly liquidity problems; they might or might not have been resolved. To have announced at that stage either a liquidity injection on such a scale that all the banks would have had their immediate liquidity difficulties dealt with or to have announced at that stage a guarantee for depositors in every bank would undoubtedly have been a signal that the authorities were deeply concerned about the entire UK banking system. That is wholly unfounded. The UK banking system as a whole is well-capitalised. In this context we should be grateful that banks did make profits in the last five years. They have a large capital cushion. They can take the conduits and vehicles that they set up in recent years back on to their balance sheets. It will take a little time and the banks will make lower profits than they would have wished but there is no threat to the stability of the banking system. To have announced measures on such a scale that would have suggested that we did not have that confidence I think would have been irresponsible, so the question is what happened with Northern Rock? The main point I want to make to you this morning is that the interaction between four apparently unconnected pieces of legislation prevented us from carrying out the operation that we wanted to do. You have a major role as a Committee in trying to get us into a position where these problems will not arise again.

Q5 Chairman: We want to broaden this inquiry - I certainly want to - to have the FSA before us who are coming just after we come back to Parliament and also to have the Treasury as well. I will ask you later but the Tripartite Agreement seems to me to be fundamentally wrong.

Mr King: I will come back to that. The most important point I want to make is to ask yourselves how would the Bank of England have dealt with this in earlier years. How would it have dealt with this in the 1990s? The first way it might have dealt with it was to invite the directors of Northern Rock and prospective purchasers into the Bank or the FSA for a weekend to see if that could be resolved and a transfer of ownership agreed over the weekend such that the depositors in Northern Rock would have woken up on Monday morning to find themselves depositors of a larger and safer bank. That is not possible because any change of ownership of a quoted company - and Northern Rock is a quoted company - cannot be managed except through a long and prolonged timetable set out in the Takeover Code. The second way in which the Bank would have preferred to do it in years gone by, and did do it in the 1990s, and the way that I would have wanted to do it on this occasion, is to have acted covertly as lender of last resort, to have lent to Northern Rock without immediately publishing that fact, publishing it after the operation had been over so that you and others could hold us accountable for the operation itself. As a result of the Market Abuses Directive in 2005, we were unable to carry out a covert lender of last resort operation in the way that we would have done in the 1990s. There is a great tension between asking companies to disclose things which may affect the decisions of shareholders and on this occasion asking them to disclose something which actually undermined the ability to carry out an operation which I believe was in the interests of everyone connected with the company. We were forced back to doing it in a covert way.

Q6 Chairman: Sir John Gieve and Paul Tucker, the Governor mentioned the assets were illiquid. Certainly the financial services companies who have spoken to me in great numbers over the past few weeks have said that Northern Rock was on the lips of a number of people for the past few months. Sir John, you sit on the FSA; were you having a sleep in the back shop while a mugging was taking place in the front?

Sir John Gieve: I am on the board of the FSA, that is true. I do not think the FSA or the Bank were asleep at the wheel.

Q7 Chairman: I am asking you, Sir John, about your responsibility. Do not talk to me about the FSA ---

Sir John Gieve: I thought you were asking me as a member of the FSA board.

Q8 Chairman: Exactly, for your accountability.

Sir John Gieve: I do not think I was asleep at the wheel. Yes, you are absolutely right, Northern Rock was in the newspapers and people could see that its business model made it more vulnerable than other banks, and the timing of the troubles in August were particularly severe for them because they were working up to a securitisation in September, so through August there was very close monitoring of their position and before it came to a Bank of England facility being offered, the FSA took the lead with Northern Rock in looking to see if there was a private sector solution but a private sector solution was not available, could not be mounted, and as a result we then moved on to our offering a liquidity facility to them. We knew when we did that that the announcement of that would have two effects: a good effect because it would show they had a new source of finance but a bad effect because it would send the market a signal that they really needed a new source of finance. In the event we knew that there was a risk that that balance would go the wrong way and it did.

Q9 Chairman: But let me go back a bit because Northern Rock grew three times faster than any other company in the past year. I was with a major retail bank just the other evening and I said to the Chief Executive, "Why didn't you grow like Northern Rock?" and he said they would not do it because it would have been folly to do it and the risks were too great. Someone should have seen the risks that Northern Rock were taking. It does not seem to me as if anyone took any concern about it, so we have one company with a bad business model which ends up threatening the financial stability of the country and therefore your role as Deputy Governor and as an ex officio member of the FSA seems to me crucial here. Should that not have been spotted?

Sir John Gieve: The first people of course who are responsible for the business model and the decisions of Northern Rock are the Northern Rock board. Secondly, of course the FSA through their supervision team have been keeping closely in touch with Northern Rock, as with other banks, throughout. You are saying should someone have stepped in and prevented them running the business they ran?

Q10 Chairman: No, what I am saying to you is a wonky business is in existence that may jeopardise financial stability; you have an obligation to ensure that you are up to the mark in seeing that and taking anticipatory action. That is what I am saying. I am not saying you should interfere. Mr Tucker, everybody was saying that Northern Rock was almost a basket case.

Mr Tucker: It is not just a question of the individual firm; it is also definitely a question of the wider market circumstances and, as the Governor mentioned, there are two key features to those, first of all the asset-backed securities seized up on the basis of problems in a relatively localised area - sub-primes - most obviously because of severe concerns ---

Q11 Chairman: But Northern Rock never had sub-primes on its books and the fact is everybody knows that Northern Rock grew because it depended on wholesale markets, they did not have enough lenders so it goes to the wholesale markets all the time.

Mr Tucker: That is where I was leading, Chairman. So the concerns around the asset-backed securities markets and about the credibility of ratings caused the asset-backed securities market to dry up. The key point I think is the way this jumped from the capital markets into the banking markets or the money markets and that was based on the fact that the bank had provided very large committed lines of credit of liquidity to a lot of vehicles in the system, and faced with an increased probability of the drawdown of these massive lines of credit they started to stockpile liquidity rather than lend in the term money markets. The striking thing is that this was a feature not just of the sterling markets in London but of the dollar markets in the States and the euro markets on the Continent, and irrespective of the fact that the three central banks concerned have taken different approaches to their operations in those markets, there has been a global drying up of term liquidity and, as you say, Northern Rock was badly exposed in those circumstances.

Q12 Chairman: Governor, I am not getting much comfort from the answers I am getting here. There is an obfuscation going on. There is a simple issue here.

Mr King: Let me try and put it simply: what happened on 9 August was that there was a realisation of an event that we had been warning against for a long time which is that the markets and the securities that many banks and others had been creating suddenly dried up. In the Mansion House speech in June I said very clearly the liquidity of markets in complex instruments is unpredictable. The problem for Northern Rock was that if that eventuality materialised they would end up with a massive maturity transformation on their balance sheet. At that stage it was clear that at some point a lender of last resort might be necessary. My basic point to you this morning, as I started earlier, is that the interaction between different pieces of unconnected legislation made it almost impossible for us to conduct the lender of last resort option in the way that we would prefer. I am willing to go through the other events and explain what happened.

Q13 Chairman: You have just explained the model of the lender of last resort. That model is really not fit for purpose now, is it, it has to be looked at.

Mr King: Can I explain why.

Q14 Chairman: It has to be looked at.

Mr King: There are certainly question marks over it but the question marks are not because we cannot in theory act as a lender of last resort but because in practice we are hemmed in by this interaction between these four pieces of legislation. Firstly, you cannot transfer the ownership of a bank over a weekend because of the Takeover Code. Secondly, the ability to conduct covert support, which would avoid the risk of creating concern among depositors, is ruled out because of the Market Abuses Directive. Thirdly, once retail depositors have become concerned - and it was not obvious that the announcement of the lender of last operation would result in people wanting to take money their out, it could have gone either way - once that run had started people were not behaving illogically in joining it and wanting to take their money out also because of the two other pieces of legislation. Firstly, there was the way in which when banks are put into administration retail depositors find their deposits frozen and they cannot access them, even in a solvent bank, and that is not something that any depositor would want to take a risk on and, lastly, that the deposit insurance is less than 100% for most of the deposits. We now require a serious reform of deposit insurance, of the administration of banks, of the clash between the wish for transparency of companies to their shareholders, the tension between that and how it applies to banks when in difficulty, and the length of time it takes to deal with transfer of ownership of banks. Those four things are fundamental. If any one of those had not been there, there would not have been the problem with the lender of last resort operation. It required all four to be there to prevent us acting in the way that we wanted to do.

Q15 Chairman: These are issues which we are going to be looking at, Governor, because the focus of this Committee will be looking at where the weaknesses are in the whole system. One area of weakness I would suggest to you is in the Memorandum of Understanding in Financial Stability because that means that different authorities in the tripartite agreement can "lead different parts of a crisis" and when Mr John Cunliffe was here before the Committee a few months ago he gave a commentary on the Memorandum of Understanding saying that the parties will agree who is in the lead of a crisis or particular aspects of the crisis. Who was in the lead in this crisis and did that change in the past few days?

Mr King: No, each party in the tripartite authority has separate responsibilities and if you ask me how would this have played out if we had not had the Memorandum of Understanding, I do not think it would have made any difference to the substantive problems we faced and I think it would actually have made it harder to manage the process. The great virtue of the MoU is that it does not change the instruments available to the authorities in any way. What it does do is to clarify responsibilities, everyone knows what their job is, and it enables us to know and to practise beforehand how we communicate with each other. When it comes to the question of decisions that might involve taxpayers' money it is right and proper that in the end the Chancellor has to approve any risk to taxpayers' money.

Q16 Chairman: Everybody knows what their job is but really the view in society is that nobody knows what they are doing in this case, Governor, that is the reality.

Mr King: I think that people outside the financial sector must regard what has happened with utter bemusement. We are in a strong British economy - we still are - we are in a strong world economy and these problems were not caused by what was going on in world markets.

