Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1660 - 1679)

TUESDAY 18 DECEMBER 2007

MR MERVYN KING AND SIR JOHN GIEVE

  Q1660  Mr Love: So you are going to leave it to the Treasury Select Committee to make up their mind.

  Mr King: I think the Treasury Select Committee are an admirable group of people to recommend where that power should reside.

  Chairman: You are going too far, Governor!

  Q1661  Mr Mudie: Does that include me?

  Mr King: Absolutely.

  Q1662  Mr Mudie: Governor, I would like to follow up on a question Mr Fallon put to you in terms of this leak that was very embarrassing for the Chancellor, Prime Minister and yourself. I accept that you are nothing to do with it, but The Sunday Times did say it was a senior Bank of England official. I would be interested to know what you have done since The Sunday Times came out. Have you had your senior people in? Have you checked diaries? Have you asked which ones put you in this embarrassing position a few days before this hearing?

  Mr King: I do not believe that anybody in the Bank would make comments of that kind. I know my colleagues well and I would not dream of saying, "Who had lunch with whom and when?" That is not the kind of comment that anyone in the Bank makes.

  Q1663  Mr Mudie: Do you think it is a type of reporting that The Sunday Times gets up to, using a source in the Bank, a senior source in the Bank of England?

  Mr King: I do not believe for a minute that those words in quotes corresponded to anything that a Bank of England official actually said.

  Q1664  Mr Mudie: So The Sunday Times were just bolstering their story by the lazy use of a Bank of England senior source?

  Mr King: You might think that, I could not possibly comment. I have learnt over the years not to believe a lot of what is in the newspapers.

  Q1665  Mr Mudie: The press are after the Chancellor, and yesterday's Financial Times made three assertions about Northern Rock, and I would like to go through them with you. One of them I raised with you last time, but I will be specific. Was there a rescue bid from Lloyd's TSB on the table the weekend before the run? That is the first part of that question. Was it specifically put to the Chancellor as either advisable or acceptable, and did he reject that advice, if given?

  Mr King: There was no firm bid on the table at all. There was one pretty vague telephone call, originating in FSA, which came to Bank officials and then passed to me, saying that there might be a bidder but they wanted to know first, before putting a bid on the table, whether it would be possible for them to borrow about £30 billion without a penalty rate for two years, and I said, well, the Bank of England does not normally lend £30 billion to a going concern. In any event, our balance sheet is not big enough for us to make that kind of decision, and it was absolutely clear, whatever way you looked at it, it was clearly state aid. It was for a takeover bid to pay a positive share price to another company; so it was clearly state aid. So I said to the Chancellor that this was not something which the Bank of England would do. My advice, clearly, was that this was not an operation which either central banks or governments normally did. If it were to go ahead it would require an indemnity for the Bank of England from the Treasury. Our legal advice was that this was clearly state aid and (and this was perhaps most important off all) it would be quite impossible to make an offer of a loan of that kind to one bank to buy Northern Rock without making it quite clear to other potential bidders that they too would have access to it, and I think, as the Chancellor said when he came to you before, the idea that if he stood up and said, "I am willing to lend £30 billion to any bank that will take over Northern Rock"—that is not the kind of statement that would have helped Northern Rock one jot or tiddle. It would have been a disaster for Northern Rock to have said that. So, I do not think it was ever a practical proposition, but, in any event, no formal bid was tabled as far as we were concerned.

  Q1666  Mr Mudie: Mr Brady pressed you on this and I would like to come back to it. Did the Chancellor get specific Bank of England advice to give the retail depositors a guarantee at the same time as the announcement of lender of last resort?

  Mr King: No. I have said that before. No, he did not.

  Q1667  Mr Mudie: Absolutely not?

  Mr King: Absolutely not. There was no discussion, in fact, among the principals until the Sunday. On the Saturday I spoke with the Permanent Secretary of the Treasury and I met the Chancellor in person on the Sunday morning, and that is when I made my clear advice, as he pointed out to you when he gave evidence to you earlier this year.

  Q1668  Mr Mudie: Let us be clear: which day did the lender of last resort leak out and become public?

