Examination of Witnesses (Questions 920
TUESDAY 13 NOVEMBER 2007
Q920 Jim Cousins: I think that is
a very important statement to make and I will just play it back
to you so that we have understood its significance. You have said
that whether or not the Chancellor so intended, the entire deposit
risk of the British banking system was socialised, as you put
it, when he gave his deposit guarantee to Northern Rock?
Professor Wood: It is my understanding,
as it is Willem's, that he said it would apply to any bank that
got into difficulties, so in that sense, yes, he was underwriting
all the risk of the British banking system. I think he did back
away from that subsequently, much to my relief; it seemed rather
a lot of money to guarantee.
Q921 Jim Cousins: But is there not
a real difficulty here that you are saying on the one hand that
a deposit guarantee was given in a form that socialised banking
risk for retail depositors and then you are saying the Chancellor
backed away from it, so where does that leave us all?
Professor Wood: It leaves us all
with the Chancellor having backed away from a 100% guarantee,
and thank goodness for that!
Q922 Jim Cousins: Professor Buiter?
Professor Buiter: It leaves us,
if indeed the Chancellor has backed away decisively from this
Q923 Jim Cousins: You are not so
clear that he has backed away?
Professor Buiter: I am not clear
at all because I think the statements, both the original ones
and subsequent ones, are sufficiently ambiguous that they are
compatible with almost any course of action.
Professor Wood: If I could take
up that pointit takes us back to the Chairman's opening
questions on why were things badly handled at the startone
of the ways in which it was badly handled were these confused
Q924 Jim Cousins: Professor Buiter,
in your evidence to the Committeeand I am following it
up directly because it is a right old shambles if you are rightyou
said that national financial regulators in the European Union
should go the way of the dodo?
Professor Buiter: Yes.
Q925 Jim Cousins: The evidence you
have given to the Committee this morning rather bears that out,
does it not?
Professor Buiter: Well, one example
does not prove the case. It is not really a matter of individual
competence so much as the fact that we have this regulatory race
to the bottom when we at least could neutralise the European element
if we had a single European regulator. Capital is global and unfortunately
governance is not and regulation is not, but where we can operate
in a larger area, especially if it includes a significant number
of serious financial centres, we should do so, yes; it just simplifies
the task of preventing the further spread of light-touch regulation.
Q926 Ms Keeble: I wanted to ask a
bit about the assessment of risk and the role of the credit ratings
agencies. To what extent do you think the complexity of the financial
instruments has made it very difficult for investors to assess
the true risk of the assets in which they are investing? Linked
to that, what do you think of the due diligence which they undertake?
Professor Wood: The instruments
have got a bit more complex but the basic problem, as I understand
it, was quite a simple oneloans secured on property were
bundled up and these loans were of various qualities of borrowing.
They were bundled up and people did not look inside these bundles.
That may have been bad ratings agency work but it was also bad
banking not to know to whom you were lending money.
Professor Buiter: It is inherent
in the process of securitisation, which by the time you get to
the ultimate investor, who is six transactions or more away from
the originator of the loan, neither the buyer nor the seller has
any idea as to the underlying risk characteristics of the security
they are buying. That gets worse when the securitised mortgage
loans get packaged with credit card receivables, the square root
of car loans, and whatever else. The structure they have put together
became so complex they probably were not even understood by their
designers. Due diligence does not mean anything if you cannot
understand what you are dealing with, and the rating agencies
are in no better position to know what the true value is, they
did not go and check individual addresses as to what the mortgages
Q927 Ms Keeble: There are two sides
to that and I want to come back on to the credit ratings agencies.
I could understand that a casual investor might not look into
the bundle to see what is there, but some of these investors are
substantial and sophisticated and one would have expected a degree
of due diligence or that they would have required a greater transparency
in the products.