Q17 Chairman: God help us if we get a weak economy in the future.

Mr King: It is good that it has come at a time like this rather than at a time of weakness and the reason for that is in the past many difficulties in the banking sector have come as a result of serious macroeconomic problems where there have been major defaults and holes in the assets side of the bank's balance sheet and we are not in that position, this is entirely a question of the structure of the liquidity funding of the banking system.

Q18 Chairman: When you talk about everybody knows their own job, Governor, I have to ask you this question because it has been in the public press: are you your own man? Were you lent on in this situation? Is that why you did the U-turn in the past seven days?

Mr King: No, I can assure you that the operation we carried out was designed in the Bank. Of course in these circumstances I want to discuss it with Callum McCarthy and the Chancellor. It would be very odd if they were to have woken up and found we had done this and they did not know anything about it, so of course we discussed it, but I give you my personal assurance that I would never do anything unless I thought it was the right thing to do. The independence of a central bank is not just about legislation; it is about having people in the central bank who will do what is right for the country in their job and not do what people ask them to do, whether it is the banks or whether it is politicians.

Q19 Chairman: What I take from this just now, Governor, is that the issue of lender of last resort, the tripartite arrangement, deposit protection - to name three at the moment - are issues that really need to be looked at and addressed again.

Mr King: Absolutely, and I would urge you all to regard this as a cross-party issue and I think it is of fundamental importance. Our system for dealing with insolvency of banks and deposit insurance is markedly inferior to other countries. That has been true under governments of all parties in this country. I think this was the unintended consequence of different pieces of legislation coming together and it needs to be acted on speedily because the guarantee that we have in place now for the banks cannot be a permanent solution; we will need an exit route. It will require speedy thought and action and the thought needs to come first. Parliament is absolutely crucial in this and your Committee has an enormously important role in leading a cross-party discussion on how we improve these matters which in the end, in my judgment, were responsible for the difficulties that we had last weekend.

Chairman: It does not look today as if people have come out well of it so we have got to try and rescue it somehow. Michael?

Q20 Mr Fallon: Governor, how long have you been at the Bank?

Mr King: Sixteen and a half years.

Q21 Mr Fallon: You run exercises to test financial stability all the time. Why have you just discovered that all these legal instruments are somehow suddenly inadequate?

Mr King: Some of them we had realised and discussed before and that had come out of, exercises; on some of them work is already going on, as I understand it, to think of the legislation; and others are much more recent. I think the problem in the Market Abuses Directive which prevented my first preference course of action here, which was to be a covert lender of last resort, is it only came into effect in 2005, the wording in it is ambiguous. I had still hoped and indeed I pressed strongly for the ability to conduct a covert operation but in the end the strong legal advice among the tripartite authorities was that it could not be done.

Q22 Mr Fallon: It is like the designer of the Titanic saying it was unsinkable and then we discovered that once four of the first six compartments are flooded the whole thing sinks. You are telling us you cannot handle a financial crisis.

Mr King: No, none of what happened was inevitable but given what happened at each stage if any one of those four pieces of legislation were not there we would have been able to get through it. This was the unintended consequence of these things. The legislation on disclosure was ambiguous and I thought the right way was to conduct a covert lender of last resort operation and I believe that would not have caused what we saw last week, the run of depositors on Northern Rock.

Q23 Mr Fallon: Okay, let me come back to the Chairman's question as to who is really in charge of this affair. You provided the additional funding that Northern Rock wanted but you are isolated in the Bank from its operations; the FSA said it was solvent but they cannot intervene in the markets; and the Chancellor then guarantees the deposits. Who is actually in charge?

Mr King: I think those different actions are all important and they all go to the responsibilities. This would have been no different without the Memorandum of Understanding.

Q24 Mr Fallon: Who was in charge?

Mr King: What do you mean by "in charge"? Would you like to define that?

Q25 Mr Fallon: What our constituents want to know given this mess is who is in charge of it, who is responsible?

Mr King: We are each responsible for the various responsibilities that we have been given under the MoU. The final decision on whether to put taxpayers' money at risk obviously belongs with the Chancellor, you would expect that. I do not have the authority to put taxpayers' money at risk. The responsibility for the design of the operations in markets that we carry out is our responsibility at the Bank and the judgment about individual institutions is that of the FSA.

Q26 Mr Fallon: Do you not see that three of you having different responsibilities all trying to reassure investors in your different ways that Friday morning ended up with the result that savers did not trust any of you - the Chairman of the FSA, you as Governor, or the Chancellor - because there were three people saying the same thing.

Mr King: No, it is not true there were three people all out there saying the same thing. The question of trust is one that you may want to reflect on. The behaviour of depositors in Northern Rock was, in my judgment, a consequence of a perfectly rational interpretation of what the end game might be. It was not so much a question of trust. Once the depositors of Northern Rock had heard the bad news and they suddenly realised that Northern Rock needed a lender of last resort facility - this is the problem with an overt operation - once they had seen that there was bad news about Northern Rock, and they could not possibly be reasonably expected to have been sitting at home thinking about the wholesale funding structure of Northern Rock, once they learned that there was concern about Northern Rock it is not that surprising that they thought perhaps it might be safer to take some money out.

Q27 Mr Fallon: Would it not have been easier to have handled this affair if you were still in charge of banking supervision?

Mr King: I honestly believe not. I think that now there is a much more formalised and legalistic framework of supervision, which is not a consequence of the division between authorities but of the evolution of the financial system. I know that Callum McCarthy and Hector Sants have been working day and night to monitor all the institutions for which they are responsible. We have been extremely busy in the Bank doing the same for our responsibilities. The idea that one institution should cope with all of these I honestly do not believe would make sense. As I said, the root cause of this, in my view, is not the question of who does what, you can argue the merits of that quite separately and I do not believe it is a question of who is responsible for what or the fact that there is a tripartite agreement. My own view for what it is worth is that the MoU worked well and it is very sensible to have the responsibilities laid down so that you know what we are accountable for. The problems in this case were quite different. They came from the inherent logic of the economic position that Northern Rock found itself in and the various constraints that were placed on the ability of the authorities to take action.

Q28 Mr Fallon: Okay. Given the that additional funding offered to Northern Rock had to be overt in the end why have you not made public the advice in the letter that you sent to the Chancellor last Thursday?

Mr King: I should be very happy to publish it at any moment but that is a question for the Chancellor and not for me.

Q29 Mr Fallon: He is preventing it being made public?

Mr King: No, I do not think. I would welcome it if you would like to ask him now for the letters. I have nothing against publication but I do not think it is for me to proffer that.

Q30 Mr Fallon: I see. If all the deposits in any bank are now guaranteed by the Government how does that not encourage exactly the kind of excessive risk-taking that you warned us about?

Mr King: It does not encourage the moral hazard of the banks themselves. It encourages potential moral hazard on the terms that might be offered to retail depositors, not the structure of the funding which the banks put in place for the conduits and vehicles and the risk of a big maturity transformation. You are quite right, however, this is not a sustainable position and it is very important that we move as quickly as possible to an exit route towards a sensible framework, but that sensible framework will not be where we started. The system of administration for banks which means that retail depositors find their deposits frozen for months on end and they cannot access them is a system which is a direct inducement for retail depositors to take their money out at any sign of trouble.

Q31 Mr Fallon: On what date did you first become aware that Northern Rock was seriously exposed with the freezing up of the wholesale market?

Mr King: Would you excuse me if I refer to the sheet which sets out dates here because you have asked about dates and I would like to run through the calendar and I would like to refer to this in doing that?

Q32 Mr Fallon: I just want the date you first became aware of it.

Mr King: 14 August was when the first tripartite phone call between deputies took placed and I was alerted to it. 9 August was when the financial market disturbance began and it was on 14 August that I was first alerted to that.

Q33 Mr Fallon: On what date were ministers first alerted?

Mr King: On the same day, I imagine, because it is a tripartite process. I cannot vouch for who in the Treasury was told. You would have to ask them; I do not know that.

Q34 Mr Fallon: Were you aware that in its interim statement on 21 July Northern Rock reported that the FSA had allowed it to weaken its balance sheet by widening its Basel II waiver and thus enable it to pay a 30% increase in its dividend?

Mr King: I was not aware of that on 25 July. After that it became irrelevant, it was water under the bridge. What I had to deal with on 14 August was the position as it was on 14 August.

Q35 Mr Fallon: Were you not involved, Sir John? Did you not read the interim statement of Northern Rock?

Sir John Gieve: No, I did not read the interim statement of Northern Rock.

Q36 Mr Fallon: It was the bank that was most exposed to the freezing of the wholesale markets because of its particular business model and it produced interim results on 25 July and you did not read them?

Sir John Gieve: No, I did not. Remember this was 25 July. At that point the markets were disturbed but the events of 9 August had not happened, and I do not as a member of the FSA board try and second-guess the teams who actually carry out the supervision, who of course would have been in close contact with Northern Rock or indeed with any other bank.

Q37 Mr Fallon: So neither you nor the Governor realised how exposed Northern Rock was until the middle of August? Is that the position?

Mr King: The 14 August was when we were first informed through the tripartite process. That is the process that informs the Bank. We do not monitor individual institutions.

Sir John Gieve: Can I just say that in our Financial Stability Report in April, for example, we identified the increasing wholesale funding of banks as a potential risk if markets became less liquid. That was one of the warnings we gave, so I was concerned in a general way about the growth of wholesale lending. Did I know the details of Northern Rock's position before this blew up? No, I did not.

Q38 Mr Fallon: You were concerned about wholesale lending back in April but it did not occur to you until you were alerted on 14 August that one institution's business model depended so strongly on access to the wholesale markets - Northern Rock - that it was going to be in trouble?

Sir John Gieve: As I have said, there is a range of institutions ---

Q39 Mr Fallon: For four months nobody at the Bank realised the implications?

Sir John Gieve: The implications of what?

