Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 920 - 939)

TUESDAY 13 NOVEMBER 2007

PROFESSOR WILLEM BUITER AND PROFESSOR GEOFFREY WOOD

  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 point—it takes us back to the Chairman's opening questions on why were things badly handled at the start—one of the ways in which it was badly handled were these confused statements.

  Q924  Jim Cousins: Professor Buiter, in your evidence to the Committee—and I am following it up directly because it is a right old shambles if you are right—you 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 one—loans 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 were worth.

  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 times.

  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 sheet?

  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 attractive.

  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 model—turns out to be mark to myth in disorderly times—and 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 these investments.

  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 same point.

  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 to give?

  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.


 
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