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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 56-i House of COMMONS MINUTES OF EVIDENCE TAKEN BEFORE TREASURY COMMITTEE
Financial stability and transparency
Tuesday 13 November 2007 PROFESSOR WILLEM BUITER and PROFESSOR GEOFFREY WOOD MR PAUL TAYLOR, MR CHARLES PRESCOTT, MR MICHEL MADELAIN, MR FRÉDÉRIC DREVON, MR IAN BELL and MR BARRY HANCOCK Evidence heard in Public Questions 853 - 1148
USE OF THE TRANSCRIPT
Oral Evidence Taken before the Treasury Committee on Tuesday 13 November 2007 Members present John McFall, in the Chair Nick Ainger Mr Graham Brady Jim Cousins Mr Philip Dunne Mr Michael Fallon Ms Sally Keeble Mr Andrew Love Mr Siôn Simon Mr Mark Todd Peter Viggers ________________ Memorandum submitted by Professor Willem Buiter
Examination of Witnesses Witnesses: Professor Willem Buiter, LSE; and Professor Geoffrey Wood, CASS Business School, City University, gave evidence. Q853 Chairman: Good morning and welcome to our Committee inquiry into financial stability. Professor Richard Portes, who was to appear with you this morning, has indicated that he is ill so he has given his apologies. Can I ask you to identify yourselves for the shorthand writer please. Professor Buiter: Willem Buiter. Professor Wood: Geoffrey Wood. Q854 Chairman: Thank you very much for agreeing to come and give us your insight into the situation which was triggered by the Northern Rock Bank and the drying up of liquidity. We have witnessed the first bank run in 140 years as a result of that. With which, if any, decisions of the Tripartite Authorities do you disagree most strongly? Professor Buiter: Well, there are quite a few. The very structure of the tripartite agreement was flawed so I disagreed with the tripartite agreement before they even started doing anything. The notion that the institution that has the knowledge of the individual banks that may or may not be in trouble would be a different institution from the one that has the money, the resources, to act upon the observation that a particular bank needs lender of last resort support is risky. It is possible, if you are lucky, to manage it, but it is an invitation to disaster, to delay, and to wrong decisions. The key implication of that is that the same institution - it could be the FSA or it could be the Bank of England - should have both the individual, specific information and the money to do something about it. Given that, the decision to provide the support to Northern Rock - which was a joint decision and had to be authorised of course by the Treasury - was not backed up at that point by a joint statement by all the parties involved to tell the public that their money was safe. As I put in my note, they should have had the Chancellor and the previous Chancellor and the Governor and the Head of the FSA and its Chief Executive all standing up saying, "Your money is safe". If they were not quite convinced that the public would believe them - and in these days you cannot be sure of that - then the immediate creation of a deposit insurance scheme that actually works and is credible would have been desirable. To wait three days was again an unnecessary delay. The FSA throughout all this seems to have been asleep on the job, not having noticed that the funding policy of Northern Rock was high risk and also not expressing stronger concerns about the breakneck rate of expansion, especially in the last half year. I like healthy growth but it is hard to believe that the quality of the asset portfolio and the ability to vet the credit-worthiness of your borrowers does not suffer when you take 20% of the net increase and 40% to 50% of the gross increase in activity in this half year period, so I think they were an organisation that was clearly engaged in high-risk behaviour, and the fact that the FSA did not call them back or felt they did not have the authority or the information (I do not know) is worrying. Then of course I think the Bank of England made policy errors, even given the existing framework, in its management of liquidity. Its demands for collateral were too strict - stricter than any other central bank that matters, much stricter than those of the ECB and stricter than those of the Fed - and its demands for collateral at its discount window, the so-called standing lending facility, were also way too strict. Basically they would discount only stuff that is already liquid: UK government securities; European area government securities; a few international organisations' debt like the World Bank; and then, under special circumstances, US Treasury bonds. All that stuff is liquid already so all the Bank offered at its discount window was maturity transformation, not liquidity transformation, and that was absolutely no good. When they created the liquidity support facility for Northern Rock they created what the Bank's discount window should have been all along - something that lends against illiquid collateral and also lends for longer periods, because the Bank discount window is only for overnight lending. The Bank has since retreated from its policy on collateral and they have also declared themselves willing to intervene more aggressively at longer maturities. At least, they offered to do so; when they did nobody came, partly because their promised interventions at three-month maturities were at a penalty rate rather than at market rates. They are not quite there yet but I think they have learnt and they are moving in the right direction. There was a whole slew of errors from the Treasury, the current and previous incumbent, from the Bank of England and from the FSA, and nobody comes out of it smelling of roses. Q855 Chairman: That was comprehensive. Professor Wood? Professor Wood: I think I can be fairly brief, Chairman. First of all, let me start by saying where I agree completely with Willem. I agree that the structure was fundamentally flawed. It is simply a mistake to have responsibility away from someone who can do something about it. I do not think it would be possible to put the responsibility onto the FSA because the FSA is not a bank and it cannot provide liquidity. The FSA, as Willem put it, was asleep on the job; that is manifestly right. A very clear signal of a bank running a big risk is rapid expansion. Northern Rock was giving that signal quite clearly; it really is remarkable that they missed it. With regard to the support operation and the provision of liquidity, again as Willem said, there should have been announcements that your money was safe. We might come back to that later in the context of deposit insurance. Walter Bagehot criticised the Bank of England's behaviour in 1866 by lending, as he put it, "hesitatingly, reluctantly and with misgiving". This prolonged the crisis and I think the same thing happened this time, there was a certain manifest hesitation and that made people nervous. A couple of issues where I do disagree with Willem just a little bit. I think the Bank is right to take collateral. I think it should charge higher rates on less good collateral, first of all, to ensure that banks do not run risks confident that the Bank of England will bail them out and, secondly, of course, to protect the taxpayer if some of this less good collateral does not eventually pay up. That the Bank was engaging in maturity transformation and not liquidity transformation is fine. I think it was the right thing to do at that time. By and large, the problems were in the structure, the division of responsibility and the lending hesitantly, reluctantly and with misgiving. Q856 Chairman: Both the Bank of England and the Financial Services Authority have claimed that they warned financial institutions about the risk of markets becoming illiquid. I think the FSA sent their paper out in January and the Bank of England sent their paper out in April 2007. I note from an interview that the Governor of the Bank of England had with the BBC last week that he said maybe more could be done in this area to ensure that financial institutions listened to the Bank and the FSA regarding their warnings and take action. What is your advice in that area? Professor Wood: The best way to make them listen is to penalise them if they do not. It seems to me therefore that the Bank of England's behaviour in being very reluctant to take securities that they would not normally take, except when the crisis got really bad, from Northern Rock and refusing to accept them from other institutions for some considerable time was exactly the right thing to do. The casual lending on almost anything that the Federal Reserve and the ECB did almost immediately seems to me to have been an error of judgment and is likely to bring problems in the future. Professor Buiter: The private banks have a lot to learn as well. They were foaming at the mouth right up to the moment that the crisis hit. The now departed Chair of CitiGroup, the American bank, said in July that they were still dancing in the asset-backed securities market, so they believed the party would never end and they acted recklessly on both sides of their balance sheets, unlike Northern Rock which seems to have acted recklessly only on one side of the balance sheet. The banks did act recklessly. How do you make them listen? What Geoffrey proposes might help but I doubt it. Financial markets and financial institutions go through these bouts of euphoria where they really believe that they know better than the authorities and that this time it is different and we have new institutions that will make the risk go away. That fallacy takes hold every so often and there is very little you can do about it. Q857 Chairman: So therefore we have just got to dance to the tune of the banks and when they get into trouble we forget about moral hazard and we bail them out because the whole financial system is at risk and therefore we are in hock to them? Professor Buiter: Not at all. Q858 Chairman: So what do we do? Professor Buiter: First of all when they do get into trouble, when I said that the Bank of England should have accepted a wider range of collateral, I did not mean to suggest - in fact I explicitly do not - that they accept illiquid collateral at face value. They should be priced at a heavy discount and even when you think you have arrived at a fair price you apply further haircuts, further discounts to it, so it becomes penalty collateral provision, over-collaterising significantly if necessary. That can be enough of a penalty. Secondly, I think that once deposit insurance was in place there was no reason to allow the institution in question, Northern Rock, to be supported. The contagion effect was contained by creating universal coverage of not just retail deposits but also wholesale deposits and in fact all unsecured credit except subordinated debt, so all the deposits were safe, and at that point the support for Northern Rock could have been withdrawn. The option there would have been to either let it go into insolvency or to take it into public ownership. That would have been a very good discouragement of future bad behaviour. Q859 Peter Viggers: There was a clear warning about liquidity not least in April from the Bank of England, and when we asked Northern Rock what notice they took of that they told us that they fulfilled all the stress tests which were agreed with the FSA. Nevertheless, the situation went badly wrong. Where would you allocate responsibility for this, on the directors of Northern Rock? Professor Wood: Ultimately Northern Rock's failure has to lie with them, but the FSA was charged, perhaps not terribly sensibly, with ensuring that they did things correctly. As I understand it, most stress tests in most banking systems focus on capital adequacy. Bankers generally have thought too little (central bankers included) about liquidity for some time, and I think attention should shift back to that. There is the basic problem. Again we come back to the issue that Northern Rock was expanding so fast that it was manifestly a danger signal. Even if you satisfy all the tests in good times you should think what is going to happen if times become not quite so good. Q860 Peter Viggers: Bearing in mind the Bank's warning about liquidity, was it surprising that the stress tests were not constructed to include liquidity? Professor Wood: That is terribly difficult because the availability of liquidity changes from circumstance to circumstance. The stress tests have to deal with a wide range of conditions and conjecture and that will be difficult to do. I think one should simply adopt a more conservative banking role than to seek technical solutions that do not always work well. There are statistical problems - I am sure Willem will confirm - in these markets because the distribution of outcomes is not a form that is readily handled by statisticians. Professor Buiter: One could have expected that they would have looked at the consequences of some of the markets in which Northern Rock was funding itself simply closing. What happened of course in the case of Northern Rock is that all of the market in which it funded itself closed, something which had never happened before, so you would have had to have an ultra stress test to capture that. However, they seem to have done not even the kind of liquidity stress-testing that I would have expected them to do, partly because the FSA is an institution that thinks more about capital adequacy and solvency issues than about liquidity issues. That is the natural province of the Bank. Q861 Peter Viggers: Does it surprise you that the board of Northern Rock, with the exception of the Chairman, are still in control of the company's destiny, bearing in mind that some £30 billion of public money is now invested through what is a discredited board? Professor Wood: It is not clear to me the extent to which they are actually in control. The company has to have directors but can they actually take decisions without the Treasury or the Bank of England's agreement? I actually do not know. The company has to have directors. Q862 Peter Viggers: Are you close enough to the situation to know the extent to which the Bank of England and the FSA are now effectively controlling decisions? Professor Wood: You must ask them that. Q863 Peter Viggers: Very well. To what extent do you think the crisis of Northern Rock can be characterised as a failure of the FSA to regulate properly? Professor Wood: Again we come back to the fact that it is basically a failure of the regulatory system as it was designed; it is a deficient system. Beyond that the FSA does not seem to have carried out its job with the skill and diligence that one might have expected, but then again the Northern Rock board was not doing a wonderful job either. Q864 Peter Viggers: Are there immediately any further powers that any of the Tripartite Authorities need or do you think the system itself needs to be reviewed? Professor Buiter: They need the power to put banks into administration effectively without the deposits being frozen, as is the current situation, which is of course a terrible situation. They have to be able to ring-fence the deposits of banks that go into administration. If anything they have to have FDIC-type powers of taking deeply troubled banks, where you do not know necessarily where there are liquidity and insolvency issues, into public ownership at no notice and to manage them as a going concern, with existing obligations, existing exposures and no new business until things settle down, and in the longer term a future for the institution can be found. The kind of open-ended breastfeeding of a private institution that goes on at the moment is the worst of all possible worlds. Professor Wood: That is exactly right. The Comptroller of the Currency in the US coined the term "too big to fail" of Continental Illinois Bank when it failed. If you have proper bankruptcy laws such as Willem has outlined then no bank becomes too big to fail and they can bear the consequences of their actions. Q865 Peter Viggers: We have had a forceful memorandum from the British Bankers' Association pointing out that liquidity regulation is the only remaining area of banking supervision that is host rather than home state regulated. The British Bankers' Association has urged us to await decisions by the Basle Committee of Banking Supervision because banking liquidity and banking supervision is essentially an international matter. Do you think we should await international developments or do you think there are steps we can take domestically? Professor Wood: I have to say I have not read the British Bankers' Association memorandum but it seems to me from how you summarise it to embody a certain lack of clarity of thought. The home country and only the home country can supply liquidity. If a British bank is short of sterling the Bundesbank cannot supply sterling; it has to be home country provision of liquidity. The only case when that is not the situation is in the euro zone where of course you have several countries using the same currency. Professor Buiter: I must say I do not understand the statement that you have just quoted at