Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 80 - 99)

THURSDAY 20 SEPTEMBER 2007

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

  Q80  Mr Mudie: Okay.

  Mr King: The lender of last resort facility was announced on the Friday and on Sunday I was asked—to be quite clear because it was a facility we were extending and if any bank were to bid for Northern Rock they would need to know the terms for the bank that they were acquiring—very explicitly would the lender of last resort facility that had been extended to Northern Rock be rolled over with the rest of the bank to a bidder, and I said yes. I encouraged the bid process. However I can tell you that last Sunday the only solution to stopping the run was a Government guarantee; anything else was a sideshow. Only a Government guarantee would have been sufficient to have persuaded the depositors to leave their money in Northern Rock.

  Q81  Mr Mudie: Just going on to one last question in terms of the second major matter of the three-month money. The Chairman asked you that question at the beginning and you said later on to one of my colleagues that there were four reasons. I wrote down, not in shorthand but as best I could as a poor Scot, your four reasons. I got two of them, if I can read my writing, queues was one, the media was one, and I am not sure I got the other two. In that letter that you wrote—and you knew about Northern Rock when you wrote this letter that put you in the corner—you said "strong reasons" and then you said to one of my colleagues "four strong reasons". Could you spell out—

  Mr King: The number four was referring to the four unconnected pieces of legislation that were relevant to the difficulties we had.

  Q82  Mr Mudie: So what were the strong reasons then because you needed strong reasons to depart from your macho line? Tell us the strong reasons then.

  Mr King: As I said in the statement to the Chairman, the balancing between concerns about strains in the banking system as a whole and the moral hazard that I have described is a balancing judgment that we were making almost daily, and we did make it daily, and after the weekend we had seen some volatility in the overnight rate, we had seen some upward movement in the spread in longer term markets, and we had seen people worried about the reputation of the British banking system and strains in it, and I judged at that point that the right balance to strike—and people can reach different views on it, I do not pretend there is an absolute right or wrong here—I reached the judgment on balance that it was better to conduct a limited operation which minimised the risk of moral hazard but did inject at that point through the announcement of the auction to be held next week some additional liquidity. That balance is one that everyone has to strike in a central bank and I struck it in that way.

  Q83  Mr Mudie: What do you think of the FSA meeting the bankers in the morning, when you met them in the evening, either directly or implicitly indicating that they thought you should do this U-turn?

  Mr King: I cannot comment on the meeting with the FSA but I can comment on the meeting that I held. I had asked for a confidential meeting with the bankers and they came along and I had hoped that it would have been regarded as confidential. In that process of course they said they would prefer to have more liquidity at a lower price. That is not very surprising. If I were in their position I would ask for exactly the same. I tried to explain why if they were in my position they would understand that I had to make a public policy judgment which is to balance the use of providing free liquidity to them against moral hazard.

  Q84  Mr Mudie: But it was not the rate that you were charging, it was the assets that you were prepared to take, you were extending them.

  Mr King: And what I discussed with them at that meeting quite explicitly was to ask them why they felt that extending support with liquidity injections against a much wider range of collateral would be helpful to them and they explained that it would. In the auction that we announced yesterday we announced that we would be willing to allow people to bid against collateral for a very much wider range of liquidity including mortgages. That is not something that either the Fed or the ECB have done and we did that because we felt that it was the breadth of the collateral that was important rather than the size of the operation.

  Q85  Peter Viggers: Is there a qualitative element in the guarantee you are giving to retail deposits? Does the guarantee cover less prudent as well as more prudently run banks or is it a blanket guarantee?

  Mr King: The Chancellor said that the guarantee would be available to banks who found themselves in a similar position. I think what that means is depositors should be reassured that when they put deposits in a British bank they will be completely protected. In the long run that is clearly not a sustainable resting position but in present circumstances I think it is absolutely vital.

  Q86  Peter Viggers: How severely do you think the principle of moral hazard has been compromised since you wrote us your rigorous and lucid letter?

  Mr King: I hope that it has not and I do not believe that it has but, as I said, this is a balancing judgment. When I listened to the banks I do not believe that they felt that offering them an ability to bid for liquidity at a 100 basis point premium over bank rate was something that they regarded as entirely generous, so I think there is still a fair chunk of restriction against moral hazard in what we have done.

  Q87  Peter Viggers: When you make advances under the proposed auction it will be against, as you have just explained, a very wide range of collateral including mortgage collateral. How rigorously will you be able to scrutinise the mortgage collateral that has been offered to you? Will there be collateralised debt obligations, securitised mortgages, which will be in a bundle and which will not be capable of proper analysis by you?

