Examination of Witnesses (Questions 1400
TUESDAY 4 DECEMBER 2007
Q1400 Mr Mudie: You are a bit more
realistic or pessimistic than Mr Hitchen whose submission says
there is nothing to worry about whereas you have said there is
a lack of transparency and there are real worries.
Mr Hitchen: To clarify, I was
not trying to give the impression there was nothing to worry about.
Q1401 Mr Mudie: Are you going to
be more pessimistic?
Mr Hitchen: No. Certainly, there
are things we do not know yet and in two years' time we will find
that more pain is being borne. But what we tried to say in our
paper was that pension funds are likely to be less affected than
some other investors because of our more cautious and diversified
Mr Pitt-Watson: Let me also be
very optimistic. Capital markets do and have done a fantastic
job, but we should learn the lessons from this credit crisis.
In my view, we have to learn exactly the lessons that we spent
20 years learning in the equities market, namely that credit markets
will not be successful unless you have someone who takes ownership
responsibility. In the equity market Mr Hitchen and Mr Montagnon
in particular have been leading lights in making sure that in
the UK we do have ownership. I think we need to learn that lesson
from this credit crisis too.
Q1402 Mr Mudie: If I were an individual
approaching my pension and listening to you I would ask: are we
learning just the theoretical lessons or will we have some pain
from this? Will there be pain in the pension industry?
Mr Pitt-Watson: We do not know
what the real world economic effects will be from this credit
crunch. I was talking yesterday to a retailer who was terribly
negative about what was happening. We simply do not know. If you
are the Bank of England by how much will you reduce interest rates
to try to keep the economy going?
Q1403 Mr Mudie: That is not very
reassuring, is it, because you are in hedge funds, private equity
and securitisation and yet you come before us and say you are
Mr Pitt-Watson: I am sure that
people's pensions in 25 years will be okay at the end of the day,
but if what we are looking at is what is likely to happen in the
immediate term there is a real problem. We do not know. There
were CDOs, special purpose vehicles issuing paper and inadequate
accounting rules. The economy particularly in the United States
bubbled. The bubble burst and we now have to hope to can bring
it down slowly without it affecting people's livelihoods and jobs.
It could affect their jobs.
Q1404 Mr Mudie: In the individual
areas we have mentioned the fundamental issue is transparency.
In your memorandum you talk about a government review and the
current tripartite discussion. In the same sentence you go on
to talk about whether greater transparency can be achieved in
the market for structured investment vehicles. Am I reading that
wrong? Are you expecting government to deliver transparency or
do you just make a plea for it? If it is the latter tell me how
we will get it. It seems to me to be the thing that is missing
from the whole exercise.
Mr Pitt-Watson: I think I am making
a plea for responsibility and ownership. To take one example,
in the area of accounting rules we have had a momentum towards
international accounting rules. Most of the world has adopted
American standards which very much value things to market. We
have talked about those problems. That move continues. It is up
to investors to make sure that we first slow this process and
consider what is happening in this country, but also if we have
a body called the International Accounting Standards Board should
not investors be in the majority on that body? Should we not be
asking that pension funds set aside some part of the enormous
fees they pay to fund managers for trading, to make sure they
have the necessary resources; so that when we do get international
accounting standards they are not ones that break under stress?
That is the sort of thing we can do and is a good lesson for the
future. In my memorandum I make one or two other suggestions about
things we could do.
Q1405 Mr Mudie: When we listened
to the banks earlier I am not sure they did not deliberately disguise
the risk in these products by mixing them up. I do not know how
any analyst can properly advise you when the same banks have the
stuff on their books and are scared stiff because they do not
know what they have. If they cannot analyse it how on earth do
they expect someone advising you to be able to tell you the risk?
In other words, it was deliberate.
Mr Pitt-Watson: I do not pretend
that we can make this perfect. What would I rather have in future?
Do I want people who start with accounting measures that fundamentally
are based on prudence or accounting measures that fundamentally
are based on market value? Who would be more likely to protect
pensions and savings? I make the assumption that prudence might
be quite helpful here.