all. The bank could be foreign owned but if it is registered in Britain then it is a British bank and it will have to be supported by the Bank of England. That is how it works. It is not true for branches but it is true for UK-registered banks and that is the only way to do it so, no, we do not have to wait at all for liquidity. Liquidity is provided at the level of the currency area, be it the dollar area, the sterling area or the euro area, so it sounds like this is confused babble. Q866 Mr Fallon: Just to be very clear then, you think that responsibility for both general and individual liquidity should transfer back to the Bank; is that right? Professor Buiter: That is one solution. The other solution would be to transfer provision for institution-specific liquidity provision lender of last resort to the FSA by giving it an uncapped and open-ended credit line with the Bank of England guaranteed by the Treasury so it can just do the lender of last resort bit. The market support will always have to be done by the Bank of England, and you may therefore wish to put the institutional support there as well. I think there are tensions there with central bank independence because especially individual institution-specific support operations are always deeply and inherently political (with a very small "p") because property rights are at stake and it is difficult to have that done by the same institution that is meant to be non-political. If you were to give banking supervision and regulation, including the lender of last resort knowledge therefore, back to the Bank of England, then you might want to take the MPC out of the Bank of England. Q867 Mr Fallon: Because we have learnt over the last few months, have we not, that the Bank is not quite as independent as we originally thought. Even the decision not to put liquidity into the market in August was referred to the Chancellor. Professor Buiter: Independence, as I interpret it, applies only to interest rate decisions and that is why I think it might be a good idea to take the MPC (which all it does is set the Bank rate) out of the Bank of England which can then do everything else, including liquidity provision, at any maturity longer than overnight, foreign exchange market intervention, whatever. Professor Wood: I do not think it is necessarily correct that we should want to give liquidity support to an individual institution if the rest of the market is in good order. That suggests that individual institution is fundamentally deficient and should be closed. The lender of last resort operation should go to the market as a whole when the market is short of liquidity. If an individual institution needs it, and the rest of the market is fine, there is something wrong with that institution. On the question of the Treasury being involved in this decision, there is a long history of course of the Treasury being involved in these decisions simply because the Bank of England, even in the 19th Century, was a very small bank and did not have much capital to lose, and had to come to its owner to make it clear that the owner would provide more risk capital if necessary. Q868 Mr Fallon: It follows from that that after saying the deposits should have been guaranteed you think that Northern Rock should simply have been allowed to fail? Professor Buiter: Yes. Professor Wood: The word "fail" is a dangerous term. Professor Buiter: Sink or swim. Professor Wood: Sink or swim, put into liquidation, in that sense fail, but not simply collapse; that would be foolish. Q869 Mr Fallon: What about the rescue operation itself; was the Treasury right to refuse the tentative offer from Lloyds TSB to carry out a takeover? Professor Buiter: I do not know the details of the offer but if it is true that they wanted up to 30 billion UK, as they would say in America, £30 billion, in continued financial support to finance a takeover, then I think the Treasury and the Bank - this was a joint decision - were absolutely right to refuse it. This would be the socialisation of banking, and that might be a good idea but I do not think that is what this was about. Q870 Mr Fallon: So it would never be right for government to lend on commercial terms in order to protect financial stability? Professor Buiter: They were not protecting financial stability. They would be protecting the shareholders of the company wishing to take over Northern Rock. Q871 Mr Fallon: But would it ever be right for the Government to lend on commercial terms if they thought there was a serious risk of financial instability? Professor Buiter: Yes. Professor Wood: I think I would resist the feasibility of that situation. If you have got proper lender of last resort facilities in place, if you have an adequate bankruptcy court for banks, the question would not arise. Q872 Mr Brady: Should the Bank of England have injected term liquidity into the financial system before the run on Northern Rock? Professor Wood: I think not. If commercial bankers, as was the situation, could not price these securities, if they did not know what they were worth - I observed and Willem pointed out to me this morning that Morgan Stanley has written these things down to zero, for example - if that is what they think they are worth, it seems to me no more than an impertinence to go to the Bank of England and say, "Use taxpayers' money to buy these things from us." Professor Buiter: I disagree. There are times when it is clear that, say, the spread of the three-month premium of the inter-bank rate, LIBOR, over the expected three-month policy rate, bank rate is not just a default risk spread but includes a liquidity risk spread, and when that goes together with a seizing up of inter-bank markets, the Bank should aggressively expand credit at that maturity or at those maturities where there is, in their best judgment, such a term structure of liquidity spreads as well as term structure of regular interest rates. You cannot in general as a bank fix multiple interest rates if markets are orderly but if markets are disorderly you can indeed intervene at multiple maturities, and the Bank should have done so against the kind of collateral that the markets found hard to price and then priced punitively, and in that way prevent moral hazard, yes, so they should have done so. Professor Wood: Maybe I could follow that up and say it is not clear to me what problem that was causing. The banks could, after all, get the liquidity they needed for their day-to-day business. The fact that they could not trade at longer maturities is not usual but it was not causing any significant difficulties at the time. Q873 Mr Brady: We also had divergent views from the FSA and from the Bank on this, with the FSA saying that if liquidity in smaller amounts had been made available to Northern Rock earlier it is quite possible that it would not subsequently have needed to apply for lender of last resort facility, whereas the Governor of the Bank made the point that because of the sheer volume of support that Northern Rock needed - close to £25 billion - it was not possible to see how you would achieve that level of liquidity for Northern Rock simply by injecting it generally into the market. Would you comment on those two views? Professor Buiter: There are two problems. The fact that Northern Rock needed £20 billion plus does not mean that it could not have been provided at the regular discount window. That is, after all, demand determined, subject to the availability of collateral; collateral is the restraint there. If the problem was just that Northern Rock could not borrow, I would not have done so, but since the inter-bank markets as a whole, and indeed the wholesale markets and the commercial paper markets were also seizing up, there might have been a case for intervening, but that is the same as the last question really, whether you could by restoring liquidity to the markets have prevented Northern Rock from going to the wall. That would take an enormous amount of money injections. We know for instance that despite all the money that the Fed and especially the ECB have put into these longer terms markets, the actual spreads of three months LIBOR and the euro equivalent and the dollar equivalent over the expected policy rate is no smaller in euro land today than it is here, so it really may take a large injection of liquidity to get an appreciable result if the market is really fearful. Professor Wood: I would simply add that I do not see how giving a small amount of liquidity earlier to Northern Rock would have been much help since the problem, as we have seen, has been the availability of a large amount of liquidity, and so I think the FSA's point is not valid. Q874 Mr Brady: Finally, just to be very explicit, you both tend to agree with the view that was put by the Governor of the Bank, and I quote his example, that looking at what the European Central Bank lent to banks through the auctions they conducted relative to the size of the banking system they lent an average of £230 million per bank whereas Northern Rock needed close to £25 billion. You tend to agree with the basis of that perception? Professor Buiter: Yes, that is correct, but you could have done it at the Bank's regular discount rate for Northern Rock. You could have done £20 billion there. Professor Wood: Calling it emergency lending was I suppose asking for trouble. Q875 Mr Dunne: Can I just pick up one of the responses you made to Mr Brady. During August was it not the case that the credit spread was considerably higher in the UK than on the Continent and in the US? Professor Wood: When? Q876 Mr Dunne: You are saying that has now narrowed? Professor Buiter: They are the same. They are about half a per cent in all three areas. Q877 Mr Dunne: But the time of the crisis was August. Professor Buiter: It was higher in the UK, yes. Q878 Mr Dunne: Indeed and was that not partly because the central bank here was not providing any liquidity? Professor Buiter: That was my interpretation, yes. Q879 Mr Dunne: Indeed. How can you therefore make the statement that had it provided liquidity it would not have had some beneficial impact on liquidity throughout the system, irrespective of Northern Rock? Professor Buiter: It would have had a beneficial impact on the system but I doubt whether it would have been enough to save Northern Rock. Northern Rock needed individual attention. Q880 Mr Dunne: There were many other issues which you identified at the beginning which caused the problem? Professor Buiter: Yes, but banks generally were not lending to each other, and that is never a good idea because that also means they are not lending to households and to venture corporations. Q881 Mr Dunne: We were told by the management of Northern Rock that they had an Irish subsidiary and had they been able to have a facility in place with the ECB through their Irish subsidiary in time, they might have been able to secure some liquidity through that. Professor Buiter: Correct. Q882 Mr Dunne: Do you think that would have been an appropriate thing to have done? Professor Buiter: Sure. Professor Wood: For Northern Rock, yes. Q883 Mr Dunne: I think you said earlier that the currency for lender of last resort is critical but in this case had the liquidity operations been managed by the Bank of England in the same way as the ECB the pure currency risk was something presumably that could have been priced into the facilities? Professor Wood: You mean if they borrowed from their Irish subsidiary? Sure, they would have had to switch into sterling and if they were a well-run bank they would have hedged that risk. Q884 Mr Dunne: Indeed. So would it be prudent then for British banks today to ensure that they have facilities with other central banks in order to maximise their prospects for liquidity if they need it? Professor Wood: I suppose if you are saying that other central banks give out liquidity too generously (which I think they did) it would be prudent from the point of view of individual British banks, yes. I do not think it would be prudent from the point of view of the British banking system. Professor Buiter: I think they should all do so, if they can, and of course not just in the Euro zone but in the United States as well because at the US discount window you can discount anything, including cats and dogs, in principle. Q885 Mr Dunne: Indeed, and two of the major British banks have taken out very substantial facilities with the Fed, have they not. Professor Buiter: Yes. Q886 Mr Dunne: Does this not raise questions of credibility about the regulation of the British financial services and banking industry? Professor Buiter: We have a financially integrated global system and that means that liquidity can be purchased abroad as long as sterling is convertible. I hope it will remain that way. Q887 Mr Dunne: Do you see damage being done to the British banking industry in particular or do you think this is not a peculiarly British problem? Professor Buiter: To me it was the way in which inappropriately restrictive British liquidity policy could be mitigated by some banks, the ones who were lucky enough to have subsidiaries abroad in the euro zone or the United States that they could use. Q888 Mr Dunne: In addition to the points that you made at the very beginning, what other lessons do you think the regulatory authorities here need to learn to ensure that these liquidity problems do not recur in the UK? Professor Wood: The regulatory authorities in a sense did ensure that it did not occur in the UK once they dealt with the Northern Rock issue. What they should certainly do is to make clear again - it has been made clear in the past - that in times of difficulty they will accept a wider range of collateral than usual, but they should also give the warning that they charge much higher rates of discount for it. Q889 Mr Dunne: The issue of providing a lender of last resort facility on a covert basis, which appears to have happened in the US and on the Continent, does not appear to be capable of happening in this country; can you explain why? Professor Buiter: I think that particular statement of the Governor is not correct. There is nothing in the appropriately titled "MAD" - Market Abuse Directive - to prevent covert support to banks in trouble. On the day he said it, the statement was contradicted by a spokesman for the Commission, and every lawyer I have talked to since then says that they have no idea where that interpretation came from. If it is true then the Directive really is appropriately named. We think we know, for instance, that the ECB, which is a national central bank, has engaged in covert discounted borrowing which really falls into that category and has gone beyond that, quite likely - and if it is covert it is covert, it is like absence of evidence and evidence of absence - so a) I think it is not true and b) if it were there should be an enormous outcry against it, but it was not an issue, they could have done that. Q890 Mr Dunne: So you think the powers exist at the moment and they have just misinterpreted it and got it wrong? Professor Buiter: Yes. Q891 Chairman: The Governor made that point in this Committee, Professor Buiter, and he said it was four pieces of legislation acting together. Professor Buiter: The other pieces were by and large correct. The deposit insurance scheme is a shambles. You cannot do under-the-table mergers or takeovers - and that is absolutely correct but that is why you should be able to take banks into public ownership. That would be a solution for that particular thing on a short-term basis. And whatever the third one was --- Q892 Chairman: Insolvency. Professor Buiter: Deposits get frozen, yes, that is also correct. Of the four things he said I only disagree factually with one which is the MAD. Q893 Mr Simon: All the people that we have had so far - the Bank, the FSA, the Chancellor and Northern Rock - have all explained to us that the tripartite arrangements work, whereas to most of us that seems a bit counter-intuitive because they do not seem to have worked very well. You are the adjudicator in this: do the tripartite arrangements work? Professor Buiter: I think we have already said that in provision of liquidity they worked but did not work well. Q894 Mr Simon: How do you think they could work better? Professor Wood: Again Willem has made two suggestions. One is that the Bank of England take over the supervision for liquidity purposes of individual banks. That would be a perfectly sensible idea. The other is to turn the FSA into a bank. I think that would be maybe sensible but certainly difficult. Q895 Mr Simon: Do you think there should be a different set of arrangements when a certain point of crisis is reached or passed? Professor Wood: No, I think that would be misguided. It would be like having two pilots on the plane and saying this other one is going to take over when things get difficult. When do they get difficult enough? We should have sensible arrangements from the start. Professor Buiter: The tripartite agreement needs to be changed along the lines that Geoffrey just restated here. It did not work well and the reason it did not