Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 40 - 59)

THURSDAY 20 SEPTEMBER 2007

MR MERVYN KING, SIR JOHN GIEVE, MR PAUL TUCKER, MS KATE BARKER AND DR ANDREW SENTANCE

  Q40  Mr Fallon: Of the fact that Northern Rock would be exposed if the wholesale markets froze.

  Sir John Gieve: I think Northern Rock has the most developed wholesale funding model among the mortgage banks in Britain. There was a detailed knowledge in the FSA of the positions of the individual banks. Did we foresee that the way that events would unfold exactly in terms of the freezing of the mortgage securitisation market and the impact on term money markets? No, we did not see exactly how it would come through. At the point of April—this is before the events—we identified that there were vulnerabilities in the system but we did not see exactly the path that they would lead back to Northern Rock. And I do not think anyone did.

  Q41  Mr Fallon: You did not see that Northern Rock would run out of money?

  Sir John Gieve: No, I do not think we did.

  Q42  Chairman: There was no risk analysis of Northern Rock?

  Sir John Gieve: I am sure that as part of the supervision of Northern Rock—I am sure this is the case—the FSA team require them to do different stress tests, so I am sure the FSA and Northern Rock looked at the impact on their balance sheet and operations of different stress tests. I do not have the details of what those were but that is something that I know the FSA has been doing a lot of work on.

  Mr Tucker: I hold the same position on the individual institutions, Chairman, but what I would add is that from July onwards we were focused on what was happening in the markets as a whole and analysing the channels of strain. And we did identify that there could be spillover to the asset-backed securities market and to the ABCP funding market and we briefed colleagues on that. Our job in this structure is to identify what is going on in markets as whole.

  Q43  Mr Fallon: You briefed which colleagues?

  Mr Tucker: Colleagues in the Bank and colleagues in the tripartite structure, but this was not about individual institutions.

  Q44  Mr Fallon: All right, could I turn, Governor, to the three-month facility that you announced yesterday. Can you explain to us the role of ministers in this three-month facility? Have they been urging it on you as long as the big banks?

  Mr King: No, the banks have clearly been urging us to do an operation like this for a long time and to some extent they would, would they not, because they are in a position now of having to acquire liquidity at a much higher price than they would have wished, given that in their risky business models, the risk materialised. The real aim of trying to minimise moral hazard, which is one of the objectives set down in the 1997 MoU, is not to provide liquidity at a zero cost, and we are not doing that. The concerns that led me to want to propose this yesterday were concerns about the banking system as a whole. This operation was designed entirely in the Bank. We have the competence to do that; I do not think people in either the Treasury or the FSA have the competence to do that, just as we do not have the competence to do their jobs. But of course I discussed it with the Chairman of the FSA and the Chancellor. In these difficult times it would be wholly irresponsible not to do so.

  Q45  Mr Fallon: But when did Ministers first canvass the option?

  Mr King: This was discussed among all parties over last weekend in the aftermath of the run on Northern Rock and the concerns that were being expressed about what this meant for the stability of the British banking system as a whole, and at that point I judged that it was worth doing something, but also limiting the moral hazard very clearly by capping the size of the operation in order to give assurance that whatever strains we might see would be alleviated.

  Q46  Mr Fallon: Governor, you have spoken on moral hazard and you have written us an eloquent essay on moral hazard, but is not the criticism that you have passed the theory but when it came to dealing with Northern Rock and when it came to dealing with three-month funding actually you failed the practical?

  Mr King: No, I do not think that is true at all. I am happy to explain a bit later if you like why I think moral hazard is such an important issue. Can I just answer this point. I have tried to set out a sequence of events in which Northern Rock required ultimately a lender of last resort, the way in which we would have preferred to do it was not open to us, and at that point we did it in an overt way. I do not think it was at all obvious what impact that would have. It might or might not have led to people wanting to take their money out. In the event it did and once that run had started people were not behaving illogically by joining it and at that point the only solution was the Government guarantee. I think this is a very clear chain of events.

  Q47  Mr Todd: I am going to come to moral hazard because you are keen to talk about that but I just want to explore the issue of information and how people understand it in this story. I think you were quite correct in saying that the initial step with Northern Rock could have been interpreted in two ways. On balance, people felt that it gave a signal of insecurity in that particular institution and they headed for the queues. Is there not an argument for saying that subsequent extension of the guarantees given to Northern Rock to the banking system at large, with depositors effectively being secured by the Government, and also the wider steps taken yesterday, also convey a more generic message of wider concern about the banking system in this country, which may convey similar messages of alarm to people on a wider scale? So what I am exploring is how actions that you can see and others in the tripartite agreement can see are logical in themselves can be perceived on the outside in a rather different way?

