Select Committee on Treasury Sixth Report

9  Heeding the warnings

217. In chapter three we discussed how a number of public authorities, including the Bank of England and the FSA, had raised questions about the pricing of risk in credit markets as well as the risk of impaired market liquidity. One of our key concerns during the course of this inquiry has been that many market participants appear to have failed to 'heed these warnings' and, whether as a result, new mechanisms are required to ensure market participants acknowledge and act upon 'warnings' by the authorities.

218. Both the Governor of the Bank of England and the Chairman of the FSA told us that they had made repeated warnings about deteriorating market conditions. Sir Callum McCarthy said "The FSA has been concerned for some time about the pricing of risk generally … there has been a mispricing of risk, and that has been repeatedly a point we have made".[320] The Governor of the Bank of England said that the Bank had "identified the increasing wholesale funding of banks as a potential risk if markets became less liquid. That was one of the warnings we gave".[321] Mr Sants told us that "we were clear on the risks that the increased complexity in the marketplace was creating for institutional investors" but:

we placed the onus on them then to draw the conclusions from that process, otherwise effectively we would be running the market which I do not think is desirable.[322]

219. We asked witnesses whether market participants had heeded these warnings. Angela Knight, Chief Executive of the British Bankers Association, told us that "there may well be an institution in any walk of life that does not necessarily take the appropriate action at the appropriate time, but in terms of the industry and banks in general, do they act on warnings, the answer is yes".[323] Adrian Coles, Director-General of the Building Societies Association (BSA) told us, when asked what action the BSA had taken, that:

On the day the Financial Risk Outlook was published by the FSA, we sent out a circular to our members strongly advising them to read the FRO. We gave them full details of the relevant pages for building societies, the relevant developments in the mortgage and savings market that would be most important for building societies to read, and our evidence is that building societies read that carefully and were fully expecting a slowdown in the housing market this year. They were not expecting the closedown of markets in August but they were expecting a slowdown and we encouraged them to read the relevant documents.[324]

Mr Sants believed that some market participants had heeded warnings, telling us that "we certainly do have evidence that some of the institutions were taking steps to manage their financial affairs on the assumption that market conditions would get more difficult".[325] However, when questioned further Mr Sants told us that the FSA had restated their concerns about market conditions in their July 2007 press conference because

we thought that not all institutions had properly anticipated the possibility of an abrupt change in market liquidity and ratings … so we have been concerned that not all institutions had properly anticipated the possibility or the likelihood of a significant deterioration in credit markets.[326]

220. The Governor of the Bank of England expressed concerns as to how far the Bank "can ensure that our general views and comments are really taken on board".[327] The Governor replied, when questioned as to whether speech-making was the only weapon available to him, that "we have no other policy instrument".[328] The Governor went on to say that:

If by giving speeches which are sufficiently compelling and through the financial stability report … we can convince people that what they were doing was to take risks that they did not fully understand, then maybe we will bring about some improvement, but I do feel that in the last few years we are seeing a certain degree of hubris, and it is never easy to persuade people suffering from that to think deeply about risk. Alan Greenspan was not very successful in getting across the idea of irrational exuberance. We have to keep plugging away and trying, but I think trying to win the argument is our main weapon.[329]

221. We asked Ms Knight what further action the public authorities should be taking to ensure that when they do issue warnings that action is taken by banks. Ms Knight told us:

I think also, though, the question is this: what is the nature of the follow-up by the various authorities themselves? Because I agree with you it is one thing to issue some sort of communication and quite another to say that they have also put in place the right tools and the right monitoring process to see whether those actions have taken place. We do wonder whether that is another area which warrants further review. [330]

The Governor agreed that there was a need to explore how the authorities could ensure that its warnings were being heeded by market participants. The Governor told us that:

One of the tasks … in the next few months is to try to work out a way in which we can ensure that when we write Financial Stability Reports and give warnings, that we do not just put it out into the ether, we try to find a mechanism by which people have to respond and they visibly have to respond. I do not have any simple answers to that, but I do think it is a challenge for us. It is one of the lessons and we have to do something about it. [331]

222. The Bank of England and FSA both gave warnings of deteriorating market conditions during 2007. It is has been reported to us that these warnings were not taken on board by some banks and building societies. We do not believe that public authorities should be prescriptive in how financial institutions must react to such warnings. However, given the strong public interest in avoiding banking crises, there is a strong case for establishing a mechanism by which receipt of warnings from public authorities would be formally acknowledged by financial institutions. We recommend that when issuing warnings of potential problems, the Bank of England and the FSA should highlight the two or three most important risks in a short covering letter to financial institutions, for discussion at Board level. The Bank and FSA should seek confirmation that these warnings have been properly considered, and publish commentaries on the responses received.

320   Q 306 Back

321   Q 37 Back

322   Q 1473 Back

323   Q 1571 Back

324   Q 1568 Back

325   Q 1480 Back

326   Q 1481 Back

327   Q 1728 Back

328   Q 1729 Back

329   Q 1730 Back

330   Q 1571 Back

331   Q 1687 Back

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