Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1608 - 1619)

TUESDAY 18 DECEMBER 2007

MR MERVYN KING AND SIR JOHN GIEVE

  Q1608  Chairman: Mr King, Sir John, welcome to the Committee. I believe that you have an opening statement. Could you first introduce yourselves for the shorthand writer, please.

  Mr King: Thank you, Chairman. On my left is John Gieve, Deputy Governor for Financial Stability. If I may Chairman, I would like to read a short opening statement. As you and the Committee will be aware, the problems in the financial sector remain with us. A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets. Uncertainty about the possible scale and distribution of losses means that interbank lending rates have risen further relative to expected official interest rates. The behaviour of those spreads has been very similar in the sterling, dollar and euro markets, exacerbating concerns about a `credit crunch' in the major industrialised countries. That remains the concern not only of the Bank of England but of all the major central banks, and I will return in a minute to our market operations. But we are also thinking about the changes needed to prevent the crisis that befell Northern Rock from happening in the future. There are, as I said in my speech in Belfast in October, three main lessons from the recent turmoil for the UK's framework for managing the financial system. First, the UK authorities are alone in G7 in being unable to deal with a distressed bank under a special resolution regime. We rely instead on normal corporate insolvency laws. But if a bank enters administration depositors may have to wait a considerable time to gain access to their funds. Knowing that, they have a strong incentive to join a bank run. So at present we cannot allow a bank to fail unless it is clearly insolvent. In turn the expectation that the authorities will try to avoid insolvency puts a floor under the bank's share price and that prevents the authorities from intervening to implement a reorganisation of the bank. So a special resolution regime is the most important reform now and it will require legislation. Second, experience in other G7 countries suggests that a new regime should be supported by credible deposit insurance arrangements. A model for deposit insurance that draws on international experience would have permanent 100% coverage up to a limit with transparent and widely understood prompt payout commitments. Third, the experience of Northern Rock demonstrates the importance of regulating the liquidity position of banks. Northern Rock believed that its adoption of Basle II meant that it would have surplus regulatory capital, and in July it proposed to increase its interim dividend for 2007 by 30%. But its liquidity position remained extremely vulnerable to the type of shock that occurred on 9 August. It is clear that regulation of capital alone is insufficient. Tomorrow the FSA will publish a discussion paper on liquidity regulation, and the Bank fully supports this initiative. Much has been said about the operations undertaken by central banks in the money markets during the recent turmoil. All central banks have the same primary objective in this area: to implement monetary policy by keeping interest rates on overnight borrowing in the money market in line with the interest rate set by the MPC. After a short period of volatility in August, we have achieved that objective. The gap between overnight interest rates and Bank Rate in the United Kingdom has, on average, been the same as in the euro area and smaller than in the United States. I will pass over a description of our money market operations but leave it in the text for the record.[2] Last week, central banks around the world announced a co-ordinated set of actions in response to increased pressures in short-term interbank lending markets. The Bank has raised the amount on offer, and widened the range of high-quality collateral eligible, in its regular three-month lending operations that had already been scheduled for both today and for 15 January. Our lending in other operations will be correspondingly reduced. The actions announced last week demonstrate that central banks are working together to try to forestall any prospective sharp tightening of credit conditions that might lead to a downturn in the world economy. A key lesson that central banks around the world have taken from the recent turmoil is that, in stressed conditions, any bank that is seen to come to the central bank to borrow—whether in regular standing facilities against high-quality collateral or against wider collateral in a discount window or support operation—can become `stigmatised' in the market. It important that, in future, banks have a means of accessing the central bank when necessary. So over the next year, and in consultation with the banks, the other tripartite authorities and other central banks, we will be reviewing this element of our money market operations. In due course we shall publish a revised `Red Book' that describes our operations in the sterling money markets. Chairman, I am grateful for the opportunity to make that statement this morning and John and I stand ready to answer your questions.


  Q1609  Chairman: Fine, thank you very much, Governor. Regarding last week's actions by the central banks, the markets appear to have taken the recent joint action, not as a sign of strength, but as a sign of things being worse than people thought. How would you respond to that suggestion?