Mr Hitchen: You have a good point.
I think investment banks will tell you anything you want to know
about a product they are selling to you, but ultimately they are
in the transaction business and their job is to get the transaction
done. It is a fact of life that there are brighter brains working
at investment banks than elsewhere in the food chain. That is
just the way the economics work, so the rest of us have to be
pretty careful about the way we deal with them, but the watchword
has always been caveat emptor.
Q1406 Mr Mudie: Does it not come
down to the old saying that if it is too good to be true it is
Mr Hitchen: There is certainly
a risk of that.
Q1407 Chairman: On the question of
reporting, the other day I read an article which said there were
five or six different ways to report losses in accounts. It may
be that some banks are just drip-feeding this, so perhaps there
is a need to look at reporting losses in greater detail.
Mr Montagnon: One area where we
do need more transparency is the reporting of this business in
financial institutions. We need to know with much greater clarity
what is on, what is off, and what has potential to come back onto
the balance sheet than perhaps we did in the past. As investors
who hold shares in financial institutions this is something that
should be looked at closely. In addition, we also want to have
a close look at the role of audit committees and risk committees
in managing these risks and deciding how they should be reported.
That is one area of transparency that we would like to see improved
as a result of this.
Mr Sears: Some of the investment
banks said they might take this back on because of reputational
risk. If we start to go to reputational risk as being the reliance
for a covenant, in the past people may have relied on that reputational
risk because things have been too big to fail. I think there are
things out there that are too big to rescue. That is the real
risk. In other words, if it is just reputational risk banks will
not step in at that time because it will be too big. We have already
seen a distinction in the approach of some investment banks.
Q1408 Peter Viggers: Following that
precise point, it might be better to be an investment bank that
has survived having sloughed off its non-attributable, non-balance
sheets assets rather than one that still finds difficulties having
taken on board those liabilities.
Mr Sears: It is an invidious position
for them. I do not suggest that I would like to sit in their seat
but that in designing the structure going forward we have to take
account of the fact that we should not be in this situation be
making such decisions at a time when there is lack of clarity.
Q1409 Peter Viggers: I asked questions
of the investment banks about the securitised assets held on their
balance sheets which had been through various stages of collateralisation.
I was reassured by bankers who said that there were recognised
models for testing a section of these CDOs as assets and it was
possible to evaluate them. Are you similarly sanguine? Do you
believe it is possible to value such securitised assets? First,
is it possible to put a value on them? Second, does liquidity
affect their value?
Mr Sears: I do not believe that
in the end the models work. You heard from others who gave evidence
this morning. They talked about the long tail and the unexpected
event, so there is a breakdown. You just have to look at what
has happened to see that the models could not cope with working
out all the complexities of the things connected to them. As another
example of models, the interim results of Northern RockI
make no criticism of its boardgive their Basel II statement.
That is entirely proper, but in that statement the waiver they
get on 30 June which allows them to move onto internal models
and such like would resultto be fair, they say there is
some asset realisation as wellin a release of £300
million to £400 million to shareholders over the next three
to four years. That was the projection of moving onto the internal
models. They may have been used utterly properly; I do not suggest
otherwise, but I think that raises questions about what the internal
models are and how much you are allowed to rely on them in these
risky areas at the end of the day. I believe that in certain other
areas the modelling is very good, but for the new frontiers the
models do not work. I believe that this morning we have heard
from very responsible investment banks that they feel the same.
Mr Hitchen: The models do not
deal very well with the world from which the data which populate
them have come. They may very well reflect the past five, 10 or
even 20 years depending on the model. I always try to remember
as a sense check that maybe these instruments did not exist in
the 1930s, but what would have happened if they did? Think about
a scenario which could clearly happen in the real world but which
might not have been so evident in financial markets in the recent
past and therefore not modelled.
