Examination of Witnesses (Questions 1680
TUESDAY 18 DECEMBER 2007
Q1680 Mr Breed: Prior to 1997, when
the Bank of England was involved with banking supervision, did
it monitor bank liquidity as part of that supervisory role?
Mr King: I think over a long period
it has declined, the attention paid to liquidity. It is quite
remarkable that in the 1950s and 1960s as much as 30% of the assets
of a bank had to be held in liquid assets. That was part of the
regulatory regime. Of course, banks were not wildly profitable
at that time because if you have to hold so much of a balance
sheet in liquid assets, your chance
Q1681 Mr Breed: Much of it was held
Mr King: Much of it was, indeed,
held with the Bank. Over time that ratio has declined until it
is not much more than about 1% now.
Q1682 Mr Breed: But you did monitor
Mr King: The Bank monitored it.
One of the interesting aspects of this is that at the time when
the Basle capital regime was being negotiated the Bank of England
did start an initiative to begin a parallel Basel liquidity adequacy
regime, and it never got off the ground; other central banks were
not so enthusiastic. It is a shame, but maybe we need to get back
Q1683 Mr Breed: Sir John, you are
the Deputy Governor with responsibility for financial stability
and you are a member of FSA Board. Why are you still in the job?
Sir John Gieve: Because there
is still an important job to do and I have been appointed for
Q1684 Mr Breed: Do you think you
have discharged that particular responsibility satisfactorily,
bearing in mind the state we are currently in?
Sir John Gieve: Obviously there
are lots of lessons to learn from the last six months, but I do
think I have done a reasonable job, yes.
Q1685 Chairman: Going back to the
point Colin made, we had one chief executive of an investment
bank in here who could not even make a stab at what a CDO was.
The issue here is the complexity of these products, is it not?
Sir John Gieve: Yes.
Q1686 Chairman: A tiny number of
people knew them, but maybe they did not even know, at the end
of the day, what it was and how explosive a cocktail this was.
This is the issue here. It is an understanding of the ownership
aspect where the risk was diversified. These are the real core
issues, are they not?
Mr King: They are, but there is
an element of (as I call it) search for yield. Alan Greenspan
would call it human nature; others might call it greed. Imagine
two neighbours on a Saturday afternoon talking over the fence,
and one says, "I have got a terrific investment adviser.
He has told me to buy these things called CDOs. I have got no
idea what they are, but you should see how much money they make."
And the other one says, "I will have some of that."
Once you see instruments that produce profit, people will invest
in it until the point when they realise it has turned into losses.
It is sad, it is unfortunate, but this is an aspect of investment
that appears to have occurred for as long as investment has been
recorded in human history.
Q1687 Chairman: Surely there have
to be some up-lines in the future. We have got to change this
Mr King: What we have to do is
two things. One is to put in place a system that as far as possible
is designed to help us deal with a failing bank, because banks
are different from ordinary companies, and, secondly, we have
to work harder to try to draw people's attention to the complexity
of some of these assets and to make them think twice. When I spoke
at the Mansion House in June I could not have been clearer. I
said: are we really cleverer than the financiers of the past?
The answer to that is pretty obvious now, but trying to get people
to think about that is not easy. One of the tasks that John and
I have in the next few months is to try to work out a way in which
we can ensure that when we write Financial Stability Reports and
give warnings, that we do not just put it out into the ether,
we try to find a mechanism by which people have to respond and
they visibly have to respond. I do not have any simple answers
to that, but I do think it is a challenge for us. It is one of
the lessons and we have to do something about it.
Chairman: We have given that some attention.
Q1688 Nick Ainger: Governor, following
on from Peter Viggers' and Colin Breed's questions, what started,
as you and Sir John have described, as mis-selling of mortgages
in Chicago or Washington DC ends with global financial turmoil,
a run on a British bank for the first time ever in 140 years and
nearly 6,000 people in the north-east of England facing redundancy.
The conduit for that virus has been the originate and distribute
model. Is there something fundamentally wrong with the model or
is it, as you describe in your October report, that there are
significant flaws in it, which you indicated earlier could be
addressed by the rating agencies, in whom around this table nobody
has got any confidence, in getting their act together, or the
auditors, and, again, around this table I do not think we have
got a great deal confidence in them? If it is so difficult to
get to the bottom of the risk involved in these complex financial
instruments, these CDOs, why do not we actually try and indicate
that they should not be used at all and we will not end up in
the position that we are in now?
Mr King: I want to try and distinguish
between the financial turmoil that we have now on the one hand
and the fate of Northern Rock on the other, because they are separate.