  Mr King: I do not think I would fully share that view. There was always a risk that any intervention by a central bank could be interpreted as a sign that the central bank has seen something that others have not, but I think the fact that this was an international co-ordinated action which we at the bank were extremely keen on making international did achieve two objectives. One was to demonstrate that the central banks were working together—perhaps that had not been as evident as it might have been since August, and, secondly, it was a clear recognition that all the central banks were saying to the market, "Yes, we do understand the deterioration in sentiment in credit markets", which had been very evident over the previous four weeks, "and we are conscious of the concerns that you have and we are determined to take whatever set of policy action is necessary to ensure that we do not see a serious downturn in the world economy."

  Q1610  Chairman: There is a view held by some that this is not just a crisis of liquidity but of solvency and, as a result, the concerted actions of the central banks may not help.

  Mr King: It is certainly true that the reason for the rise in spreads in inter-bank markets in the past month is not due to a shortage of cash. That was the case in August and September when the banks were trying to accumulate as many liquid assets as possible and the rise in the inter-bank spreads in that period did represent an attempt to accumulate liquidity, but the large banks are now awash with cash. The issue is not whether they have enough cash; the issue is whether they are willing to lend, and in recent weeks (and this was the reason for the co-ordinated action and the concern shared by all central banks) what has become evident is that banks are concerned about the capital position of other banks. They do not know where the losses resulting from the array of derivative financial instruments will finally come to rest, and, I think, in the last four weeks we have also seen a more disturbing development, which is that the banks themselves are worried that the impact of their reluctance to lend collectively will lead to a sharper downturn in the United States and perhaps elsewhere, thus generating further losses outside the housing and financial sector which will feed back onto bank balance sheets and reinforce their reluctance to lend because of the need to generate more capital. That concern is a serious one, because it does hold out the prospect that, if banks behave in that way, there will be a self-reinforcing downturn in credit and activity. That is not necessary by any means, and, provided we can help to dispel that sense of fear (and that was one of the reasons for the actions last week—a demonstration that the central banks are clearly aware of these concerns and problems and we will take the appropriate actions to respond to it) then, in fact, we will be back again in the position where, I think, after the end year banks will gradually realise that, once all the losses have been revealed and once they have taken steps to rebuild the capital of their balance sheets, which several big banks have already done, then conditions will return to a more sustainable position.

  Q1611  Chairman: It has been suggested that your own position, Governor, is characterised by a U-turn. In the summer you were saying that if you were lending to banks at a penalty rate and there were certain conditions in the collateral you were accepting, now there is not a penalty rate and you have widened the collateral which you will accept. You also mentioned on Radio 4 and other places that you were not here to bail out banks, that "the role of the Bank of England is not to do with what the banks ask us to do". People would suggest now that what you have done is the opposite of what you said you were not going to do in August and, as a result, you have done a perfect U-turn.

  Mr King: It is not my view of what I have done. What we did in September when offering a term tender was to say we are willing, given the concern about the British banking system, to offer money at a very wide spectrum of collateral, including raw mortgages, and if we were going to lend against that kind of collateral—the European Central Bank, for example, would not lend against that kind of collateral—then we felt it appropriate to put in place a penalty rate which was fixed ex ante so that any money would be lent at the clear penalty rate. What we are doing now in the co-ordinated action is to lend against a narrower range of collateral only marketable instruments. The money will be auctioned off and, in that process I fully expect that the rate which people who get the money will have pay for it will turn out to constitute a significant premium over bank rate. So, in that sense, there is a penalty rate built in through the auction process itself.

  Q1612  Chairman: Why do you think you have been so widely understood then?

  Mr King: Misunderstood, I think.

  Q1613  Chairman: Misunderstood.

  Mr King: I wish I had been widely understood.

  Q1614  Chairman: I think we all would!

  Mr King: There are two reasons for that. One is that I failed to speak out in August to explain how money market operations worked, and I wish I had done, and by the time it became possible to do so in September, we were right in the throws of the problems with Northern Rock and it was an extremely difficult environment against which to explain the arcane details of money market operations. The second reason is that very few people, in fact, do understand money market operations. Even now I find it very hard to explain, and I make big efforts to see people to explain it to them. Very few people seem to understand the basic point that, in order to implement monetary policy—to keep interest rates in the market, overnight interest rates, in line with the policy rates set by the Monetary Policy Committee in our case, the Governing Council in the case of the ECB—once the month has started, the amount of liquidity which can be injected into the system is completely fixed. If you try to inject any more in than the banks are told to hold as their reserve targets or, in our case, choose to hold as reserves, then the banks will have surplus reserves, will try and lend it out and that will push the overnight rate down. If you do not inject enough, then people will be scrabbling around to get liquidity and that will bid the interest rate up. So, whatever liquidity is injected (and often it attracts great headlines), what central banks then do is to offset that. What they give in one hand they take away with another within the same maintenance period, not the same day or even necessarily the same week, but within the same maintenance period you have to do it. That is why I have been trying to explain to people since the beginning of August that the European Central Bank has, in net terms, injected hardly any extra liquidity at all, the Federal Reserve four or 5%, I think, and the Bank of England 37% more. Why is that? It is because we allow our own banks to set their own reserve targets, and, if they choose to hold more reserves, they can do so and we supply the increased amount correspondingly.

