Examination of Witnesses (Questions 860
TUESDAY 13 NOVEMBER 2007
Q860 Peter Viggers: Bearing in mind
the Bank's warning about liquidity, was it surprising that the
stress tests were not constructed to include liquidity?
Professor Wood: That is terribly
difficult because the availability of liquidity changes from circumstance
to circumstance. The stress tests have to deal with a wide range
of conditions and conjecture and that will be difficult to do.
I think one should simply adopt a more conservative banking model
rather than seek technical solutions that do not always work well.
There are statistical problemsI am sure Willem will confirmin
these markets because the distribution of outcomes is not in a
form that is readily handled by statisticians.
Professor Buiter: One could have
expected that they would have looked at the consequences of some
of the markets in which Northern Rock was funding itself simply
closing. What happened of course in the case of Northern Rock
is that all of the markets in which it funded itself closed, something
which had never happened before, so you would have had to have
an ultra stress test to capture that. However, they seem to have
done not even the kind of liquidity stress-testing that I would
have expected them to do, partly because the FSA is an institution
that thinks more about capital adequacy and solvency issues than
about liquidity issues. That is the natural province of the Bank.
Q861 Peter Viggers: Does it surprise
you that the board of Northern Rock, with the exception of the
Chairman, are still in control of the company's destiny, bearing
in mind that some £30 billion of public money is now invested
through what is a discredited board?
Professor Wood: It is not clear
to me the extent to which they are actually in control. The company
has to have directors but can they actually take decisions without
the Treasury or the Bank of England's agreement? I really do not
know. The company has to have directors.
Q862 Peter Viggers: Are you close
enough to the situation to know the extent to which the Bank of
England and the FSA are now effectively controlling decisions?
Professor Wood: No. You must ask
Q863 Peter Viggers: Very well. To
what extent do you think the crisis of Northern Rock can be characterised
as a failure of the FSA to regulate properly?
Professor Wood: Again we come
back to the fact that it is basically a failure of the regulatory
system as it was designed; it is a deficient system. Beyond that
the FSA does not seem to have carried out its job with the skill
and diligence that one might have expected, but then again the
Northern Rock board was not doing a wonderful job either.
Q864 Peter Viggers: Are there immediately
any further powers that any of the Tripartite Authorities need
or do you think the system itself needs to be reviewed?
Professor Buiter: They need the
power to put banks into administration effectively without the
deposits being frozen, as is the current situation, which is of
course a terrible situation. They have to be able to ring-fence
the deposits of banks that go into administration. If anything
they have to have FDIC-type powers of taking deeply troubled banks,
where you do not know necessarily where there are liquidity and
insolvency issues, into public ownership at no notice and to manage
them as a going concern, with existing obligations, existing exposures
and no new business until things settle down, and in the longer
term a future for the institution can be found. The kind of open-ended
breastfeeding of a private institution that goes on at the moment
is the worst of all possible worlds.
Professor Wood: That is exactly
right. The Comptroller of the Currency in the US coined the term
"too big to fail" of Continental Illinois Bank when
it failed. If you have proper bankruptcy laws such as Willem has
outlined then no bank becomes too big to fail and they can bear
the consequences of their actions.
Q865 Peter Viggers: We have had a
forceful memorandum from the British Bankers' Association pointing
out that liquidity regulation is the only remaining area of banking
supervision that is host rather than home state regulated. The
British Bankers' Association has urged us to await decisions by
the Basle Committee of Banking Supervision because banking liquidity
and banking supervision is essentially an international matter.
Do you think we should await international developments or do
you think there are steps we can take domestically?
Professor Wood: I have to say
I have not read the British Bankers' Association memorandum but
it seems to me from how you summarise it to embody a certain lack
of clarity of thought. The home country and only the home country
can supply liquidity. If a British bank is short of sterling the
Bundesbank cannot supply sterling; it has to be home country provision
of liquidity. The only case when that is not the situation is
in the euro zone where of course you have several countries using
the same currency.
Professor Buiter: I must say I
do not understand the statement that you have just quoted at all.
The bank could be foreign owned but if it is registered in Britain
then it is a British bank and it will have to be supported by
the Bank of England. That is how it works. It is not true for
branches but it is true for UK-registered banks and that is the
only way to do it so, no, we do not have to wait at all for liquidity.