Q40 Mr Fallon: Of the fact that Northern Rock would be exposed if the wholesale markets froze.

Sir John Gieve: I think Northern Rock has the most developed wholesale funding model among the mortgage banks in Britain. There was a detailed knowledge in the FSA of the positions of the individual banks. Did we foresee that the way that events would unfold exactly in terms of the freezing of the mortgage securitisation market and the impact on term money markets? No, we did not see exactly how it would come through. At the point of April - this is before the events - we identified that there were vulnerabilities in the system but we did not see exactly the path that they would lead back to Northern Rock. And I do not think anyone did.

Q41 Mr Fallon: You did not see that Northern Rock would run out of money?

Sir John Gieve: No, I do not think we did.

Q42 Chairman: There was no risk analysis of Northern Rock?

Sir John Gieve: I am sure that as part of the supervision of Northern Rock - I am sure this is the case - the FSA team ask them and require them to do different stress tests, so I am sure the FSA and Northern Rock looked at the impact on their balance sheet and operations of different stress tests. I do not have the details of what those were but that is something that I know the FSA has been doing a lot of work on.

Mr Tucker: I hold the same position on the individual institutions, Chairman, but what I would add is that from July onwards we were focused on what was happening in the markets as a whole and analysing the channels of strain and we did identify that there could be spillover to the asset-backed securities market and to the ABCP funding market and we briefed colleagues on that. Our job in this structure is to identify what is going on in markets as whole.

Q43 Mr Fallon: You briefed which colleagues?

Mr Tucker: Colleagues in the Bank and colleagues in the tripartite structure, but this was not about individual institutions.

Q44 Mr Fallon: All right, could I turn, Governor, to the three-month facility that you announced yesterday. Can you explain to us the role of ministers in this three-month facility? Have they been urging it on you as long as the big banks?

Mr King: No, the banks have clearly been urging us to do an operation like this for a long time and to some extent they would, would they not, because they are in a position now of having to acquire liquidity at a much higher price than they would have wished given that in their risky business models the risk materialised. The real aim of trying to minimise moral hazard, which is one of the objectives set down in the 1997 MoU, is not to provide liquidity at a zero cost, and we are not doing that. The concerns that led me to want to propose this yesterday were concerns about the banking system as a whole. This operation was designed entirely in the Bank. We have the competence to do that; I do not think people in either the Treasury or the FSA have the competence to do that, just as we do not have the competence to do their jobs. But of course I discussed it with the Chairman of the FSA and the Chancellor. In these difficult times it would be wholly irresponsible not to do so.

Q45 Mr Fallon: But when did Ministers first canvass the option?

Mr King: This was discussed among all parties over last weekend in the aftermath of the run on Northern Rock and the concerns that were being expressed about what this meant for the stability of the British banking system as a whole, and at that point I judged that it was worth doing something, but also limiting the moral hazard very clearly by capping the size of the operation in order to give assurance that whatever strains we might see would be alleviated.

Q46 Mr Fallon: Governor, you have spoken on moral hazard and you have written us an eloquent essay on moral hazard, but is not the criticism that you have passed the theory but when it came to dealing with Northern Rock and when it came to dealing with three-month funding actually you failed the practical?

Mr King: No, I do not think that is true at all. I am happy to explain a bit later if you like why I think moral hazard is such an important issue. Can I just answer this point. I have tried to set out a sequence of events in which Northern Rock required ultimately a lender of last resort, the way in which we would have preferred to do it was not open to us, and at that point we did it in an overt way. I do not think it was at all obvious what impact that would have. It might or might not have led to people wanting to take their money out. In the event it did and once that run had started people were not behaving illogically by joining it and at that point the only solution was the Government guarantee. I think this is a very clear chain of events.

Q47 Mr Todd: I am going to come to moral hazard because you are keen to talk about that but I just want to explore the issue of information and how people understand it in this story. I think you were quite correct in saying that the initial step with Northern Rock could have been interpreted in two ways. On balance, people felt that it gave a signal of insecurity in that particular institution and they headed for the queues. Is there not an argument for saying that subsequent extension of the guarantees given to Northern Rock to the banking system at large, with depositors effectively being secured by the Government, and also the wider steps taken yesterday, also convey a more generic message of wider concern about the banking system in this country, which may convey similar messages of alarm to people on a wider scale? So what I am exploring is how actions that you can see and others in the tripartite agreement can see are logical in themselves can be perceived on the outside in a rather different way?

Mr King: I think that the announcement of a guarantee had it come before the run on Northern Rock would indeed have been interpreted in the way that you suggested might have happened and I think would have been an irresponsible thing to have done. It would undoubtedly be said, "Why on earth is this being done?" It was clear why it was being done when you could see the run on Northern Rock because for the four reasons I gave earlier, at that point only a Government guarantee was capable of stopping that run, there was no other way out.

Q48 Mr Todd: That guarantee has now been extended beyond Northern Rock, that is the point I am making.

Mr King: For the reason that once depositors see that if a run starts our current ability to deal with it, given that the insolvency legislation and the deposit insurance is inadequate, people must know that there is a Government guarantee and it is the Government guarantee that prevents the run. This is not a permanent solution. We have to find a way through to a better permanent system but a Government guarantee is there now to give complete reassurance that no depositor will lose. The important point to hang on to here is that no depositor has lost anything at all.

Q49 Mr Todd: Absolutely but extending that point a little further, the extension of liquidity that you have offered yesterday, on terms I entirely accept, does that not also convey a wider implication of concern, because I think that I have interpreted your actions as being to try and act cautiously and in a rather focused way and give a clear message that the broad system is working reasonably well, we have a strong economy and our banking system should be able to cope with these circumstances? There is an argument for saying that some of the actions which have been taken most recently suggest to an outsider that that statement of confidence is misplaced.

Mr King: I do not think confidence in the banking system as a whole is misplaced. As you say, there is always a delicate judgment to make about whether putting in place an auction of the kind that we did would create more concern because of the fact that we were doing it than it would benefit the system in terms of alleviating the strains, but my judgment was that after the Northern Rock run and the impact of the sight of depositors queuing in the streets to take their money out, there were potential strains, at least, in the system that were worth guarding against. It is a difficult balancing judgment. I cannot claim that it is obvious that the judgment was right or not but we have to make these judgments in real time and I think given where we are today I would still have done it yesterday.

Q50 Mr Todd: In your covering note to the letter that has been published - and I do not know whether the letter to John was published at the time - I quote the words you said there: "I am conscious that in sending you this statement I am taking a snapshot of a fast-moving situation with a long exposure camera."

Mr King: Absolutely right.

Q51 Mr Todd: I think that was a reasonable summary of the position you found yourself in. Can we talk about moral hazard. Your focus on that has perhaps been interpreted as being academic, even puritanical, in comparison to the approach taken by other central banks, and it is certainly noticeable that in the public statements of other central bankers there has not tended to be the same emphasis on moral hazard as you have placed on it yourself. Can you explain that difference of approach?

Mr King: I do not believe that moral hazard is just some dry academic concept.

Q52 Mr Todd: Nor do I.

Mr King: It is moral hazard that has actually led us to where we are. I do not want to blame anybody at all for what has happened. I think one of the interesting aspects of this crisis is that all the players have acted completely rationally given the position they were put in, and the point about taking moral hazard seriously is that if what we do is to say to the banking system if you take these risks again in the future then do not worry we will provide you with ex post insurance, that means there is no incentive for them to take out any insurance or to behave in a less risky way beforehand. Why do I think this is important? About four weeks ago I remember listening to an interview on the radio in which a young woman was explaining that she had taken out a mortgage for her and her husband. They had not anticipated the events that occurred with the rise in interest rates and she had found herself in a problem where they were short of liquidity. They had turned to other sources which were more expensive and they had now built up debts of 100,000 which she could not repay. She put those points to someone from the banking industry who I thought responded very reasonably, namely "We are deeply sympathetic, we understand the nature of your problems, but can you imagine what would happen if the banks were to forgive you those debts? What could the banks say to those customers who actually behaved more prudently, that did not borrow more than they could afford? What would happen to people's willingness to behave prudently in future if we bailed you out? It is a little bit strange that that seems to apply to the borrowers from banks but not to the banks themselves.

Q53 Mr Todd: By my question was slightly different to that because I have to say I agree with your missives on this (I have got a rather stern puritanical streak too!) but the puzzle is why that has not been emphasised by your colleagues.

Mr King: It may not have been emphasised in speeches to the same extent.

Q54 Mr Todd: Or acted on.

Mr King: It has been acted on. If you look at what the ECB and the Fed have done in their market operations they have not provided complete ex post insurance, they have not put sufficient liquidity into the banking system to enable the banks immediately to take back onto their balance sheet all the risky conduits and vehicles that they have created without incurring a cost. All banks around the world will pay a price for what has happened. What I want to do is to make sure that when they get liquidity from central banks they pay a price for it and do not get it free. The banking system as a whole can afford to do this. If I thought there was a risk to the British banking system as a whole and that the capital that the British banking system has was inadequate to take this onto their balance sheets, I would be out there putting liquidity in at a lower price to stabilise the British banking system. That is not necessary. If you always provide ex post insurance you can be quite sure that in five or ten years' time another crisis will come. That is exactly what we have seen in the last 20 years. The one thing I do not want to do is to find myself five or ten years down the road saying, "Why did I take the easy option? Why did I do that? Why did I sow the seeds of a future crisis?" The whole regime of monetary policy that we have put in place has been to demonstrate that taking the easy option and giving in in the short run without looking to the long-run consequences of those actions is damaging. Every manufacturing company I go out and meet around the country every month has come to realise that the short-term option which they wanted ten to 15 years ago - a cut in interest rates at the first sign of a problem - is not the way to go; it is having a stable framework. We need to put that view back into the financial system.