  Q1615  Chairman: You mentioned that you failed to speak out. In our inquiry we are looking at the issue of communication strategy of the tripartite arrangement. Would you consider that is an important area for us to focus on?

  Mr King: Yes, it is, and particularly in the case where there is a problem of a failed bank. I would say, though, that one of the problems that the tripartite arrangements faced in September was that, although the processes for making recommendations on a lender of last resort operation—the decision of the Chancellor—worked extremely smoothly in my view, we were still hoping, even on the Thursday, the day before the facility was offered, that it would be made on Monday—that was the plan—and it was only during the course of the Thursday, when rumours started to spread in the market, that it was felt necessary to accelerate that to the Friday morning, and that put a lot of pressure on the communication strategy, but, clearly, we need to think further about that.

  Q1616  Chairman: On the deposit protection scheme, you have mentioned in your public statements that it is inadequate. How long have you held that view and did you communicate that view to the Treasury in the past?

  Mr King: I think all the Tripartite Authorities have been aware of this and thinking about it. One of the things which Callum McCarthy and I initiated when we both started at around the same time was to pursue regular crisis management exercises, and out of those exercises in 2005-06 came the very clear understanding that we had no adequate tools for dealing with a failing bank. The Treasury completely agreed with that and, indeed, work was going on in the Treasury to think about how best to handle that right the way through 2007. So these issues, I think, were understood and, as I say, the Treasury was working on it, but when we had the exercise in 2006, I did not say to the Chancellor afterwards, "I have a great crystal ball here. I can see that in 18 months' time Northern Rock is going to get into trouble. Therefore, we'd better rush this legislation through in the next few months." This was not something, I think, that we felt had to be done overnight, this was something that needed careful thought and attention.

  Q1617  Chairman: Did you advise or provide information to the Treasury, say when the emergency money facility was announced to Northern Rock, that there would be a risk of a run given your views of the deposit protection scheme?

  Mr King: I will ask Sir John, because most of the discussions of that took place at the deputies level. What I will say is that I do not think that on the Thursday, when we suddenly had to advance the date of the operation, that we thought that a run was inevitable. The nature of a bank run is that it is a knife edge: it might happen, it might not. That is exactly why a bank run is so difficult to handle.

  Q1618  Chairman: But you have described the reaction of customers as being rational. Do you think it is rational?

  Mr King: Once the run had started, once other people had started to run, then it was, indeed, rational, given the system we had, to join the bank run, but it was not necessarily rational to be the first person in the queue, because if other people had not gone and started the run, then it might have been perfectly acceptable for it not to have happened. I do not think there was any inevitability in that.

  Q1619  Chairman: The reason I am asking that, Governor, is that you consider the deposit protection scheme inadequate. You know that it is not 100% guaranteed, so you know that when people find this out (and it was not evident to everyone) they say, "Goodness, I am only going to get 90% of the money I put in."

  Mr King: Absolutely.


2   The text read as follows: "I would add two important points about our money market operations that have not been widely understood. First, a unique feature of our system is that the total amount we lend to the banking system each month is determined, at the beginning of each month, by the banks themselves. We are now supplying £6bn more than on 1 August-an increase of 37%. Neither the ECB nor the Federal Reserve has increased their supply of reserves in this way. Second, central banks can only keep overnight interest rates in the market close to Bank Rate by lending to banks just the amount the system requires. If we were to provide more money than banks are required, or in our case want, to hold, there would be excess money in the system and overnight market interest rates would fall. That is why when the ECB lent more to banks for 3 months it reduced the amount it lent for other periods-there was no net injection of money to the system. Similarly, the Bank of England has extended funds to the banking system through its lending to Northern Rock-as Northern Rock pays away the money to its creditors, it adds to the reserves of other banks. So we too have adjusted our other lending so that the net injection of liquidity since August is in line with the extra £6bn requested by banks." Back


 
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