Liquidity is provided at the level of the currency area, be it
the dollar area, the sterling area or the euro area, so it sounds
like this is confused babble.
Q866 Mr Fallon: Just to be very clear
then, you think that responsibility for both general and individual
liquidity should transfer back to the Bank; is that right?
Professor Buiter: That is one
solution. The other solution would be to transfer provision for
institution-specific liquidity provision lender of last resort
to the FSA by giving it an uncapped and open-ended credit line
with the Bank of England guaranteed by the Treasury so it can
just do the lender of last resort bit. The market support will
always have to be done by the Bank of England, and you may therefore
wish to put the individual institution support there as well.
I think there are tensions there with central bank independence
because especially individual institution-specific support operations
are always deeply and inherently political (with a very small
"p") because property rights are at stake and it is
difficult to have that done by the same institution that is meant
to be non-political. If you were to give banking supervision and
regulation, including the lender of last resort knowledge therefore,
back to the Bank of England, then you might want to take the MPC
out of the Bank of England.
Q867 Mr Fallon: Because we have learnt
over the last few months, have we not, that the Bank is not quite
as independent as we originally thought. Even the decision not
to put liquidity into the market in August was referred to the
Professor Buiter: Independence,
as I interpret it, applies only to interest rate decisions and
that is why I think it might be a good idea to take the MPC (which
all it does is set the Bank rate) out of the Bank of England which
can then do everything else, including liquidity provision, at
any maturity longer than overnight, foreign exchange market intervention,
Professor Wood: I do not think
it is necessarily correct that we should want to give liquidity
support to an individual institution if the rest of the market
is in good order. That suggests that individual institution is
fundamentally deficient and should be closed. The lender of last
resort operation should go to the market as a whole when the market
is short of liquidity. If an individual institution needs it,
and the rest of the market is fine, there is something wrong with
that institution. On the question of the Treasury being involved
in this decision, there is a long history of course of the Treasury
being involved in these decisions simply because the Bank of England,
even in the 19th Century, was a very small bank and did not have
much capital to lose. In the 19th century it got other banks to
help out. In the 20th century it has to go to its owner, the Treasury,
to ensure that the owner would provide more risk capital if necessary.
Q868 Mr Fallon: It follows from that
that after saying the deposits should have been guaranteed you
think that Northern Rock should simply have been allowed to fail?
Professor Buiter: Yes.
Professor Wood: The word "fail"
is a dangerous term.
Professor Buiter: Sink or swim.
Professor Wood: Sink or swim,
put into liquidation, in that sense fail, but not simply collapse;
that would be foolish.
Q869 Mr Fallon: What about the rescue
operation itself; was the Treasury right to refuse the tentative
offer from Lloyds TSB to carry out a takeover?
Professor Buiter: I do not know
the details of the offer but if it is true that they wanted up
to 30 billion UK, as they would say in America, £30 billion,
in continued financial support to finance a takeover, then I think
the Treasury and the Bankthis was a joint decisionwere
absolutely right to refuse it. This would be the socialisation
of banking, and that might be a good idea but I do not think that
is what this was about.
Q870 Mr Fallon: So it would never
be right for government to lend on commercial terms in order to
protect financial stability?
Professor Buiter: They were not
protecting financial stability. They would be protecting the shareholders
of the company wishing to take over Northern Rock.
Q871 Mr Fallon: But would it ever
be right for the Government to lend on commercial terms if they
thought there was a serious risk of financial instability?
Professor Buiter: Yes.
Professor Wood: I think I would
resist the feasibility of that situation. If you have got proper
lender of last resort facilities in place, if you have an adequate
bankruptcy procedure for banks, the question would not arise.
Q872 Mr Brady: Should the Bank of
England have injected term liquidity into the financial system
before the run on Northern Rock?
Professor Wood: I think not. If
commercial bankers, as was the situation, could not price these
securities, if they did not know what they were worthI
observed and Willem pointed out to me this morning that Morgan
Stanley has written these things down to zero, for exampleif
that is what they think they are worth, it seems to me no more
than an impertinence to go to the Bank of England and say, "Use
taxpayers' money to buy these things from us."