Q55 Mr Brady: Governor, can I ask when you first discussed the possibility of the 100% guarantee for retail deposits?

Mr King: The first discussion I had about that subject was on Sunday after the run had started.

Q56 Mr Brady: Did the impetus for that come from the Bank or from the Treasury?

Mr King: It came out of discussions among all three of us. I think it was clear to everyone that the only way to stop the run at that stage was indeed a guarantee.

Q57 Mr Brady: And what was it that finally made that decision necessary? You referred earlier to seeing the screens and the impact on the screens, was that part of the rationale?

Mr King: No, I think it was clear that if the run had continued then all the retail deposits would have disappeared because once it had started it was not illogical for others to come in behind it, and therefore something had to be done to stop the run, and at that point without an adequate insurance scheme, without the ability to put the company into a position where it could immediately repay the depositors, only a Government guarantee would stop the run. It was the only solution at that point.

Q58 Mr Brady: You have already said that it is a temporary solution, which I suppose is obvious, but what is the set of circumstances which needs to be in place for the guarantee to be removed? Does it require the piece of legislation to which you referred and the whole regulatory environment to be changed or can it happen sooner?

Mr King: I think you have to ask the question why was this not regarded as something so urgent in the past? Governments of all parties did not regard it as a top priority and I think the reasons are because, first of all, the recent circumstances are pretty unusual so it was not a pressing problem and, secondly, at that point the Bank of England did have the ability to act as a lender of last resort in ways that we were not able to this time. However, I think that has all gone now. My feeling is that legislation introduced not too speedily but after careful thought is absolutely crucial now and that is the exit route from where we are into a more stable future system. This Committee clearly has an important role in leading it because this is not - and I would urge you not to regard it as such - a political issue, this is a cross-party issue in which everyone has an incentive for putting in place a more stable structure for our banking system.

Q59 Mr Brady: Can I also ask for some clarification about the extent of the guarantee. I do not think this is clear yet. Does the guarantee extend to retail deposits held with overseas banks operating in the UK or is the guarantee only to British banks?

Mr King: Sir John has been involved in the discussions. Can I just summarise the broad principle behind it which is that this would be extended to other banks if they found themselves in a similar position, that is to UK retail depositors and other unsecured creditors, but perhaps Sir John could comment on that. The Treasury put out a notice at 7 o'clock this morning and I think questions on the detail of that should go to them.

Sir John Gieve: The note that the Treasury put out was about the guarantee to Northern Rock and that is the only guarantee in place at the moment, and it defines what "existing deposits" means and it defines that in terms of "accounts up to midnight on Wednesday 19 November", with the addition that accounts closed in the last few days can be re-opened. It defines the wholesale market cover as being to existing and renewed wholesale deposits, so wholesale deposits that are rolled over at the end of their term will be covered and so will existing and renewed wholesale borrowing which is not collateralised. The point about the broader banking sector is covered in what the Chancellor said, that if another bank found itself in the same circumstances it would get the same treatment.

Q60 Mr Brady: And it is your understanding that that would apply whether it was a UK bank or a foreign bank operating in a UK environment?

Sir John Gieve: If you have a foreign bank with a branch here obviously the lead on that is taken by their own supervisor and central bank in their country of origin. So, for example, if there was, I do not know, a French bank that had a branch here, the question of whether or not that needs liquidity support depends on its position in its home country and internationally. It is difficult to think of an example where there would be a purely British liquidity crisis for a branch of a foreign bank.

Q61 Mr Brady: So UK depositors with such a bank can take no comfort from the guarantee that has come from the Chancellor?

Sir John Gieve: The Chancellor's words are not specific on this and it would obviously depend on the circumstances, but generally the home country authorities would take responsibility for their banks, and that would apply to us, too.

Q62 Mr Brady: Thank you. Can I ask just one other slightly different question to the Governor again. Governor, you said earlier that you had pressed strongly for the ability to conduct a covert operation. When did you press strongly for it? I was not sure whether that was a reference to the period when the Market Abuses Directive was under consideration or whether it was in the period since it had come into force.

Mr King: No, it was during this particular crisis with Northern Rock where I found it hard to believe that a public policy intervention that was in the interests of everyone in Northern Rock could not go ahead because of a legal responsibility to disclose. There is wording in that Market Abuses Directive which would give you the impression that in a case of financial distress it would be possible not to disclose but we had to take legal advice. I would say this occurred in the period between about 22 August and the date on 9 September when it became clear that we were discussing seriously doing the lender of last resort operation and we were advised finally that it could not be covert, but Sir John was involved in many of the discussions here at the deputies level.

Sir John Gieve: Can I just clarify one point about foreign banks. Of course many foreign banks form British subsidiaries here and they are authorised in their own right by the FSA, so the legal structure matters a lot here. I do not want to mislead you on that.

Q63 Mr Mudie: I find it hard to believe and sad, I think, that you were warned by Mr Tucker - and I am speaking to the Governor and yourself - the relevant people were warned and the relevant institutions were warned in July about the problems that were there in terms of the money markets and yet took until 14 August for it to get on your desk and there be some thought of action. What I have heard today (which alarms me) is that you have spent some time in the last question telling us what you could not do but I am sitting here as a politician and I am thinking you are the Governor of the Bank of England, you knew about this in July, you gave it some attention in August before those crowds built up outside Northern Rock and it became an issue; what was the Bank of England's inclination or policy intention because you could not sit and do nothing, you knew there was a problem, you knew it was going to blow up in September because that is when Northern Rock was going for money in the markets in a major way. How was it going to be solved before you took that action in September? What was your plan?

Mr King: The Bank of England is not responsible for individual institutions.

Q64 Mr Mudie: Sorry?

Mr King: The Bank of England is not responsible for individual institutions. We act when the FSA come to us and say, "We think an individual institution ..."

Q65 Mr Mudie: That is nice to know, but the impression you have given this Committee is you were very anxious to do something, not the answer you have just given that it is nothing to do with us.

Mr King: Can I just ---

Q66 Mr Mudie: You said it is not our responsibility but you have spent the time up to now saying, "We would have loved to have done something but it was a lack of legislation, it was this, that and the other," and I say okay, you appear to be very concerned and wanting to do something, you looked at various things and you found excuses for not doing them, so what on earth were you going to do?

Mr King: Let me tell you an answer to that question.

Q67 Mr Mudie: Good.

Mr King: The problems in Northern Rock were drawn to our attention on 14 August.

Q68 Mr Mudie: No, Mr Tucker ---

Mr Tucker: To be clear about what I said ---

Q69 Mr Mudie: Mr Tucker, I know what you said, you said that you became aware of the problems in the capital market and you sent it across to the relevant people and institutions. Northern Rock's business model is regarded as extreme. It works but it is extreme because it depends on cheap credit and easy money, liquidity at a high degree. You were telling people in the institutions and your own institution, the other departments and divisions, that we have got a problem, and anybody would have put two and two together and said which of our institutions is going to be hit first. Northern Rock was an obvious one and I am just saying that should have rung bells. Is that fair? Thank you, Mr Tucker. I am just saying in a well-run institution it should have rung bells and we would have expected the Governor of the Bank of England to say, This is going to cause us problems; what can we do?" We have heard he did say that and then he discovered that he could not do things. What could you do, what were you planning to do?

Mr King: I will tell you what we were planning to do. The problems that could have arisen in all these institutions, Northern Rock and any other British bank were triggered by the events of 9 August and we knew that if this were to cause problems we could act as lender of last resort but a lender of last resort is a lender of last resort. If we had jumped in within a week and announced that we were lender of last resort to Northern Rock that could have been very damaging to the institution. We knew that we were there as the backstop, as lender of last resort.

Q70 Mr Mudie: So you were content to watch this impending disaster, this train running towards the buffers, you knew it was going to happen in September and you were saying, "I cannot do anything, but I will be the lender of last resort when it hits the buffers"? Did you tell the Government and did you tell the FSA, did you get that tripartite committee round the table? What did they decide to do, if anything, or did they sit with you and say - because this is the impression you have given which is horrifying - we do not know what to do. I will tell you what is horrifying, that on both things - your U-turn on three-month money and on Northern Rock - it was forced upon you by people queuing outside the building societies, not that you had a well-ordered plan, not that you were preparing plans; you just watched it hit it and you panicked because it hit the buffers?

Mr King: I am afraid that none of that is true.

Q71 Chairman: Answer that short question, Governor!

Mr King: Indeed.

Q72 Mr Mudie: It is a relevant question.

Mr King: It is a very fair question and I would like to answer it.

Q73 Mr Mudie: That is what ordinary people and that is what the City are asking.

Mr King: Would you let me answer it. On 9 August the events were triggered that meant that the risks we had been warning about for a long time materialised. On 14 August we discovered that those risks were serious in Northern Rock. At that point there did not seem much point in blowing up the train before it hit the buffers because there was a long time in the intervening period in which we might be able to find a way for Northern Rock to survive. That was the main responsibility of Northern Rock's management. It tried to find funding and it tried to sell its assets. If it had been successful in these events then the problem would not have materialised. We knew that in the last resort we could be lender of last resort and we prepared for that. The way I would have preferred to be lender of last resort was not open to us but if we had activated lender of last resort earlier the same problems would have occurred beforehand without giving a chance to find another way out.

Q74 Mr Mudie: There is a suggestion that TSB walked away from the table because you were unwilling to give that guarantee. I heard that it took you about nine days to get legal opinion, which I find alarming.

Mr King: I am sorry, this is complete nonsense.

Q75 Mr Mudie: Why did TSB walk away?

Mr King: I have no idea what bid discussions were going on. I knew that there were some bidders interested. When I was asked last Sunday what the terms on which a bid could be completed were, I confirmed very quickly that we would roll over the lender of last resort facility to any bidder. I am absolutely in favour of having a bid as a long-run solution to Northern Rock if that can be achieved. I did not oppose a bid, I supported it, but last Sunday, Mr Mudie, only a Government guarantee would have stopped that run. A bid would not have done it nor would any other solutions.

