Examination of Witnesses (Questions 1608
TUESDAY 18 DECEMBER 2007
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,
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.
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 borrowwhether in
regular standing facilities against high-quality collateral or
against wider collateral in a discount window or support operationcan
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 togetherperhaps 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
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 weeka 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
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
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 collateralthe European Central
Bank, for example, would not lend against that kind of collateralthen
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
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 policyto
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 ECBonce
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
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 operationthe
decision of the Chancellorworked 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 Mondaythat
was the planand 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
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