Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 1 - 19)



  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 12 September.[1] In that letter 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 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 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, about 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. 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 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 market seized up on the basis of problems in a relatively localised area—sub-prime—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 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 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. Once retail depositors have become concerned—and 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 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. 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 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 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 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?

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