Q76 Mr Mudie: Let us just be clear. TSB were still at the table until last Sunday when they got word from you that the legal advice you had got meant you could not be the lender of last resort?

Mr King: No, not at all. I was asked by the FSA whether in the event of someone bidding - and this was a generalised proposition, not a particular institution ---

Q77 Mr Mudie: Who asked you?

Mr King: Callum McCarthy at the FSA. He said in the event of a bid being made would it be the case that the lender of last resort facility that had been put in place the previous Friday would be extended and rolled over to a bidder, and I said yes.

Q78 Mr Mudie: Let us clear it up for the City and for the media. This has been in the press for some time that Northern Rock were touting themselves around, there were two British banks interested one of which was Lloyd's (who stayed the course) but they went away after getting bad news. Are you saying this took place last Sunday when they got the bad news? The City has got the impression they walked away long before that because they were told you would not agree terms.

Mr King: That is absolute nonsense. The lender of last resort facility was only announced at seven o'clock in the morning on the Friday.

Q79 Mr Mudie: It was only announced that you were going to be lender of last resort. Lloyd's TSB, it is rumoured, had put it as a condition of taking over Northern Rock and giving a market solution that would have saved all this nonsense, and they put that to you some time before.

Mr King: That is not true.

Q80 Mr Mudie: Okay.

Mr King: The lender of last resort facility was announced on the Friday and on Sunday I was asked - to be quite clear because it was a facility we were extending - if any bank were to bid for Northern Rock they would need to know the terms for the bank that they were acquiring and I was asked very explicitly would the lender of last resort facility that had been extended to Northern Rock be rolled over with the rest of the bank to a bidder, and I said yes. I encouraged the bid process. However I can tell you that last Sunday the only solution to stopping the run was a Government guarantee; anything else was a sideshow. Only a Government guarantee would have been sufficient to have persuaded the depositors to leave their money in Northern Rock.

Q81 Mr Mudie: Just going on to one last question in terms of the second major matter of the three-month money. The Chairman asked you that question at the beginning and you said later on to one of my colleagues that there were four reasons. I wrote down, not in shorthand but as best I could as a poor Scot, your four reasons. I got two of them, if I can read my writing, queues was one, the media was one, and I am not sure I got the other two. In that letter that you wrote - and you knew about Northern Rock when you wrote this letter that put you in the corner - you said "strong reasons" and then you said to one of my colleagues "four strong reasons". Could you spell out ---

Mr King: The number four was referring to the four unconnected pieces of legislation that were relevant to the difficulties we had.

Q82 Mr Mudie: So what were the strong reasons then because you needed strong reasons to depart from your macho line? Tell us the strong reasons then.

Mr King: As I said in the statement to the Chairman, the balancing between concerns about strains in the banking system as a whole and the moral hazard that I have described is a balancing judgment that we were making almost daily, and we did make it daily, and after the weekend we had seen some volatility in the overnight rate, we had seen some upward movement in the spread in longer term markets, and we had seen people worried about the reputation of the British banking system and strains in it, and I judged at that point that the right balance to strike - and people can reach different views on it, I do not pretend there is an absolute right or wrong here - I reached the judgment on balance that it was better to conduct a limited operation which minimised the risk of moral hazard but did inject at that point through the announcement of the auction to be held next week some additional liquidity. That balance is one that everyone has to strike in a central bank and I struck it in that way.

Q83 Mr Mudie: What do you think of the FSA meeting the bankers in the morning, when you met them in the evening, either directly or implicitly indicating that they thought you should do this U-turn?

Mr King: I cannot comment on the meeting with the FSA but I can comment on the meeting that I held. I had asked for a confidential meeting with the bankers and they came along and I had hoped that it would have been regarded as confidential. In that process of course they said this would prefer to have more liquidity at a lower price. That is not very surprising. If I were in their position I would ask for exactly the same. I tried to explain why if they were in my position they would understand that I had to make a public policy judgment which is to balance the use of providing free liquidity to them against moral hazard.

Q84 Mr Mudie: But it was not the rate that you were charging, it was the assets that you were prepared to take, you were extending them.

Mr King: And what I discussed with them at that meeting quite explicitly was to ask them why they felt that extending support with liquidity injections against a much wider range of collateral would be helpful to them and they explained that it would. In the auction that we announced yesterday we announced that we would be willing to allow people to bid against collateral for a very much wider range of liquidity including mortgages. That is not something that either the Fed or the ECB have done and we did that because we felt that it was the breadth of the collateral that was important rather than the size of the operation.

Q85 Peter Viggers: Is there a qualitative element in the guarantee you are giving to retail deposits? Does the guarantee cover less prudent as well as more prudently run banks or is it a blanket guarantee?

Mr King: The Chancellor said that the guarantee would be available to banks who found themselves in a similar position. I think what that means is depositors should be reassured that when they put deposits in a British bank they will be completely protected. In the long run that is clearly not a sustainable resting position but in present circumstances I think it is absolutely vital.

Q86 Peter Viggers: How severely do you think the principle of moral hazard has been compromised since you wrote us your rigorous and lucid letter?

Mr King: I hope that it has not and I do not believe that it has but, as I said, this is a balancing judgment. When I listened to the banks I do not believe that they felt that offering them an ability to bid for liquidity at a 100 basis point premium over bank rate was something that they regarded as entirely generous, so I think there is still a fair chunk of restriction against moral hazard in what we have done.

Q87 Chairman: When you make advances under the proposed auction it will be against, as you have just explained, a very wide range of collateral including mortgage collateral. How rigorously will you be able to scrutinise the mortgage collateral that has been offered to you? Will there be collateralised debt obligations, securitised mortgages, which will be in a bundle and which will not be capable of proper analysis by you?

Mr King: Let me ask Mr Tucker who is responsible for dealing with the practicalities of this.

Mr Tucker: We will announce the details tomorrow. There will not be collateralised debt obligations. There will be triple A tranches of prime mortgage-backed securities. The issue that you raise is an important one. It will be addressed by conservative haircuts so that we would lend against X% of the value of the security and the haircuts will be conservative for precisely the reason you say.

Q88 Peter Viggers: Perhaps for those who are not conservatives and do not know about haircuts you would just explain that?

Mr Tucker: Sorry. Say a security is valued at 100. We might lend 50 against that 100 security or 70 against that 100 security and that would protect us against a fall in the value of that security during its life. That is the first step. The second is that the loan will be for three months. If the value of the collateral we hold falls during that period we will call for more collateral to protect ourselves and then if a borrower were to default we would be protected by the haircuts I described at the beginning - lending a fraction of the value of the securities that we hold.

Q89 Peter Viggers: Very well. Governor, when the Memorandum of Understanding effectively took direct banking supervision away from you and gave it specifically to the Financial Services Authority it is now quite specifically responsible for the prudential supervision of banks, building societies and for the conduct of operations in response to problem cases affecting firms. You happen to be here today and the original intention was to talk about the Inflation Report ---

Mr King: Indeed!

Q90 Peter Viggers: But it should really have been the Financial Services Authority which should be answering many of the questions which are being put now. Yet on the other hand when a proposal came through to provide a lifeline and a rescue operation it was the Bank of England, as you have explained to us, which led on this. Would you not agree that the comment originally made in 1997 that the Memorandum of Understanding was "unworkable in a crisis" has actually been proved to be correct?

Mr King: No, I do not accept that. One of the very good reasons for taking supervision away from the Bank of England was that it was becoming more and more impracticable to regard banks as being part of the financial system that could be regulated independently of a wider range of financial institutions. The whole process of supervision now is much more formal, much more legalistic, much more international. I think it is a full-time job. It takes up all the energies of senior people to do that. In the event of any crisis like this it is inevitable that those responsible for supervision, those responsible for central banking activities and the Government have to work together irrespective of where they are actually located, so even if two of those had been in the Bank of England we would still have had to work with the Government so having all three people there I think is crucial. The MoU in my experience has ensured very effective, speedy communication. Callum McCarthy, the Chancellor and I have talked regularly and frequently. We have a team of deputies under us who speak even more frequently. I do not believe that the communication or the effectiveness of the tripartite arrangements have been in any way responsible for this. Indeed in my experience it has enhanced it. I just do not believe that one institution - a central bank - can manage in today's world both monetary policy and the entire range of financial supervision.

Q91 Peter Viggers: And is the communication between the three members referred to formalised and will communications between the three of you be published?

Mr King: I think that will depend on the chair of the tripartite arrangements. I would expect a lot of the conversations that we have held to remain confidential because they are market sensitive. We have had many communications both formal and informal and the informal collaboration and communication between the Chancellor, Callum and myself has been absolutely crucial in dealing with what was a fast-moving set of events.

Q92 Peter Viggers: Finally can I ask Paul Tucker if he would comment on the current state of the commercial paper market?

Mr Tucker: A little bit better than a week ago. This is important and over the last few weeks the underlying problem has started to be addressed. The underlying problem is that investors should distinguish between one type of security that has got real difficulties and other types of security that are maybe okay. That process will take a while and it does seem to be gradually underway. I think there is still a long way to go and there could still be setbacks. The last ten days in terms of global markets as opposed to our local position have been very mildly encouraging.

Q93 Peter Viggers: And how important was it that banks were unable to raise money on the commercial paper market?

Mr Tucker: I think the fact that banks and these so-called conduits were not able to raise commercial paper or were only able to raise commercial paper at very short maturities is right at the heart of the problem. It is difficult to see that the problem will be resolved without either that market being restored to something like normality or, alternatively, a lot of that paper coming on to banks' balance sheets, reintermediation if you like from the capital markets into the banking system. It is because of the latter possibility that banks have been stockpiling liquidity and trying to protect themselves against that eventuality and that has been individually rational but collectively deleterious.