work well was not an accident, it was simply a design fault. Q896 Mr Simon: And you reckon with your two modifications or some version --- Professor Buiter: Either of them - not both please, just one. Q897 Mr Simon: Obviously not both. One of which is greatly more unlikely it seems to me than the other. You reckon that would have solved this problem and this would not happen? Professor Wood: All I can say is in previous episodes in the past in this country and elsewhere it did. Q898 Mr Simon: What do you think are the chances of them doing something like that? Professor Wood: You should ask the Government that, not me. Q899 Mr Simon: Obviously we did ask the Chancellor last week and he did not give us a very full and accurate reply. Professor Wood: Well, you can tell him from me that I think it is a good idea! Professor Buiter: We hope that after mature reflection he will decide that change is the better part of valour. Q900 Mr Simon: You are talking to all these people all the time. You must have a sense of whether there is movement likely. Professor Buiter: They may simply limit themselves to informal arrangements. I do not think you are going to see new legislation but the memorandum of understanding is just that; it is just a bit of paper, as somebody else once famously said. They may just have some clarifications in a footnote that says the Bank of England will henceforth start looking at the liquidity positions of UK registered banks and deposit institutions again. Professor Wood: That would be a change because at the moment the Bank does not have the resources to do that. Professor Buiter: Nor does it have the people. Professor Wood: In addition I think it should be done soon simply because it is important to have these institutions run in before the next problem hits. An example is in the United States where arrangements were changed and people died in fact before the financial crash of 1929-31 and it was largely because of the absence of experience that that turned into such a disaster. Q901 Mr Simon: Any more? Professor Buiter: No. Mr Simon: Thank you. Q902 Chairman: Professor Hood, can I take it from your comments that the tripartite system worked but failed? Professor Wood: That would be going too far, Chairman; it worked but not too well. Q903 Mr Love: Professor Buiter, you threw away a line earlier on suggesting that the Monetary Policy Committee should be taken out of the Bank and that effectively the functions of the FSA ought to be merged with the remainder of the Bank. I think that was the suggestion you were making. I just wonder how Professor Hood would respond to that. Professor Buiter: Only the FSA's liquidity supervision function. Q904 Mr Love: I understand. I wonder if you would respond to that because you have been suggesting that we could do one of two things. I would like to press you on which of the two; do you think the Bank should be the major institution or should it be the FSA? Professor Wood: Quite clearly the Bank should be the major institution in the provision of liquidity. Unlike Willem, I do not think we need to take the MPC out of the Bank for that purpose. The MPC is for all practical purposes out of the Bank anyway. It is involved in only one set of decisions; it plays no part in others. I think it is convenient administratively to have it in the Bank and there is from time to time some connection between monetary policy and financial stability policy and under such circumstances it is convenient to have them together. Professor Buiter: One quick footnote to that. The problem at the moment is that the MPC only sets the bank rate, but that is meant to be the target for the overnight inter-bank rate, and in fact the overnight inter-bank rate moves violently around. If you are going to have this clearer separation then the Bank of England should change its policy in the overnight market and actually pack the rate, at least the rate at which it repos, its repurchase operations, and it should always stand ready to repo at its target rate at any amount all of the time, as opposed to its current practice of trying to target both price and quantity a little bit. They really have to change their operating procedures otherwise the liquidity management policy inextricably gets tied up with interest rate setting. You have to be fair to the MPC. If they set the bank rate then they should, except for a little default spread for the inter-bank rate over policy rate, pack the overnight rate. That requires a change in operating procedures at the Bank. Q905 Mr Todd: Can we turn to depositor protection. There is an argument for saying that depositor protection introduces a moral hazard by transferring risk but not straightaway. How do we set appropriate depositor protection to ensure that that does not happen? Professor Wood: You cannot do that. The starting point has to be to think why do we want deposit insurance. It was introduced in 1933, if I recollect, in the United States in very special circumstances. The Federal Reserve had failed to act as lender of last resort. The US had many small banks financed entirely by retail depositors and deposit insurance works in such a circumstance. Nowadays what we might call flighty liquidity - banks' liquidity that disappears quickly - is in wholesale markets and deposit insurance, therefore, cannot prevent the important wholesale runs. It seems to me we should therefore think of deposit insurance as a social provision to protect what used to be called in the banking industry the widow and the orphan, and it should therefore be accessible immediately if a bank closes, and it should be set at a fairly low level. If it were set at a low level this would have the incidental benefit that first of all large depositors, other banks, might pay closer attention to those they lent to. Secondly, if it were set at a lower level it could again continue to be financed by a mutual scheme and thus the taxpayer would have less interest in propping up banks. Q906 Mr Todd: You are agreeing with that by the sound of things; is that right, Professor Buiter? Professor Buiter: Yes, but I would make a specific point that it should only extend to retail deposits, that is deposits by natural persons, not wholesale deposits or business deposits, unlike what we have now. Q907 Mr Todd: So it has no purpose as a financial stability tool? Professor Buiter: No. Q908 Mr Todd: It is purely, as you have said, social policy? Professor Buiter: Yes. Q909 Mr Todd: Okay, if that is the case, what sort of rate should it be set at? Is the current rate reasonable? There have been suggestions of raising it to £50,000, or is that just simply a political decision to be made, you draw a line somewhere which seems fair at the time? Professor Wood: Basically it is a political decision. It is linked to vulnerable persons' deposits. In the United States you can insure as much as you like simply by opening enough deposits; it has to be individuals. Q910 Mr Todd: Do you think consumers are well enough aware - and I think the evidence was in this crisis that they were not - where the current limit actually lay? I think most people thought that deposits either were not guaranteed at all or they were guaranteed almost infinitely, and to hear there was a particular limit set on it was news to most people, so is there associated with this an important function of public education so that people understand clearly? Professor Buiter: Absolutely. Every bank should have large signs when you walk in "Your deposits are guaranteed up to ..." Q911 Mr Todd: "Do not deposit more than £35,000 here". Professor Buiter: Or "do so at your peril"! Q912 Mr Todd: Right, so the effect of that would be presumably to persuade consumers to spread risk so if they have large amounts of money to deposit they would deposit it in a number of institutions? Professor Buiter: Yes, that would be right. Q913 Chairman: If I could come back to you on that. There have been figures starting off at £100,000 down to what the level is in the United States at 50,000, and the British Bankers' Association have come in and said that £35,000 is an appropriate level because 90% of the population would be covered by that. Could you give us an indication of where your sympathies lie in terms of the level? Would it be 100% of that level protected? Professor Wood: If we are protecting the widow and the orphan it has to be 100% since we cannot expect that people would have the time or the knowledge to police their banks. In terms of the level it seems to me the British Bankers' Association point (which I had not heard before) was quite a good one. Professor Buiter: A second reason for having 100% is if you have anything less it is still an invitation to run. Unfortunately while co-insurance is a good idea for most insurance - you cannot have a run on your life insurance company but you can have a run on the bank - I really would not recommend anything less than 100% and probably between £35,000 to £50,000. Certainly £100,000 would be way in excess of the widows and orphans criterion. Q914 Jim Cousins: The Chancellor, when he spoke to us on this issue, said that the 100% guarantee that was given by the Treasury was a case-by-case guarantee and each case would be assessed on its merits, but the Governor in his very interesting radio broadcast last week said something rather different. He said that the existing system of deposit insurance we have trapped retail depositors - the word "trapped" was his and "that's why we could not allow Northern Rock just to fail." Do you think that the Governor in saying that has undermined the Chancellor's promise to us that this guarantee to depositors was only a case-by-case one? Professor Wood: I am not quite clear what the Governor meant by saying it trapped depositors. If he meant that when the institution failed the depositors were then trapped because they could not get their cash out right away, that is right, but that has no bearing at all on what the Chancellor said. Q915 Jim Cousins: I am inviting you, Professor Wood, to see the implications of the Governor's remarks. He described retail depositors as being trapped by the present system of deposit insurance. Professor Wood: That statement is to me only meaningful if the Governor is saying after their bank has closed they are trapped in the sense they cannot get their money immediately. Professor Buiter: I have no idea, I cannot make sense of the statement. Professor Wood: Apart from that, I cannot see what he means. Q916 Jim Cousins: You cannot make sense of the Governor's statement? Professor Buiter: Of the statement you are quoting. I did not hear the interview, I just read excerpts from it and that was not part of it. I find it hard to see what it could refer to. Q917 Jim Cousins: What the Governor said was this: "We need a system in this country in which we can prevent the retail depositors from being trapped." Professor Wood: That becomes much clearer. What he plainly meant was that retail depositors get their money out immediately if the bank fails rather than being locked in for some months, which is part of the present system, and a very bad part. Professor Buiter: In the United States they get paid within two working days so that was what he was referring to obviously. Q918 Jim Cousins: The point I am putting to you both is that the Chancellor said the guarantee he gave to depositors in Northern Rock would not be extended anywhere else, it was a case-by-case system. The Governor's doubts about the overall system seem to indicate that it must be more general. Professor Buiter: The Governor is talking about the long-term reform - but hopefully it will be done very swiftly - of the deposit insurance system which should be one that allows you to get your money out immediately. It did not refer to this one-off or ad hoc (if there is more than one bank) series of individual bank deposit guarantees that the Chancellor created for the purpose of this specific crisis. They are two different things; there is no contradiction. Q919 Jim Cousins: Professor Buiter, while such a system, whatever it might be, is being put into place, which is not the case now, do you think it is credible that we could say in the event of another difficulty in another bank that the 100% guarantee to depositors could not be extended if retail depositors are, as the Governor says, trapped? Professor Buiter: I do not understand the question. I was surprised by the Chancellor's statement because as I understood his original announcement it said that any bank that found itself in similar circumstances to Northern Rock would get Northern Rock treatment, both on the funding side and on the deposits side. There might well be individual fine-tuning if the banks have very different funding policies or very different compositions of deposits but, as I understood it, effectively the deposit risk for the entire British banking system has been socialised. Q920 Jim Cousins: I think that is a very important statement to make and I will just play it back to you so that we have understood its significance. You have said that whether or not the Chancellor so intended, the entire deposit risk of the British banking system was socialised, as you put it, when he gave his deposit guarantee to Northern Rock? Professor Wood: It is my understanding, as it is Willem's, that he said it would apply to any bank that got into difficulties, so in that sense, yes, he was underwriting all the risk of the British banking system. I think he did back away from that subsequently, much to my relief; it seemed rather a lot of money to guarantee. Q921 Jim Cousins: But is there not a real difficulty here that you are saying on the one hand that a deposit guarantee was given in a form that socialised banking risk for retail depositors and then you are saying the Chancellor backed away from it, so where does that leave us all? Professor Wood: It leaves us all with the Chancellor having backed away from a 100% guarantee, and thank goodness for that! Q922 Jim Cousins: Professor Buiter? Professor Buiter: It leaves us, if indeed the Chancellor has backed away decisively from this --- Q923 Jim Cousins: You are not so clear that he has backed away? Professor Buiter: I am not clear at all because I think the statements, both the original ones and subsequent ones, are sufficiently ambiguous that they are compatible with almost any course of action. Professor Wood: If I could take up that point - it takes us back to the Chairman's opening questions on why were things badly handled at the start - one of the ways in which it was badly handled were these confused statements. Q924 Jim Cousins: Professor Buiter, in your evidence to the Committee - and I am following it up directly because it is a right old shambles if you are right - you said that national financial regulators in the European Union should go the way of the dodo? Professor Buiter: Yes. Q925 Jim Cousins: The evidence you have given to the Committee this morning rather bears that out, does it not? Professor Buiter: Well, one example does not prove the case. It is not really a matter of individual competence so much as the fact that we have this regulatory race to the bottom when we at least could neutralise the European element if we had a single European regulator. Capital is global and unfortunately governance is not and regulation is not, but where we can operate in a larger area, especially if it includes a significant number of serious financial centres, we should do so, yes; it just simplifies the task of preventing the further spread of light-touch regulation. Q926 Ms Keeble: I wanted to ask a bit about the assessment of risk and the role of the credit ratings agencies. To what extent do you think the complexity of the financial instruments has made it very difficult for investors to assess the true risk of the assets in which they are investing? Linked to that, what do you think of the due diligence which they undertake? Professor Wood: The instruments have got a bit more complex but the basic problem, as I understand it, was quite a simple one - loans secured on property were bundled up and these loans were of various qualities of borrowing. They were bundled up and people did not look inside these bundles. That may have been bad ratings agency work but it was also bad banking not to know to whom you were lending money. Professor Buiter: It is inherent in the process of securitisation, which by the time you get to the ultimate investor, who is six transactions or more away from the originator of the loan, neither the buyer nor the seller has any idea as to the underlying risk characteristics of the security they are buying. That gets worse when the securitised mortgage loans get packaged with credit card receivables, the square root of car loans, and whatever else. The structure they have put together became so complex they probably were not even understood by their designers. Due diligence does not mean anything if you cannot understand what you are dealing with, and the ratings agencies are in no better position to know what the true value is, they did not go and check individual addresses as to