  Mr King: I think that the announcement of a guarantee, had it come before the run on Northern Rock, would indeed have been interpreted in the way that you suggested might have happened and I think would have been an irresponsible thing to have done. It would undoubtedly be said, "Why on earth is this being done?" It was clear why it was being done when you could see the run on Northern Rock because and,, at that point, only a Government guarantee was capable of stopping that run, there was no other way out.

  Q48  Mr Todd: That guarantee has now been extended beyond Northern Rock, that is the point I am making.

  Mr King: For the reason that, once depositors see that if a run starts our current ability to deal with it, given that the insolvency legislation and the deposit insurance, is inadequate, people must know that there is a Government guarantee and it is the Government guarantee that prevents the run. This is not a permanent solution. We have to find a way through to a better permanent system but a Government guarantee is there now to give complete reassurance that no depositor will lose. The important point to hang on to here is that no depositor has lost anything at all.

  Q49  Mr Todd: Absolutely but extending that point a little further, the extension of liquidity that you have offered yesterday, on terms I entirely accept, does that not also convey a wider implication of concern, because I think that I have interpreted your actions as being to try and act cautiously and in a rather focused way and give a clear message that the broad system is working reasonably well, we have a strong economy and our banking system should be able to cope with these circumstances? There is an argument for saying that some of the actions which have been taken most recently suggest to an outsider that that statement of confidence is misplaced.

  Mr King: I do not think confidence in the banking system as a whole is misplaced. As you say, there is always a delicate judgment to make about whether putting in place an auction of the kind that we did would create more concern because of the fact that we were doing it than it would benefit the system in terms of alleviating the strains, but my judgment was that after the Northern Rock run and the impact of the sight of depositors queuing in the streets to take their money out, there were potential strains, at least, in the system that were worth guarding against. It is a difficult balancing judgment. I cannot claim that it is obvious that the judgment was right or not but we have to make these judgments in real time and I think given where we are today I would still have done it yesterday.

  Q50  Mr Todd: In your covering note to the letter that has been published—and I do not know whether the letter to John was published at the time—I quote the words you said there: "I am conscious that in sending you this statement I am taking a snapshot of a fast-moving situation with a long exposure camera."

  Mr King: Absolutely right.

  Q51  Mr Todd: I think that was a reasonable summary of the position you found yourself in. Can we talk about moral hazard. Your focus on that has perhaps been interpreted as being academic, even puritanical, in comparison to the approach taken by other central banks, and it is certainly noticeable that in the public statements of other central bankers there has not tended to be the same emphasis on moral hazard as you have placed on it yourself. Can you explain that difference of approach?

  Mr King: I do not believe that moral hazard is just some dry academic concept.

  Q52  Mr Todd: Nor do I.

  Mr King: It is moral hazard that has actually led us to where we are. I do not want to blame anybody at all for what has happened. I think one of the interesting aspects of this crisis is that all the players have acted completely rationally given the position they were put in, and the point about taking moral hazard seriously is that if what we do is to say to the banking system if you take these risks again in the future then do not worry we will provide you with ex post insurance, that means there is no incentive for them to take out any insurance or to behave in a less risky way beforehand. Why do I think this is important? About four weeks ago I remember listening to an interview on the radio in which a young woman was explaining that she had taken out a mortgage for her and her husband. They had not anticipated the events that occurred with the rise in interest rates and she had found herself in a problem where they were short of liquidity. They had turned to other sources which were more expensive and they had now built up debts of £100,000 which she could not repay. She put those points to someone from the banking industry who I thought responded very reasonably, namely "We are deeply sympathetic, we understand the nature of your problems, but can you imagine what would happen if the banks were to forgive you those debts? What could the banks say to those customers who actually behaved more prudently, that did not borrow more than they could afford? What would happen to people's willingness to behave prudently in future if we bailed you out?" It is a little bit strange that that seems to apply to the borrowers from banks but not to the banks themselves.

  Q53  Mr Todd: By my question was slightly different to that because I have to say I agree with your missives on this (I have got a rather stern puritanical streak too!) but the puzzle is why that has not been emphasised by your colleagues.