Professor Wood: One would hope
that but there actually is a difficulty because when you are putting
these products together you are bundling together various categories
of asset which had behaved differently in the past, and you estimate
what the risk characteristics of the bundle is based on the experience
of these different assets in the past. The trouble in the present
situation was the past had been rather an unusual period, a period
of remarkable stability, so I think there was probably very little
evidence, even if they had done the work, on which they could
say what would happen if we suddenly moved from stable to unstable
Q928 Ms Keeble: So people took risks
they might not have done firstly because there had been a period
of stability and was it also not secondly because it was off balance
Professor Wood: Probably the first
is more important but again
Professor Buiter: The level of
transparency of the whole process is low. Many of the institutions
have ended up holding them and dealing in them through off balance
sheet vehicles whose reporting obligations are minimal, and so
it became harder not just to understand the individual instrument,
as Geoffrey just described, and how to price them but also it
became hard to figure out who held them, so the knowledge on who
owns what is still fairly patchy.
Q929 Ms Keeble: I just want to come
on to the credit ratings agencies. I think it was Professor Wood
who said that the concept of due diligence in this area was pretty
meaningless. Would you agree with that, Professor Buiter?
Professor Buiter: Yes, you cannot
be duly diligent for things that you really cannot understand.
I think the regulators and the Bank can help create incentives
for simplicity, for instance by the Bank of England, in this particular
case, announcing that they would take certain kinds of structures
as collateral in repo operations at the discount window but not
other more complex ones. That is one way of making simplicity
Q930 Ms Keeble: You have said that
you think that it would help if there were clearer reporting requirements.
Do you think that it would also be appropriate to look more carefully
at the role of the credit ratings agencies and in particular their
propensity for being able to advise on the structure of investments
and then also do the ratings of them as well?
Professor Buiter: I have argued
that they should become `monolines', basically agencies just doing
one activity, just doing ratings. You cannot manage the potential
conflict of interest involved in advising a client on how to design
a structured financial product to get the best possible credit
rating and then rate that same product. That is going to create
a conflict of interest so it should just not be possible to do
that; you rate and that is it.
Q931 Ms Keeble: Professor Wood, would
you agree with that?
Professor Wood: Absolutely. It
slightly surprises me that the agencies have not grasped that
for themselves and set up separate ratings agencies because these
would attract customers.
Q932 Ms Keeble: Professor Buiter,
you have made comments about Basle II and the Credit Ratings Agency.
I wonder if you would just like expand on some of the comments
you have made?
Professor Buiter: The credit rating
agencies and their ratings play a central role in the first pillar
of Basle II, the capital adequacy parts, and the other element
of Basle II that I think deserves some scrutiny is the use of
internal models for marking to model the things that we cannot
mark to market because there is no market for them, and that goes
for most over-the-counter products, effectively, not just for
the ones that have temporarily become illiquid. So you have two
key pillars on Basle II: mark to modelturns out to be mark
to myth in disorderly timesand the rating agencies, which
are deeply and inherently conflicted, and we are giving these
rating agencies a semi-regulatory task through the Basle Agreement.
We cannot ask for the private provision of public goods like that.
I think Basle II has to go back to the drawing board before it
is even out of the stable. This is a mixed metaphor.
Q933 Ms Keeble: Can I ask one further
point? Really the credit ratings agency should be capable of at
least guiding people as to where the risk lies in the system.
Why have they failed and what assessment do you have of exactly
where the risk is, because there is quite a problem: the same
investments are there, the same risk assessments, the same ratings
are being undertaken, nothing has changed essentially, and there
is a lot of people's money tied up in institutions which hold
Professor Buiter: But the agencies
did reasonably well when they rated sovereign debt and corporations,
large corporations. Remember, they only rate default risk and
expected loss conditional on a default occurring; they do not
rate market risk, liquidity risk and everything else; so in some
ways they would have been completely useless for the current crisis
in any case because there was a liquidity crisis, by and large,
rather than an insolvency crisis and we should not ask of them
things that they do not promise to sell. But even in the area
where they are evaluating things, they invented this new activity,
rating fancy, structured complex products, but it is just very
difficult and basically impossible.