what the mortgages were worth. Q927 Ms Keeble: There are two sides to that and I want to come back on to the credit ratings agencies. I could understand that a casual investor might not look into the bundle to see what is there, but some of these investors are substantial and sophisticated and one would have expected a degree of due diligence or that they would have required a greater transparency in the products. Professor Wood: One would hope that but there actually is a difficulty because when you are putting these products together you are bundling together various categories of asset which had behaved differently in the past and you estimate what the risk characteristics of the bundle is based on the experience of these different assets in the past. The trouble in the present situation was the past had been rather an unusual period, a period of remarkable stability, so I think there was probably very little evidence, even if they had done the work, on which they could say what would happen if we suddenly moved from stable to unstable times. Q928 Ms Keeble: So people took risks they might not have done firstly because there had been a period of stability and was it also not secondly because it was off balance sheet? Professor Wood: Probably the first is more important but again --- Professor Buiter: The level of transparency of the whole process is low. Many of the institutions have ended up holding them and dealing in them through off balance sheet vehicles whose reporting obligations are minimal, and so it became harder not just to understand the individual instrument, as Geoffrey just described, and how to price them but also it became hard to figure out who held them, so the knowledge on who owns what is still fairly patchy. Q929 Ms Keeble: I just want to come on to the credit ratings agencies. I think it was Professor Wood who said that the concept of due diligence in this area was pretty meaningless. Would you agree with that, Professor Buiter? Professor Buiter: Yes, you cannot be duly diligent for things that you really cannot understand. I think the regulators and the Bank can help create incentives for simplicity, for instance by the Bank of England, in this particular case, announcing that they would take certain kinds of structures as collateral in repo operations at the discount window but not other more complex ones. That is one way of making simplicity attractive. Q930 Ms Keeble: You have said that you think that it would help if there were clearer reporting requirements. Do you think that it would also be appropriate to look more carefully at the role of the credit ratings agencies and in particular their propensity for being able to advise on the structure of investments and then also do the ratings of them as well? Professor Buiter: I have argued that they should become monolysed, basically agencies just doing one activity, just doing ratings. You cannot manage the potential conflict of interest involved in advising a client on how to design a structured financial product to get the best possible credit rating and then rate that same product. That is going to create a conflict of interest so it should just not be possible to do that; you rate and that is it. Q931 Ms Keeble: Professor Wood, would you agree with that? Professor Wood: Absolutely. It slightly surprises me that the agencies have not grasped that for themselves and set up separate ratings agencies because these would attract customers. Q932 Ms Keeble: Professor Buiter, you have made comments about Basle II and the Credit Ratings Agency. I wonder if you would just like expand on some of the comments you have made? Professor Buiter: The credit rating agencies and their ratings play a central role in the first pillar of Basle II, the capital adequacy parts, and the other element of Basle II that I think deserves some scrutiny is the use of internal models for marketing to model the things that we cannot market to market because there is no market for them, and that goes for most over-the-counter products, effectively, not just for the ones that have temporarily become illiquid. So you have two key pillars on Basle II: market to model - turns out to be market to myth in these orderly times - and the rating agencies, which are deeply reviewing the conflict, and we are giving these rating agencies a semi-regulatory task through the Basle Agreement. We cannot ask for the private provision of public goods like that. I think Basle II has to go back to the drawing board before it is even out of the stable. It is a mixed metaphor. Q933 Ms Keeble: Can I ask one further point? Really the credit ratings agency should be capable of at least guiding people as to where the risk lies in the system. Why have they failed and what assessment do you have of exactly where the risk is, because there is quite a problem: the same investments are there, the same risk assessments, the same ratings are being undertaken, nothing has changed essentially, and there is a lot of people's money tied up in institutions which hold these investments. Professor Buiter: But the agencies did reasonably well when they rated sovereign debt and corporations, large corporations. Remember, they only rate default risk and expected loss conditions, a default occurring; they do not rate market risk, liquidity risk and everything else; so in some ways they would have been completely useless for the current crisis in any case because there was a liquidity crisis, by and large, rather than an insolvency crisis and we should not ask of them things that they do not promise to sell, but even in the area where they are evaluating things, they invented this new activity, rating fancy, structured complex products, but it is just very difficult and basically impossible. Q934 Chairman: Can I ask both of you in terms of the rating agencies, you both believe that they are inherently and deeply conflicting? Professor Wood: Yes. Professor Buiter: Yes. Q935 Chairman: Secondly, in terms of Basle II, John Plender of the Financial Times was writing and he made comments that were along the same lines as yourself, Professor Buiter, but he is talking about Basle II, saying that it relies on the modelling techniques that led to the sub-prime disaster and the new rule book also depends heavily on the credit rating agencies in whom investors have lost confidence. Professor Buiter: Exactly the same point. Professor Wood: The same point. Q936 Chairman: So we need a fundamental look at Basle II then? Professor Buiter: Yes, back to Basle one and a half! Q937 Mr Love: We will invite you back when we are looking at Basle II. You both agreed earlier on that the Northern Rock crisis did not have any implication for the stability of the financial system. Do you believe that any of the losses suffered by the much larger banks, such as Citibank, have any implication for financial stability? Professor Wood: They obviously make the institutions which have lost capital more fragile than they were before they lost capital, but one would hope it also makes them more cautious in the future, which makes them less fragile. So, in the short term, yes, they are fragile, in the longer term perhaps not. Professor Buiter: In the short term, by impairing their capital or at least reducing the margins, it will make them more reluctant to lend, and that means that the cost and availability of loans for the real economy is going to be more restricted in times to come, so it is a net contraction area imposed. Q938 Mr Love: Quite a number of the US banks have come forward with estimates of their losses. We have not seen that so much in terms of UK banks. Should UK banks be more transparent about what is happening to the balance sheets? One of the reasons they have given for that is the difficulty in quantifying what those losses are. Is that a reasonable excuse to give? Professor Buiter: The reason most of the big ones have not reported yet is that they are on a six-monthly reporting cycle, not on a quarterly one; so that is a straightforward reason. If you started bringing in suddenly higher frequency reports, that would really put the wind up your sails. You have to have a very good reason for doing that. I think as long as they stick to the regular cycle, that is fine, but they are going to have the same problem as their American counterparts, in that they have on their books, or are exposed to, stuff that is really illiquid, has not been traded in deep, transparent markets for months now, some of them never, and therefore it is very hard to establish a price. Yes, it is very hard, and it means also that there is non-uniformity in the treatment of the same claims by different banks. My view is that we really have no idea about what most of these banks have on their books. Some of them, like maybe Morgan Stanley, apparently evaluate a fair amount of the stuff they have as if it was worth nothing, certainly have put a clear floor under what could happen, but very few other banks have been willing to do that. Professor Wood: There is a big difference between some of the British and some of the US institutions. Some of the US institutions are not strictly speaking banks. Banks have the option of carrying these loans on their banking book rather than their trading book. They are not, therefore, required to market into market. Whether that is a good thing or not, banks are allowed to treat these things very much like overdrafts. You do not market overdrafts to market because there is no market. So there is an accounting difference as well, which can produce different reports and results. Q939 Mr Love: You mentioned Morgan Stanley suggesting that quite a lot of their paper is worthless, but we understand that quite a lot of them are still valuing at 90 cents in the dollar. If it all turns out to be worthless, as perhaps Morgan Stanley are already admitting, would that shake their financial stability? Professor Wood: First of all, it would be a surprise, and I say that very seriously. When Continental Illinois Bank failed in the United States, it eventually paid out, I think, 93 cents in the dollar, or perhaps a little bit more, but it took some time, so it would be a surprise. Secondly, economically, if every bank in the system took this big hit at once, it would indeed impose a severe contraction ratio on the economy. If they spread it out, sure, it would be more diffused. Whether that is good or bad actually I cannot immediately answer; I would have to think about it. Q940 Mr Love: What is the implication of holding quite a lot of this stuff off balance sheet? Is there any implication directly and, if they took it all back onto their balance sheet, would there be problems that would arise from that? Professor Buiter: It depends on whether they are required, either through legal obligations to do so, say through a credit-line or some other legal commitment, also reputational considerations. If they are exposed, substantively exposed, then having them off balance sheet is simply a smokescreen, it is a way of hiding things. It is done generally for regulative purposes to reduce the capital you need to carry this stuff. Basically many of these vehicles are banks without capital or without reporting requirements and without governors, and so that is a lot easier to manage, but, of course, therefore also riskier. I think you have to think of most of these vehicles as ultimately ending up on balance sheets. Q941 Mr Love: Lack of transparency is a word used quite regularly both for off balance sheet but also for perhaps a lack of adequate reporting of all of this, and of course that leads to continued lack of confidence in the market place. Should we be doing much more? Should there be more robust regulation, regulatory requirements, relating to both transparency and in a sense, therefore, to stability? Professor Wood: It was, of course, in a sense, regulatory requirements that led banks to put these things off balance sheet. Because the requirements were formal and in place, they knew that if they were not on the balance sheet they did not have to count capital. So you have to think very carefully about the kind of regulation you have not to encourage that kind of behaviour. All regulation is not good regulation; all regulation does not produce improvement. Professor Buiter: There is a real problem about preventing accountancy visits, mediation by regulation that can be easily avoided. You really have to have principled bank regulation that basically says it looks like a bank, it lends like a bank. Even though it may not take too many deposits, we will treat it as a bank for regulatory purposes. So you make an institution pass the duck test but then you decide to regulate it, but that is more easily said that done because the principle still has to be translated into actual operational rules. The principle for set rules is a false dichotomy, it has always been both. It is not easy, and you can do better than we are now, but most of the activity that caused a struggle took place out of the view of the regulators. Q942 Chairman: Can I thank you very much for your evidence this morning. It has been hugely helpful to us. Professor Buiter: Thank you very much. It has been a pleasure. Memorandum submitted by Fitch and Moody's
Examination of Witnesses Witnesses: Mr Paul Taylor, Group Managing Director and Global Head of Sovereign, Public Finance, Corporate and Financial Institution Ratings, and Mr Charles Prescott, Group Managing Director, Financial Institutions, Fitch, Mr Michel Madelain, Executive Vice President, and Mr Frédéric Drevon, Senior Managing Director, Moody's, and Mr Ian Bell, Managing Director and Head of European Structured Finance and Mr Barry Hancock, Managing Director and Head of European Corporate and Government Services, Standard and Poor's, gave evidence. Q943 Chairman: Good morning and welcome to the Committee's inquiry into financial stability and transparency. Can you introduce yourselves for the shorthand writer, please, starting at this end? Mr Prescott: Charles Prescott, Financial Institutions, Fitch Ratings. Mr Taylor: Paul Taylor, Fitch Ratings. Mr Madelain: Michel Madelain, Executive Vice President of Moody's. I am responsible for bank ratings. Mr Drevon: Frédéric Drevon, I am Moody's for Europe. I am also co-head for securitisation business. I am London-based. Mr Bell: Ian Bell, I head the securitisation business of Standard and Poor's in Europe. Mr Hancock: Barry Hancock, Head of European Corporate Ratings for S&P in Europe. Q944 Chairman: Maybe I can start by asking a simple question. What do rating agencies do and what do your ratings mean? All your ratings mean different things in different companies. Is that correct? Maybe you can tell us, starting with Fitch, what your ratings mean, and Moody's, what your ratings mean and then yourselves? Mr Prescott: Our ratings are measuring the likelihood of interest on capital being repaid in terms of the conditions of the issue. Mr Madelain: Our ratings speak to the risk of default and recovery on securities issued in the capital markets. Mr Bell: Similarly to Fitch, our ratings are opinions as to the likely default, add on interest or principle in a timely basis. Q945 Chairman: So really your ratings reflect credit risks - that is the ability or willingness of a party to repay a debt - but they do not imply anything in terms of liquidity, potential for appreciation or volatility. Is that correct? Mr Bell: That is correct. Q946 Chairman: So they do not do that for liquidity. Therefore, an investment decision based only on ratings can be misguided. Mr Bell: We have always been very clear that no investor should base a decision to invest or not invest in any debt solely on the rating; this is one component of all the risks that that investor should take into account. Q947 Chairman: So the decision could be misguided? Mr Bell: If based only on a rating, almost certainly, yes. Q948 Chairman: At the end of the day, you have different quantitative models to rate the credit risk, but you usually almost always agree in terms of the rating, triple-A or whatever else. Some of you use triple-A, some of you use lower case "a", but you always usually agree. How do you agree at the end of the day when you start off with a different base? Mr Taylor: Actually we do not always agree; quite the contrary in fact. There are two levels to this. One level is what you do not see in the public markets. So each of the agencies has situations where they do not rate something because they disagree with the risk assessment that appears in the public market, but we also have differences in the ratings themselves. If you look at the specific ratings assigned to different issuers, different transactions, different companies, banks, there are differences between the levels assigned. There is a lot of similarity as well simply because of the fact--- Q949 Chairman: I am pointing out that Arturo Cifuentes, who is the Managing Director of RW Pressprich says, "In practice, however, the degree of agreement category by category is extraordinarily high. This degree of agreement seems strange." Mr Taylor: I am not sure it is extraordinarily