Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 1680 - 1699)

TUESDAY 18 DECEMBER 2007

MR MERVYN KING AND SIR JOHN GIEVE

  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 with you.

  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 liquidity?

  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 that.

  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 five years.

  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 system.

  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. Nick.

  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 understand—understanding it demonstrates the kind of abilities that win you a Nobel Prize—you 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 regulate—

  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 cause.

  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 them did.

  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 qualification.

  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.


 
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