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
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".
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
Sants told us that "we were clear on the risks that the increased
complexity in the marketplace was creating for institutional investors"
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.
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".
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.
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".
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
so we have been concerned that not all institutions
had properly anticipated the possibility or the likelihood of
a significant deterioration in credit markets.
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".
The Governor replied, when questioned as to whether speech-making
was the only weapon available to him, that "we have no other
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.
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. 
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. 
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
320 Q 306 Back
Q 37 Back
Q 1473 Back
Q 1571 Back
Q 1568 Back
Q 1480 Back
Q 1481 Back
Q 1728 Back
Q 1729 Back
Q 1730 Back
Q 1571 Back
Q 1687 Back