Q1410 Peter Viggers: To move closer
to your areas and look at the risk associated with private equity
and highly leveraged deals, have lenders to private equity been
exercising due diligence in respect of loan issuance and have
they been alert to the risks associated with weaker loan covenants?
Is this an incipient risk?
Mr Hitchen: To be candid, we invest
with a number of general partners and often take the equity piece
of private equity deals. Those partners have in the recent past
until the summer found it increasingly easy to get loans for the
deals they want to do. I do not go as far as to say that the providers
of those loans have not been doing due diligence, but it is certainly
the case that credit has been very easy over the past two or three
years and it is now markedly more difficult. The same general
partners now have to accept more difficult terms for loans or
in some cases do equity-only deals. There has been a complete
turnaround in the way underwriters look at private equity deals.
Mr Montagnon: In a seller's marketit
is a seller's marketit is quite difficult for the buyers
to demand the kind of covenants that they might wish. We have
been through a period until quite recently when better protection
might have been wanted but it has been very difficult, if not
impossible, to negotiate. If you seek such protection you will
not get any investment.
Q1411 Peter Viggers: If investors
in the past have perhaps been over-reliant on summarised risk
assessments by other organisations what can they now do to be
more specific and certain they are taking risks that they fully
Mr Montagnon: One thing we have
done at the ABI together with other bodies it to talk to the credit-rating
agencies about putting into their own assessments more reference
to the covenants and greater explanation in shorthand terms of
what is there, not necessarily their evaluation which would present
them with legal problems. We would need and hope to go further
in that direction.
Q1412 Peter Viggers: I raise a specific
point on pension fund investment. A recent Citigroup survey showed
that 85% of pension fund managers plan to raise their allocation
to alternative assets in the next three years, with private equity
being the most popular area of prospective investment. Do you
think that figure still carries weight or has there been a rethink?
Mr Hitchen: I am sure that the
figure still carries weight because pension funds tend to operate
in quite a gradual way, but we go back to a point I made earlier.
Pension funds are looking to diversify into as wide a range of
assets as possible. That is really our primary defence against
any particular problem that emerges in a section of the market.
I am sure we would like to invest not a large but significant
amount of our assets in private equity, hedge funds, property
and various other alternative assets. I suspect we will find it
quite hard to build our exposure to private equity in the near
future because I do not believe that as many deals will be done
in that sector of the market.
Mr Pitt-Watson: If you ask what
investors can do, it comes back to how it is investors will ensure
they are providing that ownership discipline. We have the principal/agent
problem and we keep passing the security on and on. By the time
it has been passed to a hedge fund that is trading in derivatives,
of some CDO originated from wherever, there are several principals
and agents. Somehow we have to get investors as a group to work
together, for example as Mr Montagnon would do for the ABI, on
a much more significant scale than historically, to make sure
that the ownership disciplines exercised by the old-style bank
manager who said, "Yes, I think you will repay the mortgage",
are there. We need that more urgently when dealing with alternative
investments because once you have them in your hedge funds what
you are investing in is quite complicated.
Q1413 Peter Viggers: Might there
be the emergence of new forms of vehicles with much more emphasis
on transparency and certainty?
Mr Pitt-Watson: That is certainly
something we at Hermes would be keen to promote for ourselves
and among other investors as well.
Q1414 Chairman: That reminds me of
an inquiry we conducted into split capital investment trusts a
few years ago. We had before the Committee one of the architects
of such trusts. He admitted to us that he really did not understand
the model. It was good for the environment in which he used it
but when it went into the outside world it blew up.
Mr Pitt-Watson: That is exactly
the sort of problem. Clearly, there are lessons to be learnt from
this issue, but if we think about what may be the problem in the
next war it will be the same thing happening again. People will
be trading but not owning and we will have lost control of where
the ownership function is. Then everybody, right across the market,
loses out. Ultimately the railway and BT pensioners suffer.
Mr Sears: However good the model
is, one will always have human fallibility.
Q1415 Chairman: But it is frightening
when the architect of the model says he does not understand it,
is it not?