high. First of all, it is based on facts. The facts we all get are the same. How we interpret those facts is down to our individual decisions and analysis. The facts are the same. So you would not expect massive differences on a frequent basis, but there are differences. Mr Drevon: I should also add in the specific context of securitisation, arrangers who create these transactions have a goal to achieve a higher rating, typically a triple-A rating, so they will structure a transaction in a way that achieves the highest rating possible; so it is not unlikely that different rating agencies rating the same instrument will achieve the same highest rating. Mr Bell: In addition, in structured finance you also have the fact that, even if there are differences in our analysis of a particular transaction because the people structuring the transaction wish to have the highest rating, they will simply take the most conservative position of the two or three agencies, so enabling each agency to give a triple-A. Q950 Chairman: Do you agree with Mr Cifuentes that the rating agencies enjoy a power that goes beyond what regulators probably intended and, maybe even worse, understand? Mr Madelain: I think that is an understatement. I think we are a provider of opinions on credit risk. There are many other providers, many different ways to form opinions, and we are one of such providers. Q951 Chairman: I will go on with what he is saying. He says whether a bond gets an investment grade rating or not is critical - in some cases it prevents certain investors from buying the bond, in others it forces the holders of the bond to sell it - but what is frightening, he says, is not only that the agencies determine whether the bond meets the BBA standard or not is the fact that you define that standard. Is that not frightening? Mr Madelain: There are two things. There are certain situations where ratings are embedded in regulations. This is clearly the case in the United States; much less so in Europe. Second, we have rating criteria that, indeed, lead to assigning certain rating levels, but those are fully transparent and available to every user of ratings and actually may default from one agency to the other. Q952 Chairman: In terms of the practice of the rating agencies, the appraiser in the rating process is paid by the seller rather than the buyer. Is that correct? Mr Madelain: That is correct. Q953 Chairman: The rating agencies provide technical assistance and advice on how to design structures that could attract the best possible rating--- Mr Drevon: That is incorrect. Q954 Chairman: ---to the very issuers whose structures they will subsequently rate? Mr Bell: That is absolutely incorrect. Q955 Chairman: So, you agree completely with Professor Buiter? Mr Drevon: No, we disagree completely. Q956 Chairman: You disagree with Professor Buiter? Mr Bell: Yes, absolutely. Q957 Chairman: Okay; that is fine. The rating agencies provide other financial services and products than ratings or ratings advice? Mr Madelain: We do not provide advice, as we have said. Q958 Chairman: Other financial services that you provide. Mr Drevon: We can speak for Moody's. We do provide some additional tools to the market but those are done separately, they will be done separately from the rating agency. Q959 Chairman: But you provide those services. Mr Hancock: Exactly the same as Standard and Poor's. Q960 Chairman: Standard and Poor's provide those services as well. Do Fitch provide those services? Mr Taylor: Actually, no. We are representing Fitch Ratings. We do not provide those services. We have a sister company, which is a completely different company, a different management structure. Q961 Chairman: There are Chinese walls between that. Mr Taylor: It is a different company, who do provide those services. Q962 Chairman: So you provide those services. Okay. Mr Madelain: What is important is that those services are unrelated to ratings. Q963 Chairman: You agree with two of the three points that Professor Buiter is making and, as a result, he came to the conclusion, as Professor Wood did, that you are inherently and deeply conflicted. Mr Madelain: The issue of pay model, which is what you have just described, is effectively creating a potential conflict. What we do believe is that we do manage that conflict effectively, as has been demonstrated by our track record in this area and also I think, as we have stated many times, by the importance of our reputation for the viability of the services we provide. Q964 Chairman: Why is your reputation under such scrutiny at the moment? Why are you getting investigated on Capitol Hill and you are considered right at the centre of the sub-prime market? You seem to be the architects of the rating of this and the fact that there are problems, in fact global problems, associated with it. You are perfectly decent guys. Why did you get yourselves centre stage here? Mr Drevon: You know, we have been in the market for many years rating different instruments and so we are used to be being under scrutiny for the simple reason that we provide a very public opinion about credit risk. It is very easy to point a finger at a rating agency because that public opinion is available in the market place, and so we are used to having to defend our opinions and we do that on the basis of our track record, which we publish, which clearly shows that our ratings have a very predictive power in terms of differentiating credit risk. In terms of your specific comment, which was in relation to our role in the sub-prime market--- Q965 Chairman: I ask questions; I do not make comments. Mr Drevon: I am sorry. In terms of your specific question in terms of our role in the US sub-prime market, I think we have been quite clear also, and I think we included that in our submission. We did not design the securities, we did not originate the underlying mortgages, we are not investors; we provided one specific role, which was the credit opinion about credit risk. Q966 Mr Fallon: Nevertheless, you are selling services to the people you are supposed to be regulating. That is the position, is it not? Mr Bell: Undoubtedly there is a potential conflict of interest. It is well known to the market. Q967 Mr Fallon: You are selling services to the people you are supposed to be regulating. Mr Bell: We do not regulate; we merely express opinions as to the credit risk. Q968 Mr Fallon: You are part of the regulatory system and you are selling services? Mr Madelain: I think we need to be clear on that point. I am not sure what you mean by "selling services". Q969 Mr Fallon: You take fees. Mr Madelain: The business model we have is that the fees are paid by the issuers of securities, yes. Q970 Mr Fallon: Let us just be clear about this. Did any of you take fees from Northern Rock? Mr Hancock: Yes. Mr Taylor: Yes. Q971 Mr Fallon: You took fees from Northern Rock? Mr Taylor: There has never been any denial of a conflict of interest in the issue of pay models. There is nothing secret, there is nothing surprising, about that. Q972 Mr Fallon: Then you will tell me Mr Taylor, how much fee you took from Northern Rock, if it is not a secret. Mr Taylor: I do not know the number. Q973 Mr Fallon: Roughly? Mr Taylor: I do not know the number. Q974 Mr Fallon: How much a year do you charge Northern Rock? Mr Taylor: I do not know the number. Q975 Mr Fallon: Does anybody else know what they charge Northern Rock? Mr Hancock: I could not tell you, no. Q976 Chairman: Is it a substantial sum? Mr Taylor: In the context of our overall business, almost certainly not. I do not actually know the number. Q977 Chairman: Could you write to us with that and give us a number so that it is a matter of public record. Mr Taylor: It is commercially sensitive. I am sure we could let you have--- Q978 Mr Fallon: You told me it was all open and above board. Mr Taylor: No, we do not disclose the fees paid by individual issuers to us. Q979 Mr Fallon: The reason I am asking you this, Mr Taylor, is that the submissions you have all made to us make it very clear that, apart from the downgrade the day the interim results came out, there was no change in your opinion of Northern Rock from 2006 until after 14 September. Why was that? Was it because they were paying you? Mr Prescott: No, it is obviously not because they were paying us. We look at every issue in its own right and we will decide what actions to take depending on the circumstances and the information that is available to us. Q980 Mr Fallon: But you did not take any action. You have written us a long submission here pointing out how Northern Rock was over-reliant on wholesale markets, its funding mix was historically very skewed, and so on, but you did not change your rating of Northern Rock before the interim results, nor between the interim results and the final crash on 14 September? Mr Prescott: That is correct. Mr Hancock: I would add that at S&P we have over 2000 clients who are rated within Europe and the fee from one of them is not going to influence a decision that we would make on their credit standing. We would be driven entirely by our belief on the likely probability of default. Q981 Mr Fallon: But you are taking fees from all of them, Mr Hancock, that is the point. You are the traffic-lights being fixed by the speeding motorist, are you not? Mr Hancock: We are driven entirely by our reputation. If we lost our reputation, if anybody doubted that we were driven by the fees we received from any individual client, that would be the end of our business model. Q982 Mr Fallon: Can you explain to me then why you did not flash any kind of warning up about Northern Rock between July and the middle of September? Mr Hancock: I think if you looked at the history of the rating of Northern Rock, in the 13 years that we have been rating them they were rated somewhat lower than many other financial institutions within the UK. We certainly highlighted their increased, or higher, reliance on wholesale funding. Certainly we did not expect the repercussions of the US sub-prime market to have the impact and repercussions on funding of all UK banks, but we have certainly highlighted the extra risks that were involved in their reliance on wholesale funding. Q983 Mr Fallon: I do not think you quite see this from the way we are seeing it. This is the first bankrupt for 140 years. You are the people who are supposed to be flashing up the warnings about the likelihood of banks getting into trouble and then you come here and tell us you are being paid by the very same banks and you did not give the warning. Mr Bell: I think it is worth drawing attention to two pieces of research or two investigations that have taken place. As the potential conflict of interest is well-known, we would like to draw attention to the fact that it has been researched in the United States. A few years ago the Federal Reserve Board asked a bunch of academics to investigate whether or not the conflict of interest did affect the way the rating agencies assigned their ratings. That academic research clearly came to the conclusion that they did not and our reputational integrity was more important to us than the fees. In the same way, after 2003 there was a quite legitimate investigation of the rating agencies by the Committee of European Securities Regulators as well as the European Parliament that was quite extensive, and they also reached the conclusion that our conflicts of interest did not impact on the ratings we gave. So, although we absolutely accept these are legitimate questions that should be asked, as there is a potential conflict we would like to draw attention to all the evidence that is accumulated in the case that that conflict does not impact on the rating process. Q984 Mr Fallon: Let us focus on the evidence on Northern Rock. Why was it that none of you flagged up after July the real danger facing Northern Rock from the closure of the financial markets? Mr Bell: I think the fact that needs to be borne in mind is that the crisis that unfolded in the international capital markets in August was of a very novel kind, one never seen before, and it took the entire market by surprise, it took the regulators by surprise, it took the Bank of England, the ECB, by surprise, it certainly took the investment bankers by surprise and it took us by surprise. Our business is to express opinions. We do so based on our best understanding of how events are likely to unfold. Undoubtedly, if your business is, as our business is, to predict the future and you try to see into the future, there are times and there will be things that you do not see. We did not see the way in which the sub-prime crisis would ripple through the capital markets of the world and impact on an English bank, Northern Rock. Q985 Mr Fallon: You all failed. Mr Madelain: I would like to give you my perspective on this situation. As has been provided to you in various submissions, I think we made an assessment of the liquidity situation and the risk situation, the funding strategy of Northern Rock. I think we felt that this risk was manageable. We had identified---. I think what is important to realise is that when you assign a rating you assign a rating to a scenario which you think is the most plausible scenario for that institution. You do not assign a rating to an extreme case. So, that is just to explain what was the background for our rating. Moving into the specifics, I think that we had obviously very early on measured the situation on liquidity that was affecting the market, and our view was that Northern Rock was obviously exposed. We did engage with the bank on that situation and we moved the rating when we were informed, effectively, of the decision of Northern Rock to seek assistance from the Bank of England. Mr Taylor: To answer your question directly, the rating did not change by much, the situation changed by a bit. Going back to your first question, which what is the rating actually doing, the rating is addressing---. If you hold a security from Northern Rock, what is the likelihood of you getting your money back? So, because of the strength of support that came in there, we did not have to change the rating, the rationale of the rating changed and was described by research issues by us, but the risk of the piece of debt did not change by that much if you were a bond holder. Q986 Peter Viggers: When you were asked whether each of you drew fees from Northern Rock, Fitch and Standard and Poor's said, yes; Moody's was slightly less forthcoming. Can I assume that Moody's also receive fees from Northern Rock? Mr Drevon: We do. Q987 Peter Viggers: In assessing these fees (and we would like you to let us know what the fees were) can you, please, also tell us whether these fees were proportionate compared with other institutions comparable to Northern Rock? In other words, were you remunerated in a manner which was perhaps in excess of that which one would normally see from such an institution? I would you like to put that question to you, please, and I hope you will be able to respond. You have been criticised for the speed with which ratings adjusted to the sub-prime crisis. Previously you were criticised for the speed with which you adjusted to problems with Enron. Were you satisfied with the speed that you responded and what plans have you to improve the speed with which you intend to respond? Mr Madelain: I think actually we feel we did effectively respond to the situation in a timely manner. I would like to make two comments. The first comment relates to what we have done. All over the summer we had very intense activity around the assessment of the situation and the communication to the investors of the impact of the situation on the bank we rated. We had weekly conference calls for global investors, we published more than 25 research reports through the summer on that very topic, so I think that the level of response and the expectation of the investors at that stage were effectively met. I guess the other question that one would have is what effectively we were able to communicate. I think it is very important that you understand that the opinions we produce are based on the public information that is available to us in the form of financial reporting as well as information that is made available by the banks that we rate; and there is obviously a limit in what we can do and that limit is affected by the amount of information that is available. Q988 Peter Viggers: But you are experts, otherwise it is just rubbish in, rubbish out. Mr Madelain: But the expert is forming an opinion using information that is made available to you. We cannot create information that is not available to us. Q989 Peter Viggers: Switching to another point, to Fitch, Filamac claim that you warned investors about the dangers of a sub-prime mortgage market in 2005. Is that correct? Mr Taylor: It is correct, yes. Q990 Peter Viggers: What did you do about it? Mr Taylor: What did we do about it? One of the challenges we have had as an industry over the last couple of years is when the markets have been so buoyant, as we have put out comments about maybe credit deterioration or