Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 900 - 919)



  Q900  Mr Simon: You are talking to all these people all the time. You must have a sense of whether there is movement likely.

  Professor Buiter: They may simply limit themselves to informal arrangements. I do not think you are going to see new legislation but the memorandum of understanding is just that; it is just a bit of paper, as somebody else once famously said. They may just have some clarifications in a footnote that says the Bank of England will henceforth start looking at the liquidity positions of UK registered banks and deposit institutions again.

  Professor Wood: That would be a change because at the moment the Bank does not have the resources to do that.

  Professor Buiter: Nor does it have the people.

  Professor Wood: In addition I think it should be done soon simply because it is important to have these institutions run in before the next problem hits. An example is in the United States where arrangements were changed and also some key people had died just before the financial crash of 1929-31 and it was largely because of the absence of experience that that turned into such a disaster.

  Q901  Mr Simon: Any more?

  Professor Buiter: No.

  Mr Simon: Thank you.

  Q902  Chairman: Professor Wood, can I take it from your comments that the Tripartite system worked but failed?

  Professor Wood: That would be going too far, Chairman; it worked but not too well.

  Q903  Mr Love: Professor Buiter, you threw away a line earlier on suggesting that the Monetary Policy Committee should be taken out of the Bank and that effectively the functions of the FSA ought to be merged with the remainder of the Bank. I think that was the suggestion you were making. I just wonder how Professor Wood would respond to that.

  Professor Buiter: Only the FSA's liquidity supervision function.

  Q904  Mr Love: I understand. I wonder if you would respond to that because you have been suggesting that we could do one of two things. I would like to press you on which of the two; do you think the Bank should be the major institution or should it be the FSA?

  Professor Wood: Quite clearly the Bank should be the major institution in the provision of liquidity. Unlike Willem, I do not think we need to take the MPC out of the Bank for that purpose. The MPC is for all practical purposes out of the Bank anyway. It is involved in only one set of decisions; it plays no part in others. I think it is convenient administratively to have it in the Bank; and there is from time to time some connection between monetary policy and financial stability policy, and under such circumstances it is convenient to have them together.

  Professor Buiter: One quick footnote to that. The problem at the moment is that the MPC only sets the bank rate, but that is meant to be the target for the overnight inter-bank rate, and in fact the overnight inter-bank rate moves violently around. If you are going to have this clearer separation, then the Bank of England should change its policy in the overnight market and actually peg the rate, at least the rate at which it repos, does its sale and repurchase operations, and it should always stand ready to repo at its target rate at any amount all of the time, as opposed to its current practice of trying to target both price and quantity a little bit. They really have to change their operating procedures otherwise the liquidity management policy inextricably gets tied up with interest rate setting. You have to be fair to the MPC. If they set the Bank Rate then they should, except for a little default spread for the inter-bank rate over the policy rate, peg the overnight rate. That requires a change in operating procedures at the Bank.

  Q905  Mr Todd: Can we turn to depositor protection. There is an argument for saying that depositor protection introduces a moral hazard by transferring risk but not straightaway. How do we set appropriate depositor protection to ensure that that does not happen?

  Professor Wood: You cannot do that; deposit insurance inevitably creates some moral hazard. The starting point has to be to think why do we want deposit insurance. It was introduced in 1933, if I recollect, in the United States in very special circumstances. The Federal Reserve had failed to act as lender of last resort. The US had many small banks financed entirely by retail depositors and deposit insurance works in such a circumstance. It was a substitute for a lender of last resort. Nowadays what we might call flighty liquidity—banks' liquidity that disappears quickly—is in wholesale markets, and deposit insurance, therefore, cannot prevent the important wholesale runs. It seems to me we should therefore think of deposit insurance as a social provision, to protect what used to be called in the banking industry the widow and the orphan, and it should therefore be accessible immediately if a bank closes, and it should be set at a fairly low level. If it were set at a low level this would have the incidental benefit that first of all large depositors, other banks, might pay closer attention to those they lent to. Secondly, if it were set at a lower level it could again continue to be financed by a mutual scheme and thus the taxpayer would have less interest in propping up banks.

  Q906  Mr Todd: You are agreeing with that by the sound of things; is that right, Professor Buiter?

  Professor Buiter: Yes, but I would make a specific point that it should only extend to retail deposits, that is deposits by natural persons, not wholesale deposits or business deposits, unlike what we have now.

  Q907  Mr Todd: So it has no purpose as a financial stability tool?

  Professor Buiter: No.

  Q908  Mr Todd: It is purely, as you have said, social policy?

  Professor Buiter: Yes.

  Q909  Mr Todd: Okay, if that is the case, what sort of rate should it be set at? Is the current rate reasonable? There have been suggestions of raising it to £50,000, or is that just simply a political decision to be made, you draw a line somewhere which seems fair at the time?