  Mr King: Let me ask Mr Tucker who is responsible for dealing with the practicalities of this.

  Mr Tucker: We will announce the details tomorrow. There will not be collateralised debt obligations. There will be triple A tranches of prime mortgage-backed securities. The issue that you raise is an important one. It will be addressed by conservative haircuts so that we would lend against X% of the value of the security and the haircuts will be conservative for precisely the reason you say.

  Q88  Peter Viggers: Perhaps for those who are not conservatives and do not know about haircuts you would just explain that?

  Mr Tucker: Sorry. Say a security is valued at £100. We might lend £50 against that £100 security or £70 against that £100 security and that would protect us against a fall in the value of that security during its life. That is the first step. The second is that the loan will be for three months. If the value of the collateral we hold falls during that period we will call for more collateral to protect ourselves and then if a borrower were to default we would be protected by the haircuts I described at the beginning—lending a fraction of the value of the securities that we hold.

  Q89  Peter Viggers: Very well. Governor, when the Memorandum of Understanding effectively took direct banking supervision away from you and gave it specifically to the Financial Services Authority it is now quite specifically responsible for the prudential supervision of banks, building societies and for the conduct of operations in response to problem cases affecting firms. You happen to be here today and the original intention was to talk about the Inflation Report—

  Mr King: Indeed!

  Q90  Peter Viggers: But it should really have been the Financial Services Authority which should be answering many of the questions which are being put now. Yet on the other hand when a proposal came through to provide a lifeline and a rescue operation it was the Bank of England, as you have explained to us, which led on this. Would you not agree that the comment originally made in 1997 that the Memorandum of Understanding was "unworkable in a crisis" has actually been proved to be correct?

  Mr King: No, I do not accept that. One of the very good reasons for taking supervision away from the Bank of England was that it was becoming more and more impracticable to regard banks as being part of the financial system that could be regulated independently of a wider range of financial institutions. The whole process of supervision now is much more formal, much more legalistic, much more international. I think it is a full-time job. It takes up all the energies of senior people to do that. In the event of any crisis like this it is inevitable that those responsible for supervision, those responsible for central banking activities and the Government have to work together irrespective of where they are actually located, so even if two of those had been in the Bank of England we would still have had to work with the Government so having all three people there I think is crucial. The MoU in my experience has ensured very effective, speedy communication. Callum McCarthy, the Chancellor and I have talked regularly and frequently. We have a team of deputies under us who speak even more frequently. I do not believe that the communication or the effectiveness of the tripartite arrangements have been in any way responsible for this. Indeed in my experience it has enhanced it. I just do not believe that one institution—a central bank—can manage in today's world both monetary policy and the entire range of financial supervision.

  Q91  Peter Viggers: And is the communication between the three members referred to formalised and will communications between the three of you be published?

  Mr King: I think that will depend on the chair of the tripartite arrangements. I would expect a lot of the conversations that we have held to remain confidential because they are market sensitive. We have had many communications both formal and informal and the informal collaboration and communication between the Chancellor, Callum and myself has been absolutely crucial in dealing with what was a fast-moving set of events.

  Q92  Peter Viggers: Finally can I ask Paul Tucker if he would comment on the current state of the commercial paper market?

  Mr Tucker: A little bit better than a week ago. This is important and over the last few weeks the underlying problem has started to be addressed. The underlying problem is that investors should distinguish between one type of security that has got real difficulties and other types of security that are maybe okay. That process will take a while and it does seem to be gradually underway. I think there is still a long way to go and there could still be setbacks. The last ten days in terms of global markets as opposed to our local position have been very mildly encouraging.

  Q93  Peter Viggers: And how important was it that banks were unable to raise money on the commercial paper market?

  Mr Tucker: I think the fact that banks and these so-called conduits were not able to raise commercial paper or were only able to raise commercial paper at very short maturities is right at the heart of the problem. It is difficult to see that the problem will be resolved without either that market being restored to something like normality or, alternatively, a lot of that paper coming on to banks' balance sheets, reintermediation if you like from the capital markets into the banking system. It is because of the latter possibility that banks have been stockpiling liquidity and trying to protect themselves against that eventuality and that has been individually rational but collectively deleterious.

  Q94  Ms Keeble: I wanted to ask a bit about the role of the credit ratings agency. I have also got some questions, Paul, on some of the things you have just said. Sir John, I wonder if you could say from the FSA's point of view if you think that the ratings agencies have provided markets with the kind of information that they need on which to base their decisions?