Q94 Ms Keeble: I wanted to ask a bit about the role of the credit ratings agency. I have also got some questions, Paul, on some of the things you have just said. Sir John, I wonder if you could say from the FSA's point of view if you think that the ratings agencies have provided markets with the kind of information that they need on which to base their decisions?

Sir John Gieve: I think this is something that we are going to look at on an international basis with other regulators and central banks in the future. I think that people definitely relied on ratings agencies' ratings in an inappropriate way. The ratings agencies would say if they read the fine print there was plenty of explanation about the limited assurances that they were putting forward but I think many investors and people setting investment remits did just say if it is triple A it is all right, not distinguishing between different sorts of instruments, so what we obviously need to look at is did the ratings agencies do it wrong or was it the investors who did not use the ratings agencies and put too much dependence on them?

Q95 Ms Keeble: If I can just come back on that. Firstly, why so late and, secondly, it is fairly well-established, is it not, that the ratings agencies work very closely with the banks to compile the vehicles to attract the kind of ratings which are then required to be attractive on the market; would you accept that? Why so late and do you not think that it is really unacceptable to have the ratings agencies virtually colluding with the banks in the construction of vehicles which are then, as the Governor has accepted, risky?

Sir John Gieve: I think the ratings agencies' response to that is that their reputation and their future business depends on producing ratings which stand up in practice.

Q96 Ms Keeble: But what is your response?

Sir John Gieve: I think there is a question about whether they went too far in relying on their models to put firm ratings against products which did not have an obvious market value and it is particularly in the sophisticated credit derivatives field where they have, I think, as good models as anyone but maybe those models were simply too limited to justify a firm rating.

Q97 Ms Keeble: And then for Paul, because you are obviously working at a different end of it, when you did your report on July 25 warning of the risks, what did you rely on and in saying now that this week is a little bit better than it was a week ago, what are you actually looking at and what real risks are you taking into account? Then I wanted to ask the Governor something about this as well.

Mr Tucker: What are we relying on? First of all, we are relying on two sources of information. One is conversations with people in these markets around the world, both people who are selling commercial paper, coming back to that particular question, and people who are buying commercial paper. This would go not just for the commercial paper market but across a whole range of markets. The second source of information is published information on the prices at which, in this case, commercial paper is being issued and also the quantities that are being issued. It is virtually always a blend of market intelligence drawn not just from the banking system but from asset managers and from many others as well and hard information produced from all sorts of sources, some of them official.

Q98 Ms Keeble: If I can just ask the Governor because this issue about risk assessment is something that the Committee has looked at in the private equity investigation as well and you referred to the possibility in the coming weeks of what would happen if the banks were forced to take risky - and I have not got your exact words because I have not got perfect shorthand either - risky conduits and special investment vehicles back onto their balance sheets? Which are those risky investments and how do you know where they are if you have not got the ratings agencies giving a good, robust assessment of what the risks are?

Mr King: Can I step back one point because I think it is very helpful to put this in the context of the real financial crisis that started on 9 August. I know most of the questions naturally have been about Northern Rock but we should not forget that all this came out of this general problem that you are referring to.

Q99 Ms Keeble: That is right, I want to know where the risks are and if there are more out there.

Mr King: I will come on to that. There is one point I want to make about ratings agencies. There is a very important call and longer term analysis to be made of how ratings agencies behave. The conflicts of interests that you have alluded to are clearly part of that, but it would be most unfortunate in present circumstances if for political reasons pressure was brought to bear on ratings agencies to have a knee-jerk response to go completely in the opposite direction and to downgrade everything at sight because they might be held responsible for their behaviour. That would lead us into a really difficult position and I know you are not suggesting it but it has come up in various international fora. We need a long look at that. In terms of the risks, what has happened is that many of the banks created these vehicles to hold off balance sheet (perhaps sometimes to avoid regulatory capital requirements) these securities in which the market is now illiquid. They will now have to take back onto their balance sheets these assets which may well be perfectly good value in the longer term when the markets re-open but they are highly illiquid. That will require some use of capital of the banks to finance this in the short term and that is why, as Paul said earlier, banks are currently hoarding liquidity in order to finance the taking back onto their balance sheets of these vehicles. They know what these vehicles are, they set them up, and the FSA and the parallel regulatory authorities around the world have been talking to the banks and finding out whether the banks know about their exposures. They say to us that they are confident that all the major banks know about their exposures and that they could take these back onto their balance sheets without any major hit on their capital so that they would still be left with capital well above their capital regulatory minimum. It does mean that the banks will have to find more expensive sources of liquidity than they had expected or hoped, they will pay a price in terms of profits. There is absolutely no difficulty in due course in their doing so but in the meanwhile there is this great demand for liquidity. You can get liquidity at a price and this is a matter of price.

Q100 Ms Keeble: Can I just come back on that because is it not the case that people do not know where the risk is, which is one of the factors which has led to the seizing up of the market, and is it not also the case what we want is not wisdom after the event, it is a warning of where the risks are, and unless there is a more robust assessment of that then you do not know where the next Northern Rock is going to be?

Mr King: There are two points I would make on that. First of all, it does not matter fundamentally whether we know exactly where the risk is, provided that the regulators know exactly what the position is of the banks with retail depositors because the ultimate aim here is that we are concerned about protecting depositors and the payments system, not protecting banks or shareholders or other investors like hedge funds. The key point here is that the investors themselves know what risks they have taken on. This is the issue. I think the problem has been that many investors, ranging from German public banks to other banks, have discovered that they did not know exactly what risks they had taken on.

Q101 Ms Keeble: Yes, which is a bit of an indictment.

Mr King: It is an indictment of them.

Q102 Ms Keeble: Yes, but it is also the fact that they do not have any system of robustly assessing what their risks are because of the ratings that are provided to the taking on of these investments.

Mr King: I do think that investors must take responsibility for what they buy. As Warren Buffett said, do not invest in what you do not understand.

Q103 Ms Keeble: Can I just ask one question because you have referred repeatedly to the pressure for greater liquidity, the regulation in relation to savers' deposits is 5% in five days which Northern Rock actually had, did it not, so is there an argument for saying that those rules need to be looked at?

Mr King: I think this is a very important point that you make of should the regulatory system not put more weight on liquidity, and the Bank of England and the FSA have been urging in international fora that more attention be paid to this issue. It takes a very long time to get agreement at international level about what the appropriate regulatory arrangements should be and we have been pressing that case internationally for quite some time.

Q104 Ms Keeble: Can I ask one further question which is just about the Inflation Report. We all have hindsight but looking at your own Inflation Report the one warning I see about all of this is where it was talking about domestic demand and it says: "Recent developments in financial markets, if they become more widespread, could pose a downside to the central case." A downside risk is a bit of an understatement given what then ensued. I think we would expect to have perhaps a greater projection of an impending crisis. Would you want to re-visit that phrase and give greater weight to the risks that you had foreseen?

Mr King: If we were back at that time when we were writing this ---

Q105 Ms Keeble: This is August.

Mr King: This was before 9 August. If you are asking whether before 9 August we would have said the same things, I think the answer is yes. After 9 August we would have said something rather different.

Q106 Ms Keeble: But anyone could have said there is a downside risk, even if I could have said there is a downside risk.

Mr King: I have been very clear with this Committee throughout. I do not pretend to be able to forecast the future with any great foresight at all; no one can. Nobody that I know said on 9 August these events would occur. We have been saying for several years that they could occur, that there were risks. It is not that we were not aware of it. We said these risks are there and the banks themselves decided to take those risks. It was their judgment, they decided to take the risks and on 9 August those risks came home to roost. I could not possibly and I would not pretend now that I could have anticipated that 9 August would be the event but once it had occurred we then responded.

Q107 Mr Love: You indicated in an earlier answer that the takeover panel rather curbs the ability to bring the parties together when there is a possible takeover in view. Going back to questions that Mr Mudie asked, do you not think since there were press report for some considerable time about a possible takeover of Northern Rock and that Northern Rock was in some difficulties - and we have discussed that - that more active intervention ought to have taken place by the authorities to assist that process?

Mr King: Perhaps Sir John could comment but as far as I know a great deal was done. It was clearly the responsibility of the FSA in discussion with Northern Rock's board, and it cannot be forced onto Northern Rock's board, they have to make the judgments, but I think everyone in this process was hopeful that discussions about a bid would emerge to provide a suitable end game to all of this. However the point you referred to at the beginning meant that even if a bank and Northern Rock had reached agreement on a bid, that could not possibly be final until we had gone through all the processes laid down, and no depositor would have known that it would have been final until then and they would have known that there was always a probability, small though it might be, that something might have gone wrong with Northern Rock in the intervening period before the bid could be consummated and that posed a risk to them and therefore it is not surprising that they thought they might wish to take their money out.

Q108 Mr Love: Can I just turn to Sir John because there is unhappiness at Northern Rock, there is unhappiness with the suitors; where did it go wrong and what responsibility does the FSA or other authorities have for it going wrong?

Sir John Gieve: Firstly, as a member of the FSA board I will give you an answer, but of course Callum McCarthy and Hector Sants will be coming here to speak for the FSA, rather than as a non-exec. Two things: firstly we were alerted first to the position of Northern Rock on 14 August but it was not obvious to them or to us at that point that they were going to require government assistance. There were two things that they were actively exploring, one was a possible merger or takeover, and the other was raising money both through short-term money markets and by actually securitising their debt. They were still hoping to securitise some debt and thus relieve their liquidity pressures right into September, and it was only when that proved impossible that it became clear that they needed another source of liquidity. In terms of the crisis, the key question that underlies your questions is was it worth on Friday announcing that the Bank was making a facility available or should we have said at the same time that the Government guaranteed all the deposits? We did realise there was a risk that, if you like, the shock effect of an announcement would overwhelm the positive effect of saying the Bank was standing by with some money. We knew that was a risk but we thought that it was not an overwhelming risk and it was worth taking that step, so actually the guarantee which proved essential in the end came out on Monday. If we had known it was going to be essential on Monday we might well have offered it on Friday but that was not certain at that stage.

