Select Committee on Treasury Sixth Report

1  Introduction and overview

The origins of the current crisis

1. On 9 August 2007, the French bank BNP Paribas announced that three of its investment funds were no longer able to value a series of complex financial instruments backed by so-called "sub-prime" residential mortgages in the United States.[1] This was the culmination of a series of announcements reflecting a growing loss of confidence among banks in Europe and the United States about their investments linked to the riskier lending in the US property market. It set off a chain of events, including a crisis of confidence in financial markets across the world, turbulence on stock markets, the run on Northern Rock, and a squeeze on credit and a crisis of confidence with a significant impact on the real economy. In a previous Report we considered the run on Northern Rock, its immediate causes, its consequences, and future arrangements for the management of systemic financial risks associated with retail banks.[2] In this Report, we examine the causes of the dislocation of international financial markets that surfaced on 9 August 2007, subsequent developments in global financial markets and the prospects for international action and other developments to promote financial stability and transparency. The unfolding crisis of confidence is important to keep in mind because of its widespread impact on financial markets, its particular impact on the United Kingdom via Northern Rock, and its emerging impact on the real economy.

Conduct of our inquiry

2. We have previously described the conduct of our inquiry into financial stability and transparency.[3] The oral and written evidence that we received between September 2007 and January 2008 has already been published with our previous Report.[4] In addition to that evidence, our inquiry has also benefited from the Chairman's participation in an Inter-Parliamentary Conference on Crisis Management and Financial Markets organised by the Economic and Monetary Affairs Committee of the European Parliament which took place in Brussels on 22 and 23 January 2008. We are grateful to all those who assisted us in the course of our inquiry, and in particular to Professor Geoffrey Wood of CASS Business School, City University, for his specialist advice.

Financial stability and why it matters

3. The clearest definition of financial stability is that used by the Swedish financial authorities who describe financial stability as meaning "the ability of the financial system to maintain its basic functions without disruptions that entail significant economic costs.[5] When we first took evidence in February 2007 from representatives of the "Tripartite authorities" with responsibility for financial stability in the United Kingdom—HM Treasury, the Financial Services Authority (FSA) and the Bank of England—Mr Jon Cunliffe, then Managing Director, International Finance, HM Treasury, defined financial stability by reference to the objective of "seeking to ensure that the financial system can operate, can play the role that it needs to play in the economy as a whole".[6] Sir John Gieve, Deputy Governor of the Bank of England, told us that it was actually easier to define financial instability than financial stability, and went on to state that

the instability that we are concerned about is a loss of functionality in the financial system which would damage the wider economy because it no longer functioned to bring savings and investment into balance or to transmit money effectively round the system.[7]

4. On that occasion, Mr Hector Sants, then Managing Director, Wholesale Business Unit and Institutional Markets, FSA, and currently the FSA's Chief Executive, drew a distinction between threats of financial instability relating to "risks to market infrastructure"—for example, as a result of terrorism or a pandemic—and "financial market risks".[8] In this Report, we are largely concerned with the latter—in other words, with instability arising from within financial markets.

5. The definitions that we have cited above draw attention not simply to the internal functioning of financial markets, but to the impact on the wider economy of financial instability. Financial instability of the kind that has been experienced since early August 2007 affects the capacity and willingness of lending institutions to provide credit to businesses and individuals, the spreads on such credit and the conditions attached to credit. Financial instability also imposes a more direct price on those with financial investments, including those with long-term investments such as holdings in pension funds. The period of turbulence in financial markets, and especially credit markets, since August 2007, and its potential impact on people in general and the real economy, has propelled the issue of financial stability to the top of the agenda, not just of supervisory authorities, but of public policy makers more generally. It has highlighted the importance of maintaining financial stability and the cost to people and the economy of financial instability.

6. One problem with defining financial stability in terms of the basic functions of the financial system, as defined by the Sweden Authorities, is that these basic functions often differ across time as well as across countries. Thus, it may also prove useful to look at the issue in terms of the impact of financial instability, which Professor Wood explained:

as episodes in which a large number of parties, whether they are households, companies, or (individual) governments, experience financial crises which are not warranted by their previous behaviour, and where these crises collectively have seriously adverse macro-economic effects.[9]

7. The market turbulence since August 2007 has propelled the issue of financial stability to the top of the political agenda. The terms "financial stability" and "serious threat to financial stability" are used in the Banking (Special Provisions) Act without a legal definition. There is a continuing lack of clarity about what is meant by financial stability as well as what events constitutes a "serious threat to financial stability". We believe there is a need for clarity from the Tripartite authorities about how they define financial stability so that stakeholder can assess whether particular events constitute a threat to financial stability. This clarification should be in advance of Parliamentary consideration of the Banking Reform Bill. Such a step would ensure that policy interventions to maintain financial stability would in future take place against a more objective backdrop and would be particularly important in aiding the work of the tripartite authorities in promoting financial stability.

The international dimension

8. In our previous Report we were concerned with the impact of financial instability on one United Kingdom institution—Northern Rock—and on the British banking system. Although some of the effects of the market instability since August have been peculiar to the United Kingdom, it is evident that the instability with which we are concerned is an international phenomenon. As we will see, its trigger lies to a significant extent in developments in the United States, most notably in the growing linkage between the markets for complex financial instruments and the US market in "sub-prime" mortgages. Banks in Germany and France were affected by these developments before British banks.

9. In July 2006, we referred to the possible risks to the world economy associated with "global imbalances", in other words with the continued rapid growth in Asian economies not being off-set by an appreciation of Asian currencies against the US dollar.[10] Since then the rapid rise in the value of oil has exacerbated these imbalances, and countries which have them now also include the major oil-exporting countries. Despite continuing concerns about these imbalances, it is notable that the current period of instability has its origins firmly in the most developed markets, most notably that of the United States. The Governor of the Bank of England drew attention to this feature of the current period of instability, telling us in December:

I think the problems we are facing are international in nature … It has been a very salutary lesson, because this crisis has become international in nature. It is not a crisis of emerging market economies or failed macro-economic policies in the rest of the world, this crisis goes right to the heart of the financial centres of the three big developed parts of the world.[11]

The international nature of the recent problems reflects the global nature of financial markets and the instantaneous nature of world communications, which make national borders largely irrelevant to the transmission of some shocks. In this Report, we examine the international dimension of the problems, and the international dimension of possible solutions.

1   Speech by the Governor of the Bank of England at the Northern Ireland Chamber of Commerce and Industry, Belfast, 9 October 2007, pp2-3; BNP Paribas, press release, 9 August 2007 Back

2   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-I Back

3   Ibid., paras 2-5 Back

4   HC (2007-08) 56-II. All references to oral evidence (in the form Q … or Qq …) or to written evidence (in the form Ev) are to such evidence published in that Volume unless otherwise stated. Back

5   Memorandum of Understanding between the Government offices (Ministry of Finance, Sveriges Riksbank and Finansinspektionen) regarding cooperation in the fields of financial stability and crisis management, June 2005, p 1 Back

6   Treasury Committee, Oral evidence, Thursday 1 February 2007, Financial Stability, HC 292-i, Q 14 Back

7   Ibid. Back

8   Ibid. Back

9   Defining and Achieving Financial Stability, William A. Allen and Geoffrey Wood, Cass Business School, City University  Back

10   Treasury Committee, Ninth Report of Session 2005-06, Globalisation: the role of the IMF, HC 875, paras 6-8 Back

11   Q 1697 Back

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