  Sir John Gieve: I think this is something that we are going to look at on an international basis with other regulators and central banks in the future. I think that people definitely relied on ratings agencies' ratings in an inappropriate way. The ratings agencies would say that if they had read the fine print there was plenty of explanation about the limited assurances that they were putting forward. But I think many investors and people setting investment remits did just say "if it is triple A it is all right", not distinguishing between different sorts of instruments. What we obviously need to look at is did the ratings agencies do it wrong or was it the investors who did not use the ratings agencies properly and put too much dependence on them?

  Q95  Ms Keeble: If I can just come back on that. Firstly, why so late and, secondly, it is fairly well-established, is it not, that the ratings agencies work very closely with the banks to compile the vehicles to attract the kind of ratings which are then required to be attractive on the market; would you accept that? Why so late and do you not think that it is really unacceptable to have the ratings agencies virtually colluding with the banks in the construction of vehicles which are then, as the Governor has accepted, risky?

  Sir John Gieve: I think the ratings agencies' response to that is that their reputation and their future business depends on producing ratings which stand up in practice.

  Q96  Ms Keeble: But what is your response?

  Sir John Gieve: I think there is a question about whether they went too far in relying on their models to put firm ratings against products which did not have an obvious market value. Particularly in the sophisticated credit derivatives field, where they have, I think, as good models as anyone, maybe those models were simply too limited to justify a firm rating.

  Q97  Ms Keeble: And then for Paul, because you are obviously working at a different end of it, when you did your report on July 25 warning of the risks, what did you rely on and in saying now that this week is a little bit better than it was a week ago, what are you actually looking at and what real risks are you taking into account? Then I wanted to ask the Governor something about this as well.

  Mr Tucker: What are we relying on? First of all, we are relying on two sources of information. One is conversations with people in these markets around the world, both people who are selling commercial paper, coming back to that particular question, and people who are buying commercial paper. This would go not just for the commercial paper market but across a whole range of markets. The second source of information is published information on the prices at which, in this case, commercial paper is being issued and also the quantities that are being issued. It is virtually always a blend of market intelligence drawn not just from the banking system but from asset managers and from many others as well and hard information produced from all sorts of sources, some of them official.

  Q98  Ms Keeble: If I can just ask the Governor because this issue about risk assessment is something that the Committee has looked at in the private equity investigation as well and you referred to the possibility in the coming weeks of what would happen if the banks were forced to take risky—and I have not got your exact words because I have not got perfect shorthand either—risky conduits and special investment vehicles back onto their balance sheets? Which are those risky investments and how do you know where they are if you have not got the ratings agencies giving a good, robust assessment of what the risks are?

  Mr King: Can I step back one point because I think it is very helpful to put this in the context of the real financial crisis that started on 9 August. I know most of the questions naturally have been about Northern Rock but we should not forget that all this came out of this general problem that you are referring to.

  Q99  Ms Keeble: That is right, I want to know where the risks are and if there are more out there.

  Mr King: I will come on to that. There is one point I want to make about ratings agencies. There is a very important call and longer term analysis to be made of how ratings agencies behave. The conflicts of interests that you have alluded to are clearly part of that, but it would be most unfortunate in present circumstances if for political reasons pressure was brought to bear on ratings agencies to have a knee-jerk response to go completely in the opposite direction and to downgrade everything at sight because they might be held responsible for their behaviour. That would lead us into a really difficult position and I know you are not suggesting it but it has come up in various international fora. We need a long look at that. In terms of the risks, what has happened is that many of the banks created these vehicles to hold off balance sheet (perhaps sometimes to avoid regulatory capital requirements). These vehicles hold securities in which the market is now illiquid. The banks will now have to take back onto their balance sheets these assets which may well be perfectly good value in the longer term when the markets re-open but they are highly illiquid. That will require some use of capital of the banks to finance this in the short term and that is why, as Paul said earlier, banks are currently hoarding liquidity in order to finance the taking back onto their balance sheets of these vehicles. They know what these vehicles are, they set them up, and the FSA and the parallel regulatory authorities around the world have been talking to the banks and finding out whether the banks know about their exposures. They say to us that they are confident that all the major banks know about their exposures and that they could take these back onto their balance sheets without any major hit on their capital so that they would still be left with capital well above their capital regulatory minimum. It does mean that the banks will have to find more expensive sources of liquidity than they had expected or hoped, they will pay a price in terms of profits. There is absolutely no difficulty in due course in their doing so but in the meanwhile there is this great demand for liquidity. You can get liquidity at a price and this is a matter of price.


 
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