Q109 Mr Love: Can I move on, you mentioned earlier, Governor, that the Market Abuses Directive of 2005 requires you - and you got legal advice to this effect - to make public the lender of last resort.

Mr King: It does not require us to make it public; it requires the recipient company or bank to make it public.

Q110 Mr Love: It has to become public. Recognising that was the case and also you mentioned earlier that you accepted that depositors of Northern Rock were rational in rushing down to Northern Rock following that announcement, was there any consideration given that because of the impact of the public statement there might be another way to do this that would not have required such a public profile for Northern Rock at that time?

Mr King: It was not obvious that the shareholders at that stage would decide to take their money out. If they had been reassured by the provision of the facility and kept their deposits in then there would have been no clash of that kind, but once some people had started to do it - and this is the key point - once some people had started to take their money out did it then make sense for others to join in. As I have said before, the only solution at that point was a Government guarantee. But it is a big step and to have done that at an earlier stage when it was not strictly necessary might well have caused wider problems and I think would have incurred the difficulties and we now need urgently to get out of this temporary position into a more stable long-run structure for the legislation around banks.

Q111 Mr Love: Let me press you on that because the statement yesterday about the three-month facility you mentioned that because of the impact on the banking sector but there are some concerns that it specifically related to smaller banks - I will not name them but they are being named regularly in the press at the present time - to what extent was that a consideration in yesterday's statement?

Mr King: I am not going to go down the road of individual institutions and you would not expect any Governor to do that. We put that facility in place for the reasons I gave. It was designed and structured in a way that minimised the moral hazard but it provides some liquidity to the markets at a point when the strains seemed somewhat greater. I have explained it was a balance of judgment and that was the balance that we struck.

Q112 Mr Love: It would seem from all that we have discussed here that the run on the Northern Rock came as an enormous surprise to everyone. Should we have expected it? Should it not have come as a surprise? I know we have not had one for 140 years but should the authorities, whichever of the three tripartite authorities, have had a better judgment about how the public would respond to these events?

Mr King: I think everyone knew that a run was a possibility. The question was what could you have done to avert it at that stage? It was not obvious that the announcement of the lender of last resort facility would prompt the run. It might have done the opposite and actually reassured depositors. It did not and at that point the guarantee was necessary.

Q113 Mr Love: Can I just stop you there because it has been widely reported that the Bank expected that the announcement would reassure rather than panic; was that the case?

Mr King: Nobody could have known what the net effect would be. It did reassure wholesale funders to Northern Rock. The situation on that front eased after the announcement, but of course those people were aware of the liquidity problems of Northern Rock. I do not think anyone could have known with any certainty at all what would have been the consequences on retail depositors of the announcement.

Q114 Mr Love: The interpretation put on yesterday's events is that everyone is chastened by the experience of Northern Rock. Have you yet had an opportunity to try and assess the reputational damage that has been done to the British banking system as a result of the first run for 140 years?

Mr King: I think that is what really matters and I do not believe that in a year's time people will look back and say there was any lasting damage to the British banking system. It is very well capitalised, it is very strong, and, as I explained before, although the banks at present are having to pay a bit more for their liquidity than they would wish, they will be able over the coming months to take these vehicles and conduits they have set up back onto their balance sheets and they will be strong. Headlines come and headlines go and even television pictures come and go, and I cannot believe and I do not believe that there is any lasting damage to the reputation of the British banking system, although I fully understand that the impact of the pictures on television last weekend came as a shock to many.

Q115 Mr Love: You said earlier on that your concern, if I can call it that, about moral hazard related to the seeds of future financial crises. Do you perceive any negative effects from yesterday's announcement of injecting liquidity into the market? Will that create problems as you indicated both in your statement to this Committee and publicly that may have consequences further down the road?

Mr King: I think not. I think the banks in this country realise that they have not been provided liquidity for free. I think they understand the reasons for the decision that was taken yesterday that they would have to pay a penalty rate to obtain liquidity from the Bank. I think that is appropriate and it is appropriate because of the circumstances in which we are providing it, with the realisation of risks that the banks themselves took in full knowledge of what the consequences would be. The one thing I would like to say at the end is if these same problems were seen in the banking system today and they had been the result of some completely different cause, say a major terrorist attack, we would be injecting liquidity at absolutely zero cost because that would not be the result of the risks that the banks themselves took. The reason for the penalty rate now is not a punishment it is not to blame anybody; it is simply to make sure that when people think about the risks they are taking in the future they do so in the knowledge that it is costly to take risks.

Chairman: Graham seeks clarification to one of Andy's questions and George has a short question before I ask one final question.

Q116 Mr Brady: Just a very quick point of clarification really to Sir John. You said that if you had realised what the consequences would be when you announced the facility on Friday you might also have announced the Government guarantee then. The Governor has told us that the question of the guarantee was not discussed until Sunday. Can you make it clear whether there was any consideration at all on Friday or before that as to whether a guarantee ought to come at the same time as the facility was announced?

Sir John Gieve: We had of course discussed what would happen if the negative news of the announcement outweighed the positive news, and obviously a Government guarantee was one of the possibilities - and I think this is what the Governor was saying - it was a formally discussed as an action and whether we should take the action now or tomorrow on the Sunday. We did realise that simply announcing that there was a new source of funds for Northern Rock might not be sufficient to restore confidence, but we thought there was a reasonable chance that it would, and in any event it was the right thing to do. They were having to make a profit warning and I think for them to make a profit warning without having clarity on their sources of funding would have been disastrous.

Q117 Mr Mudie: All this discussion today has been about the financial markets, but of course you are here in a wider capacity and we are talking about the real economy. I see that Kate has not said a word in two hours and as she is the housing expert I would say the number of repossessions on the latest figures has gone up from 33,000 to 77,000 which means that we are starting to get back into the very worrying situation where we had the last negative equity collapse. The Fed not only gave the financial markets some help, which you might disapprove of, but they also put some aid in on the mortgage side to give some relief to people who were in danger of losing their houses. A lot of these mortgages are sub-prime in this country and there were lenders who would foreclose in the way the big banks would not. I had a ten minute rule bill about it and I have researched it. I know you are preoccupied with all the financial markets but have the Treasury, Financial Services or yourselves got it anywhere on the agenda because it is a genuine problem where people are losing their homes in greater numbers? Have we got an agenda to see whether and what help can be given to stave repossessions off until the market turns?

Ms Barker: I think the first thing I would say in response to that is although it is certainly true that repossessions have risen, they nevertheless remain at relatively low levels.

Q118 Mr Mudie: They have more than doubled, Kate.

Ms Barker: Yes, I realise that but relative to the levels we saw in the last crisis, they are nothing like so high, and the housing market itself, on the latest figures we have, remains relatively robust, so I do not feel that we are yet in a situation where we would want to necessarily take those steps nor indeed would I really be the appropriate person to carry that forward.

Q119 Mr Mudie: But in terms of the wider organisation then if you are not the appropriate person to that, I disagree with you on the figures; the figures are starting to be alarming. What you have said is the conventional wisdom of three months ago and they are more alarming set against the background of what we have been discussing for the last two hours, and there are a lot of people out there in danger of losing their homes. If it is not on an agenda and if you do not prove to be correct and the numbers stay at this level, would you not think it is an appropriate thing to start looking at to see which is the appropriate agency, whether it is Treasury, whether it is Financial Services, whether it is you, to do something about it along the lines of the Fed?

Ms Barker: To go back on that, it is very difficult to take any pleasure in these numbers. These are very serious events for the individuals concerned. I do not feel however they are at the kind of levels I personally would describe as alarming.

Q120 Mr Mudie: I know that and you said that. I am saying if it turns out that they are - and we have already heard and been critical of the lack of activity - would you guarantee that we will have some activity if the numbers keep at this high level?

Ms Barker: Again, I have to say, and it must be apparent, I could not give that guarantee because it would not be within my remit.

Mr King: We have two ways in which we can be involved in this. One is that we will look carefully at the credit conditions in the economy and the housing market in making our judgments about interest rates, and that is a key point. If we feel that there are aspects of the housing market that require separate, specifically tailored interventions, we can discuss that with other government departments. It would be quite wrong for me to ---

Q121 Mr Mudie: No, I realise it is off-the-cuff but that second one is very useful. Will you undertake to do that if the high figures continue and it looks as though we are going to revert?

Mr King: I will certainly undertake to talk with colleagues in government.

Q122 Mr Mudie: Thank you.

Mr King: One last point I would like to make is that the United States does face quite serious problems in its housing market which are of an altogether different order of magnitude from those here.

Q123 Mr Fallon: Governor, you have just said that you expect the events of the last seven days not to have damaged long-term confidence in the British banking system. How much damage do you think it has done to the reputation of the Bank of England and your Governorship?

Mr King: I think only others can judge that. All I can do is take the decisions that I think to be appropriate in the interests of the country as a whole, to come and explain that to you and others before this Committee and elsewhere. You will have to make that judgment, not me.

Q124 Chairman: Paul Tucker, you have discussed the liquidity problems, you have done that all morning but what are the markets saying about the sub-prime credit problems? Are they going to wash up soon and where are they going to wash up?

Mr Tucker: This goes to the point that the Governor was just making. This is the underlying serious problem and the data over the last few months has suggested that it has got worse, and I suspect that the Federal Reserve's action on interest rates earlier this week has partly been taken with that in mind. I think one of the most important things now will be to see whether the action that the Fed has taken starts to stabilise the market in the US.

Q125 Chairman: What action are you taking, Sir John, at the FSA? Have you got any anticipatory action that you are taking on this? Do you vet it very closely?