  Professor Wood: Basically it is a political decision. It is linked to vulnerable persons' deposits. In the United States you can insure as much as you like simply by opening enough deposits; it has to be individuals.

  Q910  Mr Todd: Do you think consumers are well enough aware—and I think the evidence was in this crisis that they were not—where the current limit actually lay? I think most people thought that deposits either were not guaranteed at all or they were guaranteed almost infinitely, and to hear there was a particular limit set on it was news to most people, so is there associated with this an important function of public education so that people understand clearly?

  Professor Buiter: Absolutely. Every bank should have large signs when you walk in "Your deposits are guaranteed up to ... "

  Q911  Mr Todd: "Do not deposit more than £35,000 here".

  Professor Buiter: Or "do so at your peril"!

  Q912  Mr Todd: Right, so the effect of that would be presumably to persuade consumers to spread risk so if they have large amounts of money to deposit they would deposit it in a number of institutions?

  Professor Buiter: Yes, that would be right.

  Q913  Chairman: If I could come back to you on that. There have been figures starting off at £100,000 down to what the level is in the United States at 50,000, and the British Bankers' Association have come in and said that £35,000 is an appropriate level because 90% of the population would be covered by that. Could you give us an indication of where your sympathies lie in terms of the level? Would it be 100% of that level protected?

  Professor Wood: If we are protecting the widow and the orphan it has to be 100% since we cannot expect that such people would have the time or the knowledge to police their banks. In terms of the level it seems to me the British Bankers' Association point (which I had not heard before) was quite a good way of thinking about the question.

  Professor Buiter: A second reason for having 100% is if you have anything less it is still an invitation to run. Unfortunately while co-insurance is a good idea for most insurance—you cannot have a run on your life insurance company but you can have a run on the bank—I really would not recommend anything less than 100% and probably between £35,000 to £50,000. Certainly £100,000 would be way in excess of the widows and orphans criterion.

  Q914  Jim Cousins: The Chancellor, when he spoke to us on this issue, said that the 100% guarantee that was given by the Treasury was a case-by-case guarantee and each case would be assessed on its merits, but the Governor in his very interesting radio broadcast last week said something rather different. He said that the existing system of deposit insurance we have trapped retail depositors—the word "trapped" was his and "that's why we could not allow Northern Rock just to fail." Do you think that the Governor in saying that has undermined the Chancellor's promise to us that this guarantee to depositors was only a case-by-case one?

  Professor Wood: I am not quite clear what the Governor meant by saying it trapped depositors. If he meant that when the institution failed the depositors were then trapped because they could not get their cash out right away, that is right, but that has no bearing at all on what the Chancellor said.

  Q915  Jim Cousins: I am inviting you, Professor Wood, to see the implications of the Governor's remarks. He described retail depositors as being trapped by the present system of deposit insurance.

  Professor Wood: That statement is to me only meaningful if the Governor is saying after their bank has closed they are trapped in the sense they cannot get their money immediately.

  Professor Buiter: I have no idea, I cannot make sense of the statement.

  Professor Wood: Apart from that, I cannot see what he means.

  Q916  Jim Cousins: You cannot make sense of the Governor's statement?

  Professor Buiter: Of the statement you are quoting. I did not hear the interview, I just read excerpts from it and that was not part of it. I find it hard to see what it could refer to.

  Q917  Jim Cousins: What the Governor said was this: "We need a system in this country in which we can prevent the retail depositors from being trapped."

  Professor Wood: That becomes much clearer. What he plainly meant was that retail depositors should get their money out immediately if the bank fails rather than being locked in for some months, which is part of the present system, and a very bad part.

  Professor Buiter: In the United States they get paid within two working days so that was what he was referring to obviously.

  Q918  Jim Cousins: The point I am putting to you both is that the Chancellor said the guarantee he gave to depositors in Northern Rock would not be extended anywhere else, it was a case-by-case system. The Governor's doubts about the overall system seem to indicate that it must be more general.

  Professor Buiter: The Governor is talking about the long-term reform—but hopefully it will be done very swiftly—of the deposit insurance system which should be one that allows you to get your money out immediately. It did not refer to this one-off or ad hoc (if there is more than one bank) series of individual bank deposit guarantees that the Chancellor created for the purpose of this specific crisis. They are two different things; there is no contradiction.

  Q919  Jim Cousins: Professor Buiter, while such a system, whatever it might be, is being put into place, which is not the case now, do you think it is credible that we could say in the event of another difficulty in another bank that the 100% guarantee to depositors could not be extended if retail depositors are, as the Governor says, trapped?

  Professor Buiter: I do not understand the question. I was surprised by the Chancellor's statement because as I understood his original announcement it said that any bank that found itself in similar circumstances to Northern Rock would get Northern Rock treatment, both on the funding side and on the deposits side. There might well be individual fine-tuning if the banks have very different funding policies or very different compositions of deposits but, as I understood it, effectively the deposit risk for the entire British banking system has been socialised.

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