  Mr King: It leaked out late on the Thursday. Rumours in the market started on the Thursday afternoon which led to a meeting at four o'clock of the standing committee of deputies, and at that meeting it was decided that, because of the concern about leaks in the market, not the television leak later on but rumours in the market, that the facility should be announced at seven o'clock the next morning. That is when the decision was taken, on the Thursday afternoon. There were television reports later that evening.

  Q1669  Mr Mudie: Against that timetable you did not give advice to the Chancellor that when he made that announcement he should also announce the guarantee for the retail depositors?

  Mr King: No, we did not.

  Q1670  Mr Mudie: The third thing was that the Chancellor was advised to use the full leverage of the Bank facility to push the shareholders and management to accept an immediate private sale. Did the Bank give advice to the Chancellor to use that leverage at that sensitive time or, to your knowledge, did the FSA give the advice?

  Mr King: Can you repeat the proposition. I do not recall anything like this. This is a proposal for—

  Q1671  Mr Mudie: On the back of being so helpful to Northern Rock. You have said yourself, Governor, one of the things that is going to be a problem, if the negotiations went well and you were prepared to think there was an offer acceptable, the shareholders are going to have a say.

  Mr King: Indeed.

  Q1672  Mr Mudie: And I think the proposition is that at the time you were putting the money in and there was disarray and panic, et cetera, you had leverage to say to the shareholders, "We want an immediate private sale." Those are the exact words.

  Mr King: Well, there was no proposition like that on the table, and my understanding and our legal advice was that it would not have been possible, because whatever accelerated deal one tries to bring about, the shareholders must be given proper time to consider a bid and others must be given a chance to make their counter bids. So, there was no advice at all to do that. It was not possible.

  Q1673  Mr Mudie: Can I ask your deputy, because he has been getting a rough press and this is an opportunity. Do you think you have operated well the link between the FSA and yourself in the area you are in? Has it worked well or have there been deficiencies, and have you contributed to the deficiencies?

  Sir John Gieve: I think the links between the Bank and the FSA have worked well in terms of exchange of information and communication. They do not just depend on me. I am on the Board of the FSA, Callum McCarthy is on our Board, but we have put in place daily calls about market developments, the FSA are represented on my Financial Stability Board and I think those did ensure that we shared the information we had and we discussed the issues. It does not mean we always agreed, of course.

  Chairman: Thank you very much.

  Q1674  Peter Viggers: A central ingredient of our present difficulties is securitisation, the banks have it, of originating and distributing loans and other assets, and in your October Financial Stability Report you stated that this model has been shown to have significant flaws. Would you calibrate those for us?

  Mr King: Let me make a brief comment and then ask John, because he is in charge of the Financial Stability Report. The securitisation model, I think, will return, but not in the way in which it has been operating in the last few years in which an enormous superstructure of derivative instruments has been built on top of securitised assets, the whole complex structure of CDOs and CDOs of CDOs, and so on,.. I suspect there may be less demand for it. I think they will still exist for those people who genuinely believe they really understand the instruments, and there are those in specialised financial institutions who do that, but I rather think that pension funds and others may come to recognise that securitisation is fine but just follow the basic maxim: only invest in what you understand. John.

  Sir John Gieve: I think the key thing that the FSR has shown up is that some unintended incentives were set up in the originate and distribute model as it applied to credit products. So you find the originators of mortgages had a strong incentive to go for volume rather than quality and an awful lot of bad loans were made; I think the rating agencies had an incentive to take on as many ratings for as many products as they could; I think the investors had an incentive, because of the different yields, not to look at the fine print of what those ratings actually offered and, instead, just to go on the label; and, finally, I think the banks had an incentive to use off-balance-sheet vehicles for a lot of their operations. The market will correct some of these and the role of the authorities will be to step in where official action is also necessary to correct them.

  Q1675  Peter Viggers: Yes. Banks do not trust other financial institutions, and you, Governor, said that part of your role is to "dispel that sense of fear", but is not the problem that that fear is justified?

