Examination of Witnesses (Questions 1
THURSDAY 20 SEPTEMBER 2007
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
Sentance, 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
In that letter you told us that providing extra liquidity at longer
maturitiesin your wordsundermines 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
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 confidence 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 announced 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 to, 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 go back to those circumstances
quickly and get back to where we were in July would have meant
injecting a massive amount of liquidity. 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
inquiryI certainly want toto 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 companyand Northern Rock is a
quoted companycannot 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, about your
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. The timing of
the troubles in August was 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. 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 had 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
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
market seized up on the basis of problems in a relatively localised
areasub-primemost 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 they went 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
banks had provided very large committed lines of credit or 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
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. Once retail depositors have become
concernedand it was not obvious that the announcement of
the lender of last resort operation would result in people wanting
to take money their out, it could have gone either wayonce
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. 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 Jon
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 economywe still
arewe 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 knowing 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
a U-turn in the past seven days?
Mr King: No, I can assure you
that the operation we announced 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 protectionto name three
at the momentare 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
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?
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