Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 860 - 879)

TUESDAY 13 NOVEMBER 2007

PROFESSOR WILLEM BUITER AND PROFESSOR GEOFFREY WOOD

  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 problems—I am sure Willem will confirm—in 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 them that.

  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 Chancellor.

  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, whatever.

  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 Bank—this was a joint decision—were 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 worth—I observed and Willem pointed out to me this morning that Morgan Stanley has written these things down to zero, for example—if 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 needed—close to £25 billion—it 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 liquidity?

  Professor Buiter: That was my interpretation, yes.

  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 attention.


 
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