  Mr King: It may not have been emphasised in speeches to the same extent.

  Q54  Mr Todd: Or acted on.

  Mr King: It has been acted on. If you look at what the ECB and the Fed have done in their market operations they have not provided complete ex post insurance, they have not put sufficient liquidity into the banking system to enable the banks immediately to take back onto their balance sheet all the risky conduits and vehicles that they have created without incurring a cost. All banks around the world will pay a price for what has happened. What I want to do is to make sure that when they get liquidity from central banks they pay a price for it and do not get it free. The banking system as a whole can afford to do this. If I thought there was a risk to the British banking system as a whole and that the capital that the British banking system has was inadequate to take this onto their balance sheets, I would be out there putting liquidity in at a lower price to stabilise the British banking system. That is not necessary. If you always provide ex post insurance you can be quite sure that in five or ten years' time another crisis will come. That is exactly what we have seen in the last 20 years. The one thing I do not want to do is to find myself five or ten years down the road saying, "Why did I take the easy option? Why did I do that? Why did I sow the seeds of a future crisis?" The whole regime of monetary policy that we have put in place has been to demonstrate that taking the easy option and giving in in the short run without looking to the long-run consequences of those actions is damaging. Every manufacturing company I go out and meet around the country every month has come to realise that the short-term option which they wanted ten to 15 years ago—a cut in interest rates at the first sign of a problem—is not the way to go; it is having a stable framework. We need to put that view back into the financial system.

  Q55  Mr Brady: Governor, can I ask when you first discussed the possibility of the 100% guarantee for retail deposits?

  Mr King: The first discussion I had about that subject was on Sunday after the run had started.

  Q56  Mr Brady: Did the impetus for that come from the Bank or from the Treasury?

  Mr King: It came out of discussions among all three of us. I think it was clear to everyone that the only way to stop the run at that stage was indeed a guarantee.

  Q57  Mr Brady: And what was it that finally made that decision necessary? You referred earlier to seeing the screens and the impact on the screens, was that part of the rationale?

  Mr King: No, I think it was clear that if the run had continued then all the retail deposits would have disappeared because once it had started it was not illogical for others to come in behind it, and therefore something had to be done to stop the run, and at that point without an adequate insurance scheme, without the ability to put the company into a position where it could immediately repay the depositors, only a Government guarantee would stop the run. It was the only solution at that point.

  Q58  Mr Brady: You have already said that it is a temporary solution, which I suppose is obvious, but what is the set of circumstances which needs to be in place for the guarantee to be removed? Does it require the piece of legislation to which you referred and the whole regulatory environment to be changed or can it happen sooner?

  Mr King: I think you have to ask the question why was this not regarded as something so urgent in the past? Governments of all parties did not regard it as a top priority and I think the reasons are because, first of all, the recent circumstances are pretty unusual so it was not a pressing problem and, secondly, at that point the Bank of England did have the ability to act as a lender of last resort in ways that we were not able to this time. However, I think that has all gone now. My feeling is that legislation introduced not too speedily but after careful thought is absolutely crucial now and that is the exit route from where we are into a more stable future system. This Committee clearly has an important role in leading it because this is not—and I would urge you not to regard it as such—a political issue, this is a cross-party issue in which everyone has an incentive for putting in place a more stable structure for our banking system.

  Q59  Mr Brady: Can I also ask for some clarification about the extent of the guarantee. I do not think this is clear yet. Does the guarantee extend to retail deposits held with overseas banks operating in the UK or is the guarantee only to British banks?

  Mr King: Sir John has been involved in the discussions. Can I just summarise the broad principle behind it which is that this would be extended to other banks if they found themselves in a similar position, that is to UK retail depositors and other unsecured creditors, but perhaps Sir John could comment on that. The Treasury put out a notice at 7 o'clock this morning and I think questions on the detail of that should go to them.

  Sir John Gieve: The note that the Treasury put out was about the guarantee to Northern Rock, and that is the only guarantee in place at the moment, and it defines what "existing deposits" means and it defines that in terms of "accounts up to midnight on Wednesday 19 November", with the addition that accounts closed in the last few days can be re-opened. It defines the wholesale market cover as being to existing and renewed wholesale deposits, so wholesale deposits that are rolled over at the end of their term will be covered and so will existing and renewed wholesale borrowing which is not collateralised. The point about the broader banking sector is covered in what the Chancellor said. If another bank found itself in the same circumstances it would get the same treatment.


 
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