  Mr King: Certainly at present it is justified to be cautious about where the losses on many of these complex and opaque instruments will ultimately come to reside. That is why I think we need a little bit of patience to get through the period, perhaps the end of February, March, when financial institutions will have had to reveal most of those losses marked to market and take whatever resulting steps are necessary to rebuild their balance sheets, and at that point I would hope that we will have made a big step forward. But, as I said in August and when I came to see you in September, the most important step that is required here is that the private sector (and it can only be the private sector) needs gradually to restructure and re-price many of those complex instruments which people are now very reluctant to lend against or buy, and that will take time, but the process is slowly beginning. There are risks to the world economy in the meanwhile if it results in a banking system that is reluctant to lend to industry, and it is our job to try and take steps to minimise that, but the resolution of the problems in the financial sector will hinge on the restructuring and re-pricing of instruments and the revelation of losses and the rebuilding of balance sheets. At that point, and at that point only, will you see inter-bank spreads, these LIBOR spreads, return to normal levels, and it is very instructive that, whatever view you take on how central banks have conducted their money market operations, there may be room for disagreement, but whatever central banks did, these three-month LIBOR spreads are absolutely identical now in the euro area, sterling and dollar, and that tells you that it does not have a lot to do with the provision of liquidity and money market operations, it has a great deal to do with the factors that you mentioned.

  Q1676  Peter Viggers: The weapon available to you, of course, is credit, and it is rather like pushing on a piece of string, whereas what we need is someone to sort out the rotten apples?

  Mr King: Yes, and that will gradually happen, and I think the regulators and, indeed, the banks themselves have a very strong incentive to see this happen, but it does require auditors to go through a careful process of working out and validating the valuations which banks themselves put on their assets, and this will gradually happen over the next few months.

  Sir John Gieve: I think the fear consists of two things. One is that we do not know yet what the price is of what has already happened, the subprime crisis, and, if you like, where the losses lie and whether it will require recapitalisation. But there is also a fear about the future of the economy, particularly in the US, and the possibility that if that goes into recession there will be a further round of losses. I think that part of the central banks' job is to provide some confidence that the economy will be managed in a responsive way going forward. We may not be able to do much about the subprime losses, which are in a sense still being worked out, in the past.

  Q1677  Peter Viggers: No doubt the situation will shake down, but should there be a role for leadership here and who should take it?

  Mr King: Central banks have discussed this a great deal amongst themselves, and I think the conclusion we have all reached is that actually the resolution of the re-pricing of instruments is something which has to be conducted in the private sector, and the accounting bodies and the regulators have their important role to play in trying to make sure that the banks, as soon as is feasible, reveal the size of the losses and take steps to rebuild their balance sheets, and you can see that beginning to happen, and I think we just need a little bit of patience to see that process through. Meanwhile, as John says, the challenge facing central banks, and one of the reasons for our co-ordinated action last week, was to try to ensure that the sense of confidence in how the future policy will be conducted is sufficient not to add this further fear that there will be a layer of extra losses coming down the road.

  Q1678  Mr Breed: Teasing out a little bit more what you said about these asset-backed securities, is it not now clear that far too many banks were irresponsible in lending vast sums of money against so-called asset-backed securities where they had no idea whatsoever of the underlying value of that asset?

  Mr King: I do not want to make generalisations about what banks did or did not do. I think what is very clear is that in the United States there was some pretty extraordinary lending in the subprime mortgage market where people, without a great deal of sophistication, were encouraged to take on loans that perhaps they could just about afford to buy a home that they never thought they would ever be able to afford and they were encouraged to think that they could afford it, but only when the policy rate set by the Fed was 1%, and once interest rates got back to a more normal level of 5%, they clearly could not afford it.

  Q1679  Mr Breed: That might have been the genesis of the problem; that does not absolve our banks from lending vast amounts of money against asset-backed securities the underlying value of which they had no idea or ability to calculate.

  Mr King: I think a wide range of purchasers of those assets should ask themselves questions about whether they really did understand what they were buying, but they are accountable to their shareholders, their trustees, whoever, and I think those people will have a lot to say about the decisions that were made to take on board these assets.


 
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