Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 853 - 859)

TUESDAY 13 NOVEMBER 2007

PROFESSOR WILLEM BUITER AND PROFESSOR GEOFFREY WOOD

  Q853  Chairman: Good morning and welcome to our Committee inquiry into financial stability. Professor Richard Portes, who was to appear with you this morning, has indicated that he is ill so he has given his apologies. Can I ask you to identify yourselves for the shorthand writer please.

  Professor Buiter: Willem Buiter.

  Professor Wood: Geoffrey Wood.

  Q854  Chairman: Thank you very much for agreeing to come and give us your insight into the situation which was triggered by the Northern Rock Bank and the drying up of liquidity. We have witnessed the first bank run in 140 years as a result of that. With which, if any, decisions of the Tripartite Authorities do you disagree most strongly?

  Professor Buiter: Well, there are quite a few. The very structure of the tripartite agreement was flawed so I disagreed with the tripartite agreement before they even started doing anything. The notion that the institution that has the knowledge of the individual banks that may or may not be in trouble would be a different institution from the one that has the money, the resources, to act upon the observation that a particular bank needs lender of last resort support is risky. It is possible, if you are lucky, to manage it, but it is an invitation to disaster, to delay, and to wrong decisions. The key implication of that is that the same institution—it could be the FSA or it could be the Bank of England—should have both the individual, specific information and the money to do something about it. Given that, the decision to provide the support to Northern Rock—which was a joint decision and had to be authorised of course by the Treasury—was not backed up at that point by a joint statement by all the parties involved to tell the public that their money was safe. As I put in my note,[1] they should have had the Chancellor and the previous Chancellor and the Governor and the Head of the FSA and its Chief Executive all standing up saying, "Your money is safe". If they were not quite convinced that the public would believe them—and in these days you cannot be sure of that—then the immediate creation of a deposit insurance scheme that actually works and is credible would have been desirable. To wait three days was again an unnecessary delay. The FSA throughout all this seems to have been asleep on the job, not having noticed that the funding policy of Northern Rock was high risk and also not expressing stronger concerns about the breakneck rate of expansion, especially in the last half year. I like healthy growth but it is hard to believe that the quality of the asset portfolio and the ability to vet the credit-worthiness of your borrowers does not suffer when you take 20% of the net increase and 40% to 50% of the gross increase in activity in this half year period, so I think they were an organisation that was clearly engaged in high-risk behaviour, and the fact that the FSA did not call them back or felt they did not have the authority or the information (I do not know) is worrying. Then of course I think the Bank of England made policy errors, even given the existing framework, in its management of liquidity. Its demands for collateral were too strict—stricter than any other central bank that matters, much stricter than those of the ECB and stricter than those of the Fed—and its demands for collateral at its discount window, the so-called standing lending facility, were also way too strict. Basically they would discount only stuff that is already liquid: UK government securities; European Economic Area government securities; a few international organisations' debt like the World Bank; and then, under special circumstances, US Treasury bonds. All that stuff is liquid already so all the Bank offered at its discount window was maturity transformation, not liquidity transformation, and that was absolutely no good. When they created the Liquidity Support Facility for Northern Rock they created what the Bank's discount window should have been all along—something that lends against illiquid collateral and also lends for longer periods, because the Bank discount window is only for overnight lending. The Bank has since retreated from its policy on collateral and they have also declared themselves willing to intervene more aggressively at longer maturities. At least, they offered to do so; when they did nobody came, partly because their promised interventions at three-month maturities were at a penalty rate rather than at market rates. They are not quite there yet but I think they have learnt and they are moving in the right direction. There was a whole slew of errors from the Treasury, the current and previous incumbent, from the Bank of England and from the FSA, and nobody comes out of it smelling of roses.

  Q855  Chairman: That was comprehensive. Professor Wood?