Q934 Chairman: Can I ask both of
you in terms of the rating agencies, you both believe that they
are inherently and deeply conflicting?
Professor Wood: Yes.
Professor Buiter: Yes.
Q935 Chairman: Secondly, in terms
of Basle II, John Plender of the Financial Times was writing and
he made comments that were along the same lines as yourself, Professor
Buiter, but he is talking about Basle II, saying that it relies
on the modelling techniques that led to the sub-prime disaster
and the new rule book also depends heavily on the credit rating
agencies in whom investors have lost confidence.
Professor Buiter: Exactly the
Professor Wood: The same point.
Q936 Chairman: So we need a fundamental
look at Basle II then?
Professor Buiter: Yes, back to
Basle one and a half!
Q937 Mr Love: We will invite you
back when we are looking at Basle II. You both agreed earlier
on that the Northern Rock crisis did not have any implication
for the stability of the financial system. Do you believe that
any of the losses suffered by the much larger banks, such as Citibank,
have any implication for financial stability?
Professor Wood: They obviously
make the institutions which have lost capital more fragile than
they were before they lost capital, but one would hope it also
makes them more cautious in the future, which makes them less
fragile. So, in the short term, yes, they are more fragile, in
the longer term perhaps not.
Professor Buiter: In the short
term, by impairing their capital or at least reducing the margins,
it will make them more reluctant to lend, and that means that
the cost and availability of loans for the real economy is going
to be more restricted in times to come, so a net contraction on
demand is imposed.
Q938 Mr Love: Quite a number of the
US banks have come forward with estimates of their losses. We
have not seen that so much in terms of UK banks. Should UK banks
be more transparent about what is happening to the balance sheets?
One of the reasons they have given for that is the difficulty
in quantifying what those losses are. Is that a reasonable excuse
Professor Buiter: The reason most
of the big ones have not reported yet is that they are on a six-monthly
reporting cycle, not on a quarterly one; so that is a straightforward
reason. If you started bringing in suddenly higher frequency reports,
that would really put the wind up your sails. You have to have
a very good reason for doing that. I think as long as they stick
to the regular cycle, that is fine, but they are going to have
the same problem as their American counterparts, in that they
have on their books, or are exposed to, stuff that is really illiquid,
has not been traded in deep, transparent markets for months now,
some of them never, and therefore it is very hard to establish
a price. Yes, it is very hard, and it means also that there is
non-uniformity in the treatment of the same claims by different
banks. My view is that we really have no idea about what most
of these banks have on their books. Some of them, like maybe Morgan
Stanley, apparently evaluate a fair amount of the stuff they have
as if it was worth nothing; that certainly puts a clear floor
under what could happen, but very few other banks have been willing
to do that.
Professor Wood: There is a big
difference between some of the British and some of the US institutions.
Some of the US institutions are not strictly speaking banks. Banks
have the option of carrying these loans on their banking book
rather than their trading book. They are not, therefore, required
to mark to market. Whether that is a good thing or not, banks
are allowed to treat these things very much like overdrafts. You
do not mark overdrafts to market because there is no market. So
there is an accounting difference, which can produce different
reports and results.
Q939 Mr Love: You mentioned Morgan
Stanley suggesting that quite a lot of their paper is worthless,
but we understand that quite a lot of them are still valuing at
90 cents in the dollar. If it all turns out to be worthless, as
perhaps Morgan Stanley are already admitting, would that shake
their financial stability?
Professor Wood: First of all,
it would be a surprise if it were all worthless, and I say that
very seriously. When Continental Illinois Bank failed in the United
States, it eventually paid out, I think, 93 cents in the dollar,
or perhaps a little bit more, (but it took some time). So it would
be a surprise if these securities turned out to be worthless this
time.. Secondly, if every bank in the system took this big hit
at once, it would indeed impose a severe contraction ratio on
the economy. If they spread it out, sure, it would be more diffused.
Whether that is good or bad I cannot immediately answer; I would
have to think about it.