concerns in increasing leverage, for example, in transactions, many, many players in the investor community simply were not viewing credit perhaps at the forefront of their investing decision. So, even though we can draw attention to commentaries about deteriorating credit risk, it was not being reflected in investor behaviour. A good way of describing that is the average ratings we have been applying, for example, in leveraged corporate transactions in Europe have been coming town on average for the last two years. Until recently the price was coming down as well. The increase in risk as we reviewed it has not been reflected in market pricing; so there was an imbalance between what we were saying, the direction of credit and the way the market was responding to deals being placed. Q991 Peter Viggers: Were you content that the information you were putting out reflected the reality that investors would probably want? Mr Taylor: It is very difficult to say that, because what actually happened in the US sub-prime market was very much unprecedented. We had not seen anything like it before. You can argue about the magnitude of what happened verses the magnitude of what we were talking about, but I think the direction was clear, but it was not just us, many commentators in the market were saying similar things. Q992 Peter Viggers: Do you at Standard and Poor's and Moody's accept that Fitch was ahead of you in warning of the dangers of sub-prime? Mr Bell: I am not exactly sure when their warning came out. We had warnings at roughly the same time. They may well have been ahead. I think one has to remember two things. First of all, we did, as did the other agencies, warn investors about the deterioration in sub-prime, but also one has to bear in mind how you rate structured finance transactions, which is that the criteria require a credit cushion. In order to have a triple-A you have to have a credit cushion so the pool of mortgages can absorb a certain amount of losses before there are any losses at the triple-A level. These cushions were very substantial in the case of sub-prime. They reflect our analysis of past data. Those cushions are not simply reflective of what happened in the past for triple-A rates. We simply do not say we assume the future will be the same as the past; what we do is we stress the past. We look at how bad things got in the past and we say we will multiply that level of rates to create a cushion that should survive not just credit problems in the past but a much worse credit scenario. What happened in the case of US sub-prime, however, is that the future was much worse than even our worst case assumptions - the deterioration in credit, the deterioration in underwriting, the deterioration on the fraud side, the amount of fraud involved, and also a series of very unusual and completely novel patterns of behaviour by sub-prime borrowers, things that had never been seen before in any other market. All of these combined to create a situation that was worse than our worst case assumptions and also completely novel, not just to us but to the entire markets. As a result, with hindsight, if we had known exactly what was going to unfold, we would have rated these transactions differently. However, we maintain that we rated them with all our knowledge and all our skill to the best of our ability. Q993 Peter Viggers: But you are experts and presumably well paid. Did you study the initial sub-prime market, notice the way they were collateralised and then draw conclusions to enable you to warn people? Mr Bell: Absolutely. I think also one needs to remember that we have been rating sub-prime transactions since the early 1990s. This was not a new market for us. In 2001 there was a crisis in the then sub-prime markets, so we drew all the lessons that we could from this. What happened is that the crisis in 2007 was of a speed and amplitude much greater, not just than in the past, but much greater than anything we had seen as a worst case scenario in the future. Q994 Peter Viggers: Can I turn to Moody's. Brian Clarkson from Moody's said in the Financial Times on 18 September, "A more uniform method of valuation is essential for efficient and rational price discovery and to address future liquidity issues." Could you expand on that statement? Mr Drevon: I think it appears right now that one of the main reasons why we are in these very troubled times is not necessarily linked to the credit risk we are seeing but more to liquidity-related issues and liquidity-related issues due to the fall in values we are seeing on a number of securities. Why are we are seeing this level of falls? First of all, it is very clear that these instruments are complex and require significant amounts of time to fully understand and, therefore, to try to find a tool for valuation. There is no standardised solution to that. Different banks will come up with different solutions to value these securities and, by definition, this will result in different methodologies across different institutions across different markets. This creates generally concerns that institutions may have more risk than they have been disclosing because they are using different methodologies. So there certainly is, I think, a clear understanding in the market place that there needs to be more done in terms of agreeing on solutions to have a more standardised approach for valuations. From Moody's point of view, this is not an area that we are involved in at this stage. We provide credit ratings, but we think it is an area which may benefit in the market in the future. We plan on developing tools to provide fundamental valuations to help investors with valuing these securities. Q995 Peter Viggers: You have a unique status under US security laws. You profit from your privileged status and it was Mr Bell, I think, who referred to your reputational integrity. Do you think you deserve this unique status in the US? Mr Drevon: Moody's has generally been in a position to say that we are not in favour of using ratings for regulations. We have been very clear about that in all our observations. We think that ratings are used for many things already, including by investors, by issuers. They are used by investors who buy whole issues, investors who trade, by investors who will short sell. We think that adding regulations to that as an instrument that will be using ratings is not something that we recommend, in fact. Mr Bell: I would go further to say that, although undoubtedly we do commercially benefit from that status, we have always, as well as Moody's, been opposed to being part of regulation. We did not ask for this status, we did not lobby for this status, we disagreed with the ICC when they created this status and we have said ever since that it is a bad idea. We welcome the changes in the law that provide more clarity about how this status is going to be provided in the future. Q996 Chairman: If I can go back to another question, roughly speaking you all rated Northern Rock the same. Mr Hancock: Not dissimilar. There were minor differences. Chairman: Not dissimilar, and you all had business with Northern Rock. I will be writing to you formally on that regarding your relationship with Northern Rock and the income you have, and if you decide to write back to me and say it is confidential, then it is going to be a matter of public record, but you will be getting a letter from me on that. Sally. Q997 Ms Keeble: I must say what it reminds me of is the children's game, pass the parcel. You have got some risk bundled up, it gets passed from pillar to post and, when the music stops, people open it and find that there is nothing there, or next to nothing there. It makes me wonder how hard you actually looked at the securities that you were supposed to be rating: because once the information had come out about the sub-prime market, it is hard to imagine how anyone could have regarded them as sound investments at all. I just wondered, if you listen to what the professors said as well, how far you look and scrutinised what you were rating? Mr Bell: We have 30 years of experience of rating structured finance and the first structured finance transactions, both in Europe and in the United States, were residential mortgages. The advantage of residential mortgages is that because the pools are quite large, thousands and thousands of mortgages, they do respond fairly well traditionally to statistical analysis. We have used that statistical type of analysis, taken quite a lot of information from the pools, and we do a lot of due diligence in that sense, over the 30 years. Our record shows that actually it has been extremely successful in predicting the probabilities going forward. Q998 Ms Keeble: In this particular case it is not just that we had the first run on the bank and all that; a lot of people, a lot of my constituents, could have lost a lot of money, all their money, so it is desperately serious. How far down through the structure did you actually prod to test how viable these loans were and what this was built on? Not just general mortgages, specifically these risky loans, obviously risky because they are sub-prime, and it is very clear that there was basically pretty much nothing there? Mr Bell: I think that is not actually correct. What you are seeing is a large number of down grades. We do not know what the ultimate default will be, but right now the defaults on these pools are very, very small; they are less than 1% of defaults. Those will almost certainly rise, but to say that something that was rated triple-A, for example, was downgraded to double-A or double-A minus, that there is nothing there, in all likelihood those bonds will be paid out in full. Q999 Ms Keeble: If you bundle things up and pass them on and keep on doing that, it is just like pass the parcel: it keeps on going until somebody blows the whistle and it stops. What I want to know is how far down did you go, not just saying they have not defaulted, the record is good, we have got 30 years experience. What analysis did you actually do of what these securities were actually based on? Mr Drevon: Again, our analysis is really statistically based because we are looking at very large pools, in the case of US sub-prime we are looking it more than 40 different pieces of data on each loan to come to a conclusion, and that helped us to understand the level of risk in each individual loan and then, based on that data, make assumptions about the credit risk of those pools. It is a very serious amount of work, extremely detailed, and we make available to the market place the models we use to analyse that type of risk. We are very transparent about the process. Q1000 Ms Keeble: When it is peeled off now, it is quite clear that there was gross mis-selling, or what would be deemed to be mis-selling - people could not repay, they did not have the income, all kinds of things - so how reliable can your statistical tools have been? I could understand that if you applied them to middle income mortgages they might be very reliable, but sub-prime is different, is it not? Mr Bell: It is, and that is why our rules for sub-prime and the way in which we stress them is very different. We do not stress them at all the way we stress prime mortgages. Clearly there are lessons that we are going to have to learn about the US sub-prime. Clearly we are looking at what went wrong and how we could possibly learn from this and how we can change our criteria, change our tools of analysis. Are there any items we should be looking at that we did not look at before? Such crises are always an opportunity for us to learn. Q1001 Ms Keeble: I want to ask you in a minute about the lessons you have learned, but you have also said repeatedly that your advice functions are different from your ratings functions and that you have got different structures, different agencies. You say that, but everybody else who is coming here (and obviously we all talk to people informally too) says there are conflicts of interest: that you advise and that you rate on the same products. How is everybody else so mistaken about what you are doing? Mr Bell: I cannot answer that. What I can say is that we have a potential conflict of interest which is known and managed. We simply do not provide advice. It is very difficult for me to say anything more than that. We do not have advisory functions, we do not have a consultancy function for structured finance, our analysts are hired and our company is hired to rate transactions. We do not have any advisory contracts. Q1002 Ms Keeble: Okay. You have sat here, Mr Bell, and you have talked about the cushion that is needed, this and that and the other, to get a triple-A rating. That comes perilously close to saying, if you do this so we can tick these boxes, you can get a triple-A rating. You have sat there and said it, and we will see it when the transcript comes out. How do you actually make sure that other people do not listen to you, say "Oh, well, to get the triple-A I have to do X, Y and Z and then I will get it, and that is the model and that is all I need to do"? How do you safeguard against that? Mr Bell: All our ratings are done by a committee; all of our rated transactions and structured finance are analysed. Because our criteria are transparent and available to the market and available to investors so that they can understand how we rate, we are very conscious that there will be a tendency by investment bankers and market participants to game our ratings and, therefore, the rating process is never a mechanical one. We always look at each transaction and try to understand and try to see whether or not anybody has tried to game our criteria. Q1003 Ms Keeble: Can you say whether, as a result of this, you have actually tightened up things? Do you actually sit on doing the final assessment or do you have a completely arms-length group of people who get all the data, a bit like the MPCA, I suppose, and look at it all and then think, "Right"? Mr Bell: Different from whom? Because we do not have an advisory function. Q1004 Ms Keeble: You have sat here and described how we could go about---. You have described briefly some of the things that are needed to get a triple-A rating. Do you actually take decisions on the ratings that people get or do you have some people who will assess a product, do all the reports and then a separate group of people who take the decisions on what ratings they should get? Mr Bell: The latter. Maybe it is easier if I just explain the way in which we operate. Our criteria are public so that market participants know how we apply the rules. They have provisions so that we can have different criteria if we feel someone is gaming them, but basically our criteria is public. The client will approach us; an analyst will be assigned to a particular transaction - that is the primary analyst. Sometimes on big transactions, complex transactions, there may be two analysts. They will gather the information; they will ask the questions that they believe they should have obtain answers to in order to achieve the rating. They will then, once they have done this, go to a committee and they will present the conclusions of their work to the committee. The committee will vote on the rating. That is how we operate. Q1005 Ms Keeble: Do the assessors get information from separate sources or just from the client? Mr Bell: They will get assessment; they will get information from all the sources they need relevant, so they will get it from the client, they may get it from the press, they will get it from other market participants if need be. Q1006 Ms Keeble: What happens if the client says, "If I tweak it here or there, will I get a triple-A"? What do you do then? Mr Bell: We basically answer the issue of our criteria. So if a client says, "I thought I had followed your criteria. I thought I would get a triple-A. I have not got a triple-A. What is wrong? Why did I not get a triple-A?" We will give them an answer and say the criteria had not been followed. Q1007 Ms Keeble: But before hand, I mean, when you are doing the assessment? Mr Bell: This is what I am talking about. When we are doing the assessment the client will sometimes come to us and say, "I do not understand; I thought I had met the criteria", and we will explain, "No, we do not believe the criteria has been met", and then they will decide whether they want to go ahead with the transaction or maybe they want to change the transaction. Q1008 Ms Keeble: How about the others? How does what you have described compare with the other agencies? Mr Drevon: I think the committee process is probably somewhat similar. One thing to note which I think is important is that the reason why we have transparent methodology being made available to the market is because we think it is good practice. We were being accused a few years ago of being black boxes: a client, an arranger comes to us and asks us to rate a transaction, we give the rating but we do not explain the rationale for that rating. We have taken many steps over the last few years, in fact, to become much more transparent and make available our criteria to