  Professor Wood: I think I can be fairly brief, Chairman. First of all, let me start by saying where I agree completely with Willem. I agree that the structure was fundamentally flawed. It is simply a mistake to have responsibility lie away from someone who can do something about it. I do not think it would be possible to put the responsibility onto the FSA because the FSA is not a bank and it cannot provide liquidity. The FSA, as Willem put it, was asleep on the job; that is manifestly right. A very clear signal of a bank running a big risk is rapid expansion. Northern Rock was giving that signal quite clearly; it really is remarkable that they missed it. With regard to the support operation and the provision of liquidity, again as Willem said, there should have been announcements that your money was safe. We might come back to that later in the context of deposit insurance. Walter Bagehot criticised the Bank of England's behaviour in 1866 for its lending, as he put it, "hesitatingly, reluctantly and with misgiving". This prolonged the crisis and I think the same thing happened this time there was a certain manifest hesitation and that made people nervous. A couple of issues where I do disagree with Willem just a little bit. I think the Bank is right to take collateral. I think it should charge higher rates on less good collateral, first of all to ensure that banks do not run risks confident that the Bank of England will bail them out and, secondly, of course, to protect the taxpayer if some of this less good collateral does not eventually pay up. That the Bank was engaging in maturity transformation and not liquidity transformation is fine. I think it was the right thing to do at that time. By and large, the problems were in the structure, the division of responsibility and the lending hesitantly, reluctantly and with misgiving.

  Q856  Chairman: Both the Bank of England and the Financial Services Authority have claimed that they warned financial institutions about the risk of markets becoming illiquid. I think the FSA sent their paper out in January and the Bank of England sent their paper out in April 2007. I note from an interview that the Governor of the Bank of England had with the BBC last week that he said more could be done in this area to ensure that financial institutions listened to the Bank and the FSA regarding their warnings and take action. What is your advice in that area?

  Professor Wood: The best way to make them listen is to penalise them if they do not. It seems to me therefore that the Bank of England's behaviour in being very reluctant to take securities that they would not normally take, except when the crisis got really bad, from Northern Rock and refusing to accept them from other institutions for some considerable time was exactly the right thing to do. The casual lending on almost anything that the Federal Reserve and the ECB did almost immediately seems to me to have been an error of judgment and is likely to bring problems in the future.

  Professor Buiter: The private banks have a lot to learn as well. They were foaming at the mouth right up to the moment that the crisis hit. The now departed Chair of CitiGroup, the American bank, said in July that they were still dancing in the asset-backed securities market, so they believed the party would never end and they acted recklessly on both sides of their balance sheets, unlike Northern Rock which seems to have acted recklessly only on one side of the balance sheet. The banks did act recklessly. How do you make them listen? What Geoffrey proposes might help but I doubt it. Financial markets and financial institutions go through these bouts of euphoria where they really believe that they know better than the authorities and that this time it is different and we have new institutions and instruments that will make the risk go away. That fallacy takes hold every so often and there is very little you can do about it.

  Q857  Chairman: So therefore we have just got to dance to the tune of the banks and when they get into trouble we forget about moral hazard and we bail them out because the whole financial system is at risk and therefore we are in hock to them?

  Professor Buiter: Not at all.

  Q858  Chairman: So what do we do?

  Professor Buiter: First of all when they do get into trouble, when I said that the Bank of England should have accepted a wider range of collateral, I did not mean to suggest—in fact I explicitly do not—that they accept illiquid collateral at face value. They should be priced at a heavy discount and even when you think you have arrived at a fair price you apply further haircuts, further discounts to it, so it becomes penalty collateral provision, over-collaterising significantly if necessary. That can be enough of a penalty. Secondly, I think that once deposit insurance was in place there was no reason to allow the institution in question, Northern Rock, to be supported. The contagion effect was contained by creating universal coverage of not just retail deposits but also wholesale deposits and in fact all unsecured credit except subordinated debt, so all the deposits were safe, and at that point the support for Northern Rock could have been withdrawn. The option there would have been to either let it go into insolvency or to take it into public ownership. That would have been a very good discouragement of future bad behaviour.

  Q859  Peter Viggers: There was a clear warning about liquidity not least in April from the Bank of England, and when we asked Northern Rock what notice they took of that they told us that they fulfilled all the stress tests which were agreed with the FSA. Nevertheless, the situation went badly wrong. Where would you allocate responsibility for this, on the directors of Northern Rock?

  Professor Wood: Ultimately Northern Rock's failure has to lie with them, but the FSA was charged, perhaps not terribly sensibly, with ensuring that the directors did things correctly. As I understand it, most stress tests in most banking systems focuses on capital adequacy. Bankers generally have thought too little (central bankers included) about liquidity for some time, and I think attention should shift back to that. There is the basic problem. Again we come back to the issue that Northern Rock was expanding so fast that it was manifestly a danger signal. Even if you satisfy all the tests in good times you should think what is going to happen if times become not quite so good.


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