I think the turmoil created the conditions in which Northern Rock
met its fate, but it was not inevitable, had we had a well designed
system for dealing with failing banks, that it would have resulted
in what actually happened. So we can deal with that, even if there
is future financial turmoil. We can put in place, as the Chairman
said earlier, a system for dealing with failing banks. In terms
of the originate and distribute model, I think, that has been
helpful in may respects and the plain vanilla sale of securitised
mortgages has been a very healthy development and has, in fact,
enabled a number of smaller financial institutions to obtain funding
from others by borrowing against the securitised form of mortgages,
and that has been helpful. Where it has become much more problematic
is certainly the excitement, possibly the hubris, of parts of
the financial system in thinking that they could devise and invent
instruments of ever-growing complexity and, at the same time,
assume that the market in those instruments would always be deep
and liquid. It is almost a contradiction in terms that if you
invent an instrument that only a handful of people understandunderstanding
it demonstrates the kind of abilities that win you a Nobel Prizeyou
cannot expect the market to be deep and liquid, and what we have
to try to do is to make sure that people responsible for investment
decisions, whether it is pension fund managers or others, just
say to themselves, "I am not going to be seduced into investing
into something I do not understand, even if I get criticised by
people for not earning a high enough rate of return as the next
man last year." One of the difficulties here is this immense
pressure from short-termism to demonstrate, even as a fund manager,
that you have to have each quarter an above average return. This
is a collective madness, the idea that everyone can have above
average returns, and that is the sort of psychology that needs
to be changed, not that we need to ban certain instruments. I
do not think that will help. It is the underlying motivation behind
it: what led people to buy things that they did not understand?
That is the problem we have to address.
Q1689 Nick Ainger: Yes, it is a problem
we have to address. How are we going to address it?
Mr King: I have no simple answer.
On our part, we have the responsibility for trying to think much
more deeply about how we can get our message about the risks in
the financial system across to a wider range of people and to
make sure that the financial institutions respond and acknowledge
in public that they have seen our warnings and understand them
so they cannot use alibis later on, but in the end it does come
down to human motivation that, if they think that something they
do not really understand may nevertheless give them a higher profit,
they will go for it.
Q1690 Nick Ainger: If that is a problem,
then it is going to continue, is it not, unless there is clear
regulation to prevent it happening, to actually change human behaviour
or banking behaviour?
Mr King: I do not think you can
Q1691 Nick Ainger: The problem is
we already had a situation, because of the business model of Northern
Rock, that was far riskier than other models, but nothing was
done about it.
Mr King: That is where liquidity
regulation would help: because if we had a system of proper liquidity
regulation, although Northern Rock would have shown up as doing
very well on the capital side, it would have looked very flawed
on the liquidity side, and that would have been picked up. The
FSA recognise that, and that is why they are proposing their discussion
paper, so they can improve the system of liquidity regulation.
That is the lesson from Northern Rock.
Q1692 Nick Ainger: In terms of lessons
that can be learnt about the originate and distribute model and
the CDOs, would you propose regulation to prevent what you have
described as human or banking nature, if you like the requirement
within certain financial institutions to take unnecessary risks
to achieve high returns?
Mr King: I would not be in favour
of regulation to prevent people devising and selling instruments
if they wanted to do so. What I believe is that, after this episode,
the demand for such instruments, the very complex and opaque ones,
will fall radically. What is much more important is that 15 years
from now we publish in our financial stability report a reminder
that 15 years ago this is what happened, because there are cycles
in this. You see crises, people learn the lessons and then gradually
they forget them.
Q1693 Nick Ainger: Exactly. Surely
the problem would be in 15 years' time if you actually publish
in your financial stability report, "We told you so, and
so it has happened again." Is not that the risk by not taking
regulation to try and address the problem?
Mr King: I think clearly we need
an adequate system of regulation of banks, but I think the combination
of the existing capital regulation and a new regime for liquidity
regulation would be sufficient, provided that we also had in place
an ability to have a special resolution regime for banks so that
when they did get in trouble it did not have adverse consequences
for the depositors.
Q1694 Nick Ainger: But that way of
dealing with it just deals with the symptom rather than the real
Mr King: I think the real cause
does lie, in essence, in human nature and the wish to try and
get higher returns. My own belief in this, and I think experience
bears it out, is that if you try to pass some detailed regulation
saying a particular kind of security cannot be sold to certain
people, then there are very clever people out there who will just
devise a new kind of instrument that has not yet been prevented
from being sold to others and people will get round it that way.
What we do need is clearly a sense of responsibility. There is
cultural change, I think, in getting away from this extraordinary
short-term focus on returns in the financial world, but also people
who buy these instruments, whether they are pension fund managers
or people who hold positions in banks, need to recognise that
they should be held accountable for making decisions about what
assets they choose to hold and it does not make sense to go out
and buy a whole lot of clever things that you do not understand
just because somebody whom you have hired as a fund manager tells
you that is what you should do; it is the latest thing.
Q1695 Nick Ainger: But that is exactly
what they did.