Sir John Gieve: On the sub-prime within the UK as opposed to the sub-prime losses, the FSA has been doing some intensive work on, if you like, the riskier end of the mortgage market and you will see it issued something just at the beginning of last month about mis-selling and standards at that end of the market. I would just like to repeat what the Governor says that all the analysis that they and we and I think outside commentators have done suggests that the sub-prime problem insofar as it exists in the UK is very, very much smaller than in the US.

Q126 Chairman: 5% I think it was. Paul Tucker, you are in charge of the market area. How long has market chatter been going on about Northern Rock? Somebody has described it to me as "a bright red flashing light which the FSA did not look at" and "they would not know a potential problem if it hit them in the face".

Mr Tucker: We do not focus on individual institutions. We really do stick to our mandate under the MoU and the market situation as a whole and I have described and John and the Governor have described ---

Q127 Chairman: It does not give me much assurance that you stick to your mandate because we ended up with a crisis. As George Mudie said, we are looking for some action from people to ensure that we do not get into the difficult situations, so sticking to your mandate is a pretty unacceptable phrase.

Mr King: Chairman, there have been other occasions when we have come before the Committee where you have asked us the question "Is not that going outside of your mandate?" We have been given a clear mandate and our responsibility is to meet our mandate.

Q128 Chairman: I understand, Governor, but the fact of the matter, as I said earlier on, is here we have a situation where we end up with problems that affect the whole financial system and it is how you work that, that is what we are looking for; we are looking for reassurance.

Mr King: I understand that and what I would suggest is that you talk to all the players involved and then reflect on it and make your judgment.

Q129 Chairman: We will do that. Are there any others in potential trouble? You do not need to name them!

Mr King: I think you know perfectly well that central bank governors cannot go ---

Q130 Chairman: Governor, I was not even talking to you; I was talking to Paul Tucker.

Mr Tucker: Central bank directors take the same approach.

Q131 Chairman: Okay. John Gieve, you say you were alerted to the Northern Rock situation on 14 August. How many days have you been at the Bank since 14 August? Has every day been a strenuous day for you?

Sir John Gieve: No, I was not at the Bank on 14 August. I was away for two weeks in August, first at a family funeral and then for a week in France.

Q132 Chairman: So you were away for three weeks?

Sir John Gieve: No, two weeks.

Q133 Chairman: So from 14 August you were away until the beginning of September?

Sir John Gieve: No, I was back at the end of August. I was in touch with the office. I discussed with the Governor whether I should return. At that stage he thought that was not necessary. I therefore came back at the beginning of September and of course I have been there since.

Q134 Chairman: Okay. Are your FSA and Deputy Governor roles at one? In other words, is the agenda which the FSA has the agenda which the Bank of England has at one? If we read some of the papers yesterday we would be forgiven for thinking they were not at one. What is your view as an ex officio member of the FSA as well as Deputy Governor?

Sir John Gieve: I think like the Governor said the co-operation has worked extremely well and relations are good and there has been no conflict. Of course there are different views between and within institutions about should we do this or that, but I think the tripartite arrangements have worked well. Just on this red flashing light, it is easy to be wise after the event but the markets through the spring and early summer were not saying that Northern Rock is a disaster waiting to happen and it was not the institution that would be affected by problems in sophisticated credit derivatives.

Q135 Chairman: But there was market chatter.

Sir John Gieve: Market chatter accelerated through August.

Q136 Chairman: Northern Rock increased its mortgages threefold beyond anybody else in the market. It had fewer deposits to which to have recourse. In other words, it was almost wholly dependent on going to the wholesale markets. Any good risk director worth his or her salt would have said, "Wait a minute, if we are dependent on one variable here, if that goes wrong we are all up the shoot," so what we are really asking here is was the FSA on the job, were you on the job in saying, "Wait a minute, if things go wrong here, Mr Applegarth, we are really in trouble." You are not giving us any assurance this morning that you were on the job.

Sir John Gieve: I first spoke to Mr Applegarth about the facility we were going to operate on 10 September. It is not my job as a non-executive director of the FSA to get involved in talking to the risk managers and managers of individual banks, but I do believe that the FSA were very closely in touch with them.

Q137 Chairman: Do not try and minimise this.

Sir John Gieve: I am not trying to minimise this.

Q138 Chairman: You are responsible for the strategic focus, that is what it is, we are not asking you to go into micro management, it is the strategic focus, and we are asking you were you alert to that and your answer given to us this morning is that you were not doing much. In fact it seems to me that you were pretty laid back about it.

Sir John Gieve: I do not agree with that. We were alert to the dangers of the financial markets.

Q139 Chairman: I do not think you have convinced this Committee.

Sir John Gieve: If you look at what we said in April and what we said in a number of speeches, notably the Governor's speech just before the summer, it could not have been clearer about the risks of liquidity problems in financial markets. If you say did we see exactly how it would pan how and why it would impact on Northern Rock, which had no particular sub-prime connections and credit derivatives holdings, no, we did not see that, but of course you are absolutely right ---

Q140 Chairman: People were talking about Northern Rock. They were talking to me about Northern Rock and others were talking about Northern Rock so it is absurd for you to come here and say you did not know anything about it. You are the guy in charge of financial stability. You have twin hats on as the Deputy Governor of the Bank and at the FSA and, frankly, I do not think you are doing your job.

Mr King: Chairman, may I just say it is very clearly not the job of the Bank or Sir John as a non-executive director of the board of the FSA to take responsibility for individual institutions.

Q141 Chairman: Governor, understand this, we do not want to be complacent here, there is a big picture we have got to focus on but when we get complacent answers it gets us riled.

Mr King: I do not think the answers are complacent, with respect, and I would urge you please to suspend your judgment about this until you have been able to talk to all three parties in the tripartite arrangement.

Q142 Chairman: Okay. Sir John, lastly, are you disappointed that market participants appear to have taken no notice of comments made by you and the Financial Stability Report warning of the dangers of a change in the price of risk and the illiquid nature of certain market instruments?

Sir John Gieve: Well, I think some of them took more notice than others and adopted less risky approaches, but, yes, obviously it would have been better, and it is not just the Bank, it is the FSA and other regulators too. Obviously looking back on it they mispriced risks especially some liquidity risks.

Q143 Chairman: What lessons have you learned from that?

Sir John Gieve: Well, I think two things. Firstly, markets under the new sophisticated markets as well as under the old banking markets do get a momentum of their own and the players fear more the possibility of being left behind and losing business position than they fear the possible costs if something goes wrong, and that has been apparent in other financial booms, if you like. I think a lot of lessons have been learnt about the details of how in particular sophisticated derivative markets work, and I think we will see in the market and among regulators a number of changes in the pattern and structure of dealings.

Q144 Chairman: Governor, this 10 billion facility that was announced yesterday what about the point of view from banks who say, "We are not going to go near that money, we are not going to ask for it because if we go for the money then there will be a question mark about us and some people will say there is a problem with our bank." In other words, there is a mark of Cain on people who approach you for that money. How are you going to get over that issue?

Mr King: This is an anonymous auction, we do not reveal the names of the people who appear at the auction.

Q145 Chairman: You do not think it will leak?

Mr King: I know this is a leaky world but frankly this is about the only facility ---

Q146 Chairman: You are sitting in the leakiest place in the world here.

Mr King: That is why I am not going to tell this Committee the names of the banks who will take part in it.

Q147 Chairman: I hope that was not a snub, Governor.

Mr King: We have designed this with a balance of considerations and we are putting on the table some liquidity. I would say one last thing, you put to Sir John what lessons have we learnt, for me the key lessen in all this is that I do not want to let down those banks who did read our report and did get out of profitable business in order to reduce the risks of their activities, and what is most important now is that we actually make clear to all banks that if they undertake risky activities we cannot stop them doing that and I do not believe you can get the regulators to stop them doing that. The only thing that will stop banks undertaking risky activities is the knowledge that if things go wrong and the risks materialise they and they alone will bear the consequences.

Q148 Chairman: Governor, thank you very much. I have got a last question and, believe it or not, it is for Dr Sentance, sorry, my apologies but in terms of inflation what signals are you looking for that would indicate that the credit crunches are having a worrying effect on the real economy and have you seen any indications already?

Dr Sentance: I think it is very early to talk about indications. I think so far the indications from the real economy, if you take for example the most recent CBI survey, do not show much impact but we would expect it to take some time if there are going to be impacts. I think the things we are looking at where we expect these financial market developments to impact are through the cost of borrowing and through the availability of borrowing in various forms, both to companies and to individuals, so we will be monitoring that very closely and Bank staff have stepped up the information they are providing to us on the Monetary Policy Committee on this issue. I think we made clear in the minutes that we will be monitoring very closely the price and the availability of credit to see if it is being impacted. I think we have to have an open mind at the moment and it will be the impact on the real economy and hence on inflation that will guide our actions on the Monetary Policy Committee. In my mind that is very clear. We have a mandate on inflation on the Monetary Policy Committee. Clearly demand conditions overseas and in the UK will affect inflation prospects and that is where we need to be looking to see if this is going to have any impact.

Q149 Chairman: Governor, as I said earlier, as an all-party Committee we are intent on ensuring that we get to the root of this issue and the root of the problem and for us that is to see that the system is working properly. To date that has not been the case. We want to work with you and others in the future on that. As I said earlier, we are taking evidence from the FSA very soon after the house returns and then we will hear from the Treasury, but as a result of today's meeting I will also be writing to the Chancellor and when we have heard from him and sought wider evidence then we will no doubt come back to you for further questions and perhaps a further evidence session. Can I thank you and your colleagues for your attendance this morning.

Mr King: Thank you very much, Chairman. Can I say there is a very key area, as I stressed before, of working together forward and that is the exit route from the current Government guarantee, which can only be an exit route to something better than where we were before. This Committee has a very important role to play in that and we would be very happy to work with you on it.

Chairman: Thank you very much.