Professor Buiter: I disagree.
There are times when it is clear that, say, the spread of the
three-month premium of the inter-bank rate, LIBOR, over the expected
three-month policy rate, bank rate, is not just a default risk
spread but includes a liquidity risk spread, and when that goes
together with a seizing up of inter-bank markets, the Bank should
aggressively expand credit at that maturity or at those maturities
where there is, in their best judgment, such a term structure
of liquidity spreads as well as term structure of regular interest
rates. You cannot in general as a bank fix multiple interest rates
if markets are orderly but if markets are disorderly you can indeed
intervene at multiple maturities, and the Bank should have done
so against the kind of collateral that the markets found hard
to price and then price it punitively, and in that way prevent
moral hazard, yes, so they should have done so.
Professor Wood: Maybe I could
follow that up and say I just do not see what problem that was
causing. The banks could, after all, get the liquidity they needed
for their day-to-day business. The fact that they could not trade
at longer maturities is not usual but it was not causing any significant
difficulties at the time.
Q873 Mr Brady: We also had divergent
views from the FSA and from the Bank on this, with the FSA saying
that if liquidity in smaller amounts had been made available to
Northern Rock earlier it is quite possible that it would not subsequently
have needed to apply for lender of last resort facility, whereas
the Governor of the Bank made the point that because of the sheer
volume of support that Northern Rock neededclose to £25
billionit was not possible to see how you would achieve
that level of liquidity for Northern Rock simply by injecting
it generally into the market. Would you comment on those two views?
Professor Buiter: There are two
problems. The fact that Northern Rock needed £20 billion
plus does not mean that it could not have been provided at the
regular discount window. That is, after all, demand determined,
subject to the availability of collateral; collateral is the constraint
there. If the problem was just that Northern Rock could not borrow,
I would not have done so, but since the inter-bank markets as
a whole, and indeed the wholesale markets and the commercial paper
markets were also seizing up, there might have been a case for
intervening, but that is the same as the last question really,
whether you could by restoring liquidity to the markets have prevented
Northern Rock from going to the wall. That would take an enormous
amount of money injections. We know for instance that despite
all the money that the Fed and especially the ECB have put into
these longer terms markets, the actual spreads of three months
LIBOR and the euro equivalent and the dollar equivalent over the
expected policy rate is no smaller in euro land today than it
is here, so it really may take a large injection of liquidity
to get an appreciable result if the market is really fearful.
Professor Wood: I would simply
add that I do not see how giving a small amount of liquidity earlier
to Northern Rock would have been much help since the problem,
as we have seen, has been the shortage of a large amount of liquidity,
and so I think the FSA's point is not valid.
Q874 Mr Brady: Finally, just to be
very explicit, you both tend to agree with the view that was put
by the Governor of the Bank, and I quote his example, that looking
at what the European Central Bank lent to banks through the auctions
they conducted relative to the size of the banking system they
lent an average of £230 million per bank whereas Northern
Rock needed close to £25 billion. You tend to agree with
the basis of that perception?
Professor Buiter: Yes, that is
correct, but you could have done it at the Bank's regular discount
rate for Northern Rock. You could have done £20 billion there.
Professor Wood: Calling it emergency
lending was I suppose asking for trouble.
Q875 Mr Dunne: Can I just pick up
one of the responses you made to Mr Brady. During August was it
not the case that the credit spread was considerably higher in
the UK than on the Continent and in the US?
Professor Wood: When?
Q876 Mr Dunne: You are saying that
has now narrowed?
Professor Buiter: They are the
same. They are about half a per cent in all three areas.
Q877 Mr Dunne: But the time of the
crisis was August.
Professor Buiter: It was higher
in the UK, yes.
Q878 Mr Dunne: Indeed and was that
not partly because the central bank here was not providing any
Professor Buiter: That was my
Q879 Mr Dunne: Indeed. How can you
therefore make the statement that had it provided liquidity it
would not have had some beneficial impact on liquidity throughout
the system, irrespective of Northern Rock?
Professor Buiter: It would have
had a beneficial impact on the system but I doubt whether it would
have been enough to save Northern Rock. Northern Rock needed individual