Mr King: That is what some of
Sir John Gieve: Can I just add
a couple of points. Firstly, the investors in these cases were
professional investors and included actually the banks themselves,
many of whose losses came from retaining chunks, tranches, of
securities that they themselves had helped promote. The second
point is that addressing this has to be done on an international
basis, because these are international instruments; and so we
are working through Basle, where the director of financial stability
in the Bank is leading the work on liquidity, and in the FSF,
where I and Callum McCarthy are involved, to try and get an international
policy consensus on how to address these issues.
Q1696 Chairman: Another method, to
add to Nick's point, is training for people and banks so they
have proper training, Governor. To take the example of Northern
Rock, neither the Chief Executive nor the Chairman had a financial
Mr King: I do not want to comment
on that. What I would say about Northern Rock (and this is the
tragedy of Northern Rock) is that most of the staff that worked
in Northern Rock on the lending side, all the evidence shows,
did an excellent job in appraising the loans that they were making,
and that they monitored very carefully and they did not lend money
to people who should not be borrowing from them. The lending side
was handled extremely well. It was the borrowing side; it was
the business strategy that was fatally flawed in this episode
where, once those markets had closed in mortgage backed securities,
they were absolutely unable to finance their wholly illiquid assets.
Chairman: That as is an eloquent answer
for us. Sally.
Q1697 Ms Keeble: I wanted to ask
about the credit rating agencies, but first, very quickly, what
you basically said this morning is that there is uncertainty still
about the possible scale and distribution of losses, that there
is some work taking place to bottom these out, although it is
not clear whether people know where the risks are, and they are
just not saying, and we will not really know until next March
April, once the banks start to rebuild their balance sheets, exactly
where all the risks have been and what the losses will be. That
will be seven or eight months after the start of the crisis. Do
you really think it is adequate to watch this unfold with the
possible risk of another Northern Rock disaster?
Mr King: I think the problems
we are facing are international in nature, as John has said. The
problem of Northern Rock is a UK problem because we do not have
an adequate framework for dealing with failing banks, but to solve
the international problems will require a process. We said at
the very beginning that it will be lengthy process by which all
these complex instruments will have to be restructured and re-priced
in order for the auditors and accountants to be able to calculate
what the true position of each financial institution is. We have
certainly encouraged them, and the IMF have encouraged them, to
move as quickly as possible in this process. It is not easy, because
when markets are open, and deep and liquid, then marking to market,
as is the current convention for establishing losses, makes a
great deal of sense and can be done without an enormous degree
of exceptional effort, but once those markets have closed, it
then becomes extraordinarily difficult to know at what prices
you should value some of those instruments, and that is exactly
the difficulty that some of the banks have had. It it is quite
possible that if the auditors are insisting on using, say, a fire-sale
price used by another bank to value the assets, many of the losses
that are currently going to be revealed will be marked up again
to profits next year as some of those prices recover a bit. This
is a tricky and difficult process. It does need to be gone through,
but it has been a very salutary lesson, because this crisis has
become international in nature. It is not a crisis of emerging
market economies or failed macro-economic policies in the rest
of the world, this crisis goes right to the heart of the financial
centres of the three big developed parts of the world, and that
has been, I think, a salutary lesson. I think many of those lessons
will be learnt, but what we have to do now is to encourage the
banks to go through this process of revealing the losses and then
recapitalising the balance sheets.
Q1698 Ms Keeble: Can we turn to the
credit ratings agencies, because in the financial stability report
there are a number of recommendations made for reform, including
widening the scoring systems to include different factors. Do
you think that this might have the unintended consequence of actually
making some of the investors more dependent on credit ratings
agencies because they will look to them for a wider range of assessments?
Mr King: Rating agencies is a
very important issue for everyone to confront. It is being discussed
internationally in the Financial Stability Forum, and John is
the representative of the Bank in the Financial Stability Forum,
so I think John should take this.
Sir John Gieve: On the five suggestions,
the final one, should they give some view on market risk, I think
when Hector Sants came here he said it depends on whether they
can do it sensibly and in an understandable form, and I agree:
if it is going to confuse people further, then they should not
do it. I think it is quite important for the functioning of capital
markets that the rating agencies do re-establish their credibility,
because it is a collective good, if you like, to the players in
the capital markets that they are able to rely on an independent
body to give some assessment of credit quality.
Q1699 Ms Keeble: But (a) they are
not actually independent, which is one of the basic problems,
and (b) there is a little sort of caveat at the end, and I think
it is from your report, saying that it is still critical how they
carry out their own due diligence, which is like a health warning,
which is an astonishing throw-away line. How do you propose to
get people to improve the due diligence?
Sir John Gieve: First of all,
we do not have to make them do it. In a sense investors all round
the world are currently thinking they put too much weight on the
rating agencies and are trying to either restrict their investment
range to the products they understand well or to increase their
own work on where to put their money. So, I think that that is
a market development.