the market place. From a policy point of view, I think this was the right track to take. Q1009 Mr Simon: Going back to the extent to which you agree or not and why, you started off by saying that the ratings that you issue measure different things, they are not all the same; so S&P measures default probability, Moody's measures expected loss. Then, the next thing you said is that it is not true that there is an extraordinarily high degree of agreement between the things that you rate. So far that would make sense. If you are all measuring different things it is not surprising that there is not an extraordinary high degree of agreement, although it is surprising that there are people in the market saying that there is an extraordinary high degree of agreement. Then Mr Taylor told us that the reason there is an extraordinary high degree of agreement is that the facts are the same, at which point I am starting to lose it. The facts are the same, so there is an extraordinary high degree of agreement, but you are all measuring different things, so it is not surprising that there is not an extraordinary high degree of agreement. If there is an extraordinary high degree of agreement, what is the point of having three of you in a normal market where the product is the same and the price is roughly the same? What would be the point of having three providers if you are not in any competition, if you agree about everything, even though you are measuring different things? Mr Madelain: Let me answer the first point, which is that we are measuring different things. When you talk about investment rate security, the difference between measuring expected loss and default probability tends to be very small. The reason it is very small is because the difference is made up by the expected recovery, effectively. Q1010 Mr Simon: What are you adding to the market by measuring these things differently? What is the point? Why do you not measure the same thing? Mr Madelain: Obviously Fitch can comment on their own practices, but we feel that what is important for the investor is to actually know the ultimate recovery, pay-out, effectively, that he can expect from the investment he is making. Q1011 Mr Simon: So you think that is the best way. You need to measure the loss, not just the probability of default? Mr Madelain: That is correct. Q1012 Mr Simon: And you are Moody's? Mr Madelain: Yes. Q1013 Mr Simon: S&P, you think that is wrong. You think that you only need to measure the probability of default? Mr Taylor: No, I am Fitch. I do not think it is wrong actually. A lot of this is nuanced, to be honest. For an investment grade security the impact of recovery assessment is very limited, because if you are taking a healthy, strong investment company and saying, "Let us predict what it is going to look like as it is about to go down the pan", there is hardly any purpose for doing that, there is no value we can add. We actually do our ratings below investment grade; we build in the assumption of recovery. So we are actually doing the same thing, but we are saying, as you start getting down to the much riskier levels of assessment, we think it therefore adds value to talk about recovery prospects as the risk becomes greater. Q1014 Mr Simon: So you are only measuring very slightly different things? Mr Taylor: In practice, yes. Q1015 Mr Simon: The facts are the same, and you are all talking to the same people and using similar procedures to establish the facts, so it is not surprising that you all come up with the same answers all the time, which you obviously do even though you do not like admitting it. In which case, going back to the fees that you charge and receive, if I am a typical participant in this market would I normally be attempting to have a relationship with all of you: I pay you all and you all rate me. Mr Madelain: It depends. Q1016 Mr Simon: I know that sometimes you decline to rate. I know that you do not all rate everybody every time. Mr Madelain: Exactly, yes. Q1017 Mr Simon: If I want to make a good impression, would I not want to be rated by all three of you? Mr Hancock: There will be a number of clients who are rated by all three, there will be a number who are rated by two and there will be some who are just rated by one. There is different market practice in different countries and sectors of the market that we operate in. Q1018 Mr Simon: Roughly how would that break down? Would two be the most common, would you say? Mr Hancock: Yes, probably. Q1019 Mr Simon: Why is that? Speculate a little from a very informal position as to what I as a punter gain by being rated by two of you when you almost never disagree with each other and you are measuring the same things and the same facts? Mr Madelain: The point is we can disagree. Q1020 Mr Simon: I know it is possible. Mr Madelain: And we can disagree sometimes on things that are very important - the cut off point between investment grade and non-investment grade, for example, or special situations where we may take a view and other raters may take a very different view. Q1021 Mr Simon: We have been hanging this around the Northern Rock situation. Give us an example in the Northern Rock situation of such a nuanced disagreement and the positive impact that it had? Mr Madelain: At the moment, I understand--- Q1022 Mr Simon: No, no, I am talking about the run up to the run on this bank, which none of you sussed out in advance. To be fair, nobody else noticed it either and it is obviously not your fault - I am not saying it is your fault - but give us an example of how this might have worked in this particular instance where you rated it in some nuanced different way and thereby sent a subtle signal to the market? Mr Madelain: We had a higher rating for Northern Rock than Fitch and S&P. We had a double issue rating on Northern Rock, and the reason we had a higher rating was because in our rating methodology we do assign a higher weight to systemic support to bank ratings. Q1023 Mr Simon: But that does not really make any difference, does it? It is a different methodology, everybody knows that, everybody knows what the methodology is, so unless you are actually going to be making decisions in a different way, unless you are going to be forming views differently--- Mr Madelain: We formed a view, which was that effectively we are rating the bank higher. Q1024 Mr Simon: That is because you always rate those higher banks higher than they do, and everybody knows that, so what is anybody learning from this? Mr Hancock: It comes back to the users of ratings value a variety of opinions. In this case Moody's took a different slant on the likelihood of state intervention in the case of Northern Rock. These are opinions, there is no right or wrong, and clearly our users value having a variety of opinions. Q1025 Mr Simon: Very briefly, Mr Bell, two hypotheticals. If one of the three of you did not exist, would it be a big problem for the market? Secondly, if none of you existed, would it throw the markets into crisis? Mr Bell: If one of us did not exist, it would narrow and reduce the number of opinions that investors can turn to. Q1026 Mr Simon: That is called a truism. Mr Bell: Yes. Q1027 Mr Simon: If one of you did not exist, there would be one fewer of you than there are now. I understand that. I would like a little bit of interpretation, which is what you do for a living after all. Mr Bell: I think the more educated, informed opinions there are, the more--- Q1028 Mr Simon: So it would be better if there were ten of you? Mr Bell: Absolutely. Q1029 Mr Simon: Good. Mr Bell: If none of us existed, it depends which markets you are looking at, but in markets which are structured finance, which are global markets with fairly complex instruments, it is difficult to see how such markets could meaningfully exist without a series of independent opinions that looked directly at the transactions. Q1030 Mr Simon: Why cannot we just have a computer model? Everybody knows what these criteria are. Why can we not just have a programme and everybody runs it through at their desk? Mr Madelain: They are available today. Q1031 Mr Simon: Why do we need you then? Why do we need to pay you to do that? Mr Bell: Because the thing about computer models is they are very inflexible and, therefore, they are subject to gaming. There are a lot of very highly paid people in banks whose job it is to try to figure out a better mouse trap, and if you have an inflexible model with no human element to actually see how the model is being gamed, you will get yourself into a lot of trouble fairly quickly. Q1032 Mr Simon: I am sorry if I am going on a little bit, but when I ask, "How come you all agree or you do not quite agree?", nobody says, "We disagree because we have added a little bit of human element into this, because we made a slightly different judgment." The only reason you disagree is, "Oh, we have got a slightly different criteria"? Mr Madelain: It is not. It is human judgment. That is exactly what it is. Q1033 Mr Simon: You could write that into your model? Mr Madelain: No, it is not a model, it is actually a view we form over time for bank ratings. We assign a higher element. Q1034 Mr Simon: In all cases; in every instance? Mr Madelain: No. Q1035 Mr Simon: "In these cases we assign this rating" - that is not a warm, human, touchy judgment. You could write it as an algorithm. Mr Madelain: Well, eventually you can, but how you came to that conclusion is exactly the image, and that is what you differentiate as. Q1036 Mr Simon: That is another truism. These are all human judgments because the algorithms are written by humans. Mr Bell: Let me give you an example outside of Northern Rock which I think is useful. Both Moody's and us rate structured finance transactions in emerging markets, including Russia. They are not, you will be glad to know, rated triple-A. However, we have formed quite different views about the nature of the risk of sovereign interference in Russia on various asset classes and Moody's view of their analysts based in Russia, knowing the market and knowing the Government, about what is more likely an interference with a mortgage transaction or an interference with a consumer loan transaction, is the exact opposite of ours. We have our view; they have their view. As a result we rate those transactions differently and we explain why we rate them differently. That is a classic example of the human subjective element based on our staff in Russia and their understanding of what is happening. Moody's staff in Russia have a different understanding. I am not saying I believe ours is better because I am S&P, but I think it is of value to investors to be able to see those different ratings, to understand why they are differently assigned, to understand the subjective element behind them and then, as an investor, to make their own view as to whether they feel Moody's is right or whether we are right. Q1037 Chairman: You mentioned about value to investors to see the different ratings. Would you take it then that some investors can mistake a good credit rating for a green light to invest? Mr Bell: My experience of investors over the 20 years that I have been in the structured financial market is that the spectrum of investors in structured finance is huge. At one end it is the cause of extremely sophisticated funds that have their own--- Q1038 Chairman: My question is a very simple one, Mr Bell: do you think that some investors can mistake a group credit rating for a green light to invest? Mr Bell: I think some investors may well have done that, yes. Q1039 Chairman: You would all agree on that? Mr Bell: Yes. Q1040 Chairman: So the fact that you have all given roughly a good credit rating to Northern Rock to investors and they invested on that basis, you would come back to them and say, "Oh, it is nothing to do with us because it is only about creditworthiness"? Mr Madelain: We are very clear in our communications in what the meaning of the rating is. Q1041 Chairman: Back to my point earlier that some investors would invest and use that as a green light. As one commentator has said of your defence on that, whilst some can have sympathy with it, it reminds him of what the gun manufacturers say after each mass shooting in the United States, "There is blood on the floor but it really is not anything to do with us." Mr Hancock: We are certainly aware of these concerns and issues and we go to great lengths in trying to educate investors and others on how to use ratings. Q1042 Chairman: You have not done very well so far? Mr Hancock: By way of example, we have an event every working day of the year somewhere in Europe, and part of the efforts of those events is to get clarity on these issues. We are investing a huge of amount of time in trying to invest in the market more generally. Q1043 Chairman: But after the Northern Rock situation it does not seem as if there has been much success here for all three you. Mr Madelain: I am not sure what is the link, what is the statement that you made. Q1044 Chairman: Some investors use your debt ratings as a green light to invest. They have invested in Northern Rock and at the end of the day, as Mr Fallon said, you did not downgrade your ratings until September, so some people are going to find themselves on their backside as a result of that and you are then going to turn round and say, "It is nothing to do with us, mate", because this is all to do with credit risk. But we are here as the interface between Parliament and the City and the community and trying to get some handle on the situation, as Mr Fallon has tried and Mr Siôn has tried, but it is no use you then turning round to us and saying, "It is nothing to do with us." You have got to do something as a result of this now. Mr Drevon: On the question of are ratings misused in a certain way? Again, I think we have done a lot to try to communicate on that and maybe that is not enough. We have in fact been looking at providing more information to investors on other risks. We have been looking at terms of--- Chairman: I think this Committee, from the evidence you have given us this morning, would think that you have really failed hopelessly on that situation Philip. Q1045 Mr Dunne: I would like to take us a bit above the Northern Rock situation to look at the impact of particularly the new financial structured products and your relationship with the explosion of issuance. Could you start by telling us, somebody, a volunteer, how many triple-A rated sovereign credits there are? Mr Taylor: It would vary by agency. Q1046 Mr Dunne: In order of magnitude: one dozen, one hundred? Mr Taylor: Thirty maybe, 30, 40. Q1047 Mr Dunne: How many corporates below the triple-A rating? Mr Hancock: A handful. Q1048 Mr Dunne: Banks? Mr Hancock: A handful. Q1049 Mr Dunne: Any? Mr Hancock: There is the Rabbobank in the Netherlands which remains triple-A rated. It is the only one in Europe without public support. Q1050 Mr Dunne: How many structured financial products are triple-A rated? Mr Taylor: Thousands. Q1051 Mr Dunne: Can you give us some idea of the volume of issuance which is rated by you. I think one of you, I think Standard and Poor's, provided us with a figure of 34 trillion dollars of debt obligations which are currently rated. Can you give us some idea of what proportion of that is triple-A rated? Mr Bell: Totally or just structured finance? Q1052 Mr Dunne: That you look after, that you rate. What proportion is triple-A? Mr Bell: I genuinely do not have that number. I would say 50, 60%. Mr Hancock: We can certainly refer to you with that. Q1053 Mr Dunne: It would be very helpful if we could have an analysis, Chairman, by rating category, by type of issuer, the volumes and the number of issuers? Mr Hancock: Sure. Q1054 Mr Dunne: That would be very helpful. How long has each agency been rating the different types of structured financial products? I think you mentioned 30 years. Mr Bell: About 76, I think. Q1055 Mr Dunne: And is that the same for Moody's and Fitch? Mr Drevon: Yes, approximately. It should be the same thing. Q1056 Mr Dunne: But that is just for mortgage bank securities. Mr Bell, as you were saying earlier, there are some very ingenious minds generating new products all the time, so can you give us some sense for the longevity of the historic track record that you look at when you come to approach a new instrument and explain how you do that. Perhaps Moody's. If somebody comes up with a new instrument, how do you go about assessing where it sits within the rating structure? Mr Drevon: It is in fact very simple. The more information there is, the more track record there is, the clearer we have a view of what could be future performance and we can evolve models around that. To the extent that there is a new instrument that comes in which has virtually no track record, it would be very difficult for us to come to a conclusion. Q1057 Mr Dunne: Does that mean you do not offer rating or you do offer rating? Mr Drevon: No, we may decide there is not enough information or enough data made available to assign a rating. That is quite possible. It is certainly the