Mr Sears: I do not disagree with
Q1416 Jim Cousins: I want to turn
to the insurers. The Governor of the Bank of England made it very
clear that he wanted a change to the solvency arrangements for
the banks to prevent retail depositors from being trapped, as
he expressed it. Do you favour that?
Mr Montagnon: We believe that
we need a robust system of deposit protection but we think that
it needs to be very carefully crafted in such a way as not to
distort the savings market as a whole. The danger is that if there
is over-protection of depositors it will act as a disincentive
to other forms of saving. How one gets there is quite complicated.
It may be we need to look at the way the insolvency laws operate
to ensure that savers can get their money or deposits out of banks
quickly in the event of a bank failure. One of the problems with
the present system is that it seems to get a long time to get
the money out. That may mean it is probably helpful to have some
adjustment to the insolvency arrangements.
Mr Sears: While this is not particularly
an IMA view, like Mr Pitt-Watson I am the author of two chapters
of Tolley's Insolvency on regulated bodies and financial
market insolvency. I worked on the Credit Institutions Reorganisation
and Winding Up Directive in Brussels. I think the issue is not
whether or not depositors ultimately get their money back. The
innovative thing people can consider in looking at it again is
whether or not there is a way to ensure people can keep getting
their cash notwithstanding an administration or collapse. Given
that most people take money through a cash point I presume it
is not beyond the wit of man somehow to plug into the cash point
system so people can still withdraw money while there is an insolvency
up to the limits of the protection. A lot of the discussions have
been about how much money people should get. As your constituents
will know far better than I, telling people that for example after
Christmas they will get their money back if there is an administration
of Northern Rock is not something they need. Many of us use cash
points. I can go to one that is not provided by my bank and I
presume there must be a way of plugging the Bank of England into
it at moments of crisis up to some limit.
Q1417 Jim Cousins: Of course, the
implication of that is that rather more banks will go bust because
it will be easier to make them go bust if retail depositors are
protected. I want to ask the insurers about Mr Sears' earlier
point about toughening the reserving requirements on banks with
the idea of preventing them going bust in the first place.
Mr Montagnon: Clearly, it is better
if banks do not go bust in the first place. The problem with Northern
Rock was essentially a matter of liquidity. I believe it is generally
agreed that not enough attention was paid to the liquidity risks
facing that bank in the run-up to the crisis. I therefore presume
that in future people will be paying such attention. Even if you
have the best protection or prudential supervision in the world
sometimes there will be cases when you have problems. If when
a problem arises the retail customers know that their own money
up to a given limit is safe and they can have access to it when
they want at least you are spared the risk of a run because there
will be less need for customers to go immediately to the bank
to try to take everything out. It is from that point that one
gets the risk of contagion.
Mr Sears: Equally, the bank is
put into administration if it needs to be.
Q1418 Jim Cousins: I have understood
the written evidence of the insurers to mean that they would not
favour much higher limits of depositor protection than we currently
Mr Montagnon: That is correct.
The question is not whether the limit needs to be increased but
rather how the system works and whether one can have confidence
in it. If one takes a limit of £35,000 that covers 98% of
all savers who have their savings only in cash and about 80% of
all individual savers, so one will capture the bulk of the most
vulnerable people in that protection. If one increases the amount
one tends to distort the market for savings because in view of
the guarantees one makes bank deposits more attractive relative
to products that do not have the same guarantees. That is not
necessarily good for the savings industry and the country's overall
propensity to save.
Q1419 Jim Cousins: Where does that
leave the so-called bank assurance model in which the bank is
also a portal into other kinds of savings products?
Mr Montagnon: I do not believe
it necessarily affects the model. What we would like to see is
a market for savings where choices are not distorted. If we can
offer products across that range we are very pleased to do that.
One of the things we are concerned about in terms of bank deposits
is that the way the protection scheme is funded should not involve
cross-subsidisation from insurance to banking deposits to protect
the latter because that would tend to distort the position.