case in some emerging markets, it may be the case for a new type of asset class, but typically, again, if you look at some of the large asset classes which have been discussed, and mortgages, in most markets there is sufficient data being made available now and some of the new asset classes, like collateralised debt obligations, have been around for approximately ten years now. Q1058 Mr Dunne: After what point do you start to issue ratings? Mr Drevon: There is no specified point in terms of--- Q1059 Mr Dunne: Let us take collateralised debt obligations, which have been going for ten years. How long did it take before you started to provide ratings? Mr Drevon: Collateralised debt obligations, they started with the repackaging of corporate debt, so we had a lot of information on the underlying risk, which is a corporate debt. So, we could have assigned these instruments very rapidly, again, on the basis of the underlying data. I think we have to look at what also goes in the structured fund's instrument. Q1060 Mr Dunne: That is a good line. How carefully do you look at what is going into the individual products as they are evaluated? Let us look at a complicated one. How about a first default basket? How closely do you get into what comprises the first default basket? Mr Drevon: The analysis would be on each individual instrument that goes into that transaction, and we would take a view on what is the likelihood of default of that specific instrument, what is the correlation between those different instruments, model that and come to a conclusion. Q1061 Mr Dunne: If we take something else, a CDO square, which is new expression to me, that essentially is a CDO vehicle investing in pools and tranches of other CDO instruments? Mr Drevon: That is correct. Q1062 Mr Dunne: Do you go down to the underlying individual asset across a pool? Mr Drevon: That is correct, yes. We do what we call a "look-through", so we go, in fact, not at the first level, but we go for the underlying assets, which is the corporate risk. Q1063 Mr Dunne: Is the issuer able to provide access to the underlying data in every case? Mr Drevon: In most cases the underlying corporate names are rated; so we use the rating information. Q1064 Mr Dunne: Let us suppose we are not dealing with corporate names, we are dealing with packages of securities which do not have to issue accounts and do not have to issue public statements. Mr Drevon: Typically those instruments would be rated by us and we would use the rating as an input. Q1065 Mr Dunne: So you rely on your own rating of an underlying instrument. Mr Drevon: That is correct, yes. Q1066 Mr Dunne: Without necessarily going in to look at whether that rating is correct or not? Mr Drevon: No, we believe that our ratings are correct as a policy for our rating system. Q1067 Mr Dunne: How frequently do you reassess ratings of individual instruments? Particularly I am interested in the financial products rather than the corporates, which have a natural publication cycle. Mr Drevon: It is on-going work at Moody's. The day we assign the first rating is also the first day we start monitoring the rating; so there is no specific day in the year we decide we are going to review the ratings, it is an on-going review. Q1068 Mr Dunne: Once a year, once every two years, once every three years? Mr Drevon: It really is instrument specific. In some instruments we will review them every week because there are very specific events surrounding that instrument. In some other instruments, take a high quality sovereign risk, we know that the likelihood of that changing is going to be lesser, and so the monitoring is going to be on an annual basis. Q1069 Mr Dunne: Who monitors the monitors? Is there any independent assessment of any of your methodologies? Perhaps I will ask somebody else. Mr Bell, you are nodding. Mr Bell: The independent assessment is basically conducted by the investors. Our criteria are public. Therefore, it can be conducted by anyone who wishes: the regulators, CESR, the investors. Q1070 Mr Dunne: Do any investors in your experience ever analyse your methodology, other than in relation to questioning your decision? Do they go back to first principles? Do they ask for all of your data to cross-check with their own models--- Mr Bell: Yes. Q1071 Mr Dunne: ---in relation to that instrument. Mr Bell: Certainly in Europe I have come across a number of investors. Also we do do exactly that. If the information that we have received suggests that we should change our criteria, we will often request a comment from the investors. We sometimes get quite vociferous comments against any proposed change, so is there an on-going debate with the investor community. Mr Hancock: I would just add, it is exactly the same on the corporate and government side. We have an enormous number of phone calls from investors and other interested parties questioning our opinions every day and, as a matter of policy, we put the names and phone numbers of the analysts on each piece to encourage that. Q1072 Mr Dunne: Do you publish your methodology in relation to individual instruments and your model? Can somebody actually come in and look at your model? Mr Bell: Yes. In CDOs, for example, our model is available for free on the website. I believe that is the case for the other agencies. Q1073 Mr Dunne: Do any regulators overlook your methodologies or models? Do you have discussions with them at all? Mr Bell: We have had discussions with regulators where they have asked questions about our methodologies. Q1074 Mr Dunne: Any question of whether it is valid, or was it more to do with the conclusions that you have come to for a particular instrument that they are interested in? Mr Drevon: I believe the regulators have been looking more at the conclusion than the methodology itself. Mr Taylor: The experience that I have had is just that they are trying to understand how we look at things, how the process works. Q1075 Mr Dunne: So they are looking ultimately at how you arrive at the outcome, but they are not seeking to question whether the methodology itself is correct or appropriate? Mr Taylor: Correct. Q1076 Mr Dunne: Can you explain why it is that different credits with the same rating have such widely different spreads in the market place? To give you an example which was given to me the other day, if you take an emerging market, Peru 2016, which is trading this spring at 96 basis points above the relevant US treasury and you compare that with a US corporate dollar bond, say General Motors, 2031, which had a 250 basis point spread over Treasury, whereas a foreign corporate dollar bond, KazCommerce Bank 2013 had a 263 basis point spread, that is a significant difference, all of which have got a double-B plus rating, I think it was from Moody's in that case, so perhaps Moody's can answer. Why is it that the spread is so significant if the rating is the same? Mr Madelain: I think the spread speaks to more than just credit risk but also to the liquidity of the instruments, and there may be also some diversions of view between our perspective on the credit risk as a suitable security and the general consensus of the market. Q1077 Mr Dunne: So the credit rating is not a guide to an investor as to the performance of the underlying instrument, it is merely a guide as to whether it is going to repay at the end of its maturity. Mr Madelain: If you define performance as return, that is correct. Q1078 Mr Dunne: What about the default rate of different types of instruments? What has the experience been of that? Mr Drevon: We published a very significant amount of statistics looking at the performance of our ratings, and if you look over long periods of time, particularly 15 years or more, the performance of structured finance ratings, in fact, are in line with the performance of other bonds, such as corporate bonds. Q1079 Mr Dunne: That is interesting, because there was an article in the FT in August that suggested that actually the performance of CDOs was ten times riskier than corporate bonds, and that was from a Moody's study? Mr Drevon: I think you always have the possibility to drill down and say, if we look for a period of six months at a specific asset category and specific rating level, there will be differences - that is absolutely normal - but the work we do is based on long-term statistical data and when we look over the long-term horizons, there is a high degree of convergence in terms of the performance of the ratings on the structured final side and the corporate side. Q1080 Mr Dunne: If I can quote to you from this article, it comes from a Bloomberg's market report in July which said that corporate bonds rated BAA, the lowest Moody's investment grade rating, had now reached 2.2% default rate over five-year periods from 1983 to 2005, according to Moody's, but from 1993 to 2005 CDOs, which have only been going that long, with the same BAA grade, suffered five-year default rates of 24%. Are you going to suggest that that CDOs have much higher default rate with the same rating than corporate bonds over their life? Mr Drevon: No, it does that in general. It does it in specific rating levels, and I think you commented on one rating level for a specific horizon, but even within the CDO categories there are a number of different types which will have different performances. Q1081 Mr Dunne: Can we turn for a moment then to how you decide at a certain point that credit is deteriorating? We have touched on what happened in Northern Rock, where you did not decide it was deteriorating until the Bank of England had stepped in. Is it the case that you tend to reduce grades of debt that you see heading towards default shortly before the final default in order to improve these performance statistics that we have just been talking about? Mr Hancock: Certainly not. Indeed, the way the statistics are actually published, you can look through that, so the investor is quite able to look at what the rating was one year, two years, five years before the default, so there is absolutely zero incentive to do that, and it will be seen through by the users, who have access to all of this information. Mr Madelain: I think what is important to note is the performance of the rating. There is a very high degree of transparency about that. I think all agencies publish a huge volume of statistics, either at the aggregate level or at the asset class level, actually tracking the performance of our ratings. So, it is certainly an area where transparency is very high. Q1082 Mr Dunne: Have you read Peter Warburton's report? This is language which you may disagree with, I expect. It says, "The final trick that rating agencies pull is to post-validate their assignment of a rating by making sure that very few bonds actually default from a high rating. Hence, by heavily downgrading a nearly bust bond a few weeks before its final demise, the agencies can claim that it defaulted as a C-rated bond rather than a DD-rated bond which it was when the bad news hit? Mr Hancock: Can I just reinforce that the user of all our ratings has all of the data available to identify if that behaviour is prominent. Mr Bell: I would also say, if you look, for example, at the table that we include in our submission of the default rates in the US RMBS, they are from initial rating not from final rating. Q1083 Mr Dunne: I think your best defence to that charge actually is what happened with Northern Rock, because you failed to downgrade them and perhaps you should have seen the warning signs a bit earlier. A couple more questions, if I may, Chairman. One is in relation to the information that is available to you as a rating agency in the US compared to Europe. You routinely receive information not generally available to the public markets from issuers, but in the US information on underlying collateral is generally available to investors, whereas it is not in Europe, and a charge has been made that during the summer crisis prices of securities began to show investors perceiving risk well ahead of the rating agencies in the US. That did not happen in Europe because the information was not available. Would anybody like to comment on that? Mr Taylor: I do not think we have any problem at all with greater transparency in the markets. We have no problem whatsoever with the market seeing absolutely what data we get. Q1084 Mr Dunne: You would be quite happy to see information made available to investors in Europe in the same way as it is in the US? That does not happen at the moment. Mr Bell: Yes, absolutely, in fact we welcome it and we have been, in some cases, urging, particularly in this crisis, our clients to make that information available, because we think it is good for the market that they should be available. Q1085 Mr Dunne: Do you see any parallels with what is happening in the US banking sector: losses being generated by investors, particularly in these CDOs, between other market failures such as the Lloyd's insurance market? If you take the example of the Piper Alpha loss of one billion dollars, because the way the reinsurance arrangements worked, that translated into a 16 billion dollar Lloyd's reinsurance loss. Do you see investment in CDOs by CDO funds as creating a spiral in a similar way to that, or potential risk of a spiral? Mr Bell: I think you need to distinguish between a credit loss and a market to market loss. The credit risk never disappears, but neither is it necessarily magnified by being repackaged, it is just moved around. In terms of credit losses, the credit losses suffered so far in the global market as a result of the events of the summer have been actually very small. The losses you are looking at which are being announced by all the banks are market to market losses. Undoubtedly, if you have many transactions, including in this specific area, then you have much greater value of issues out there, and on a market to market basis you clearly have a greater chance that the losses will be magnified. In terms of credit losses, there is no magnification because the loss does not get magnified as it gets moved around. Q1086 Mr Dunne: Until somebody defaults, and then it does get magnified. Mr Bell: Sure, but there is no magnification. The ultimate default, the borrower in the sub-prime who borrowed 25,000 or 100,000 dollars, can only default to the 100,000 dollar tune even if that loss has been repackaged to an RMBS or a CDO. It has been moved around, but he cannot default more than 100,000 dollars. The losses that you are now witnessing in the system are market to market losses as these securities' values have been marked down, and I think this is one thing that is worth bearing in mind. In terms of the magnitude of those mark-downs, we, for example, looked at one triple prime UK RMBS bond that traded at 80 cents in the dollar or 80 pence in the pound. That loss, taking into account the credit enhancement already in the bond, assumed that the person who sold it at 80 pence in the pound was selling it on the assumption that in a UK prime residential mortgage backed security 80% of the pool would default and the price of properties in the UK would fall by 40%. I do not think that on any valuation theory, other than Armageddon, anybody believes that eight out of ten UK borrowers are going to default on their mortgage and the price of houses in the UK is going to fall by half. What you are seeing in the market today, all those enormous market to market losses, does not reflect credit deterioration, it also reflects the clear element of panic. Q1087 Mr Dunne: Are any of you considering liquidity and introducing a measure of liquidity as part of your rating methodology? Mr Prescott: We are setting up a working party to look at liquidity in financial institutions. Mr Hancock: It is certainly something we will be looking at. Q1088 Chairman: Why do you need a working party in the light of Northern Rock? Why do you not just go ahead and ensure that you assess liquidity? For God's sake, you have all given Northern Rock a really good rating, the disaster happened and now you are saying, "We are going to set up a working party because we never assessed liquidity." Why do you not just say here and now you are going to assess liquidity? Mr Hancock: Certainly within the rating of Northern Rock we did assess liquidity. Clearly our assessment of liquidity did not withstand the repercussions--- Q1089 Chairman: So they failed. Mr Hancock: I think what Philip was referring to - tell me if I am wrong - was some sort of separate indicator for liquidity in addition to the probability of loss indicators. Q1090 Mr Dunne: My question is how do you do that if you are not participating in the market? Mr Taylor: We are looking at it. We are investigating it because market participants are asking if we can provide that kind of service. We will investigate and do the best we can to look into it and see if we can put something together. Maybe we need to buy in new expertise, new tools and new data. There is no guarantee we can come up with that kind of product, but it is work in progress. Mr Bell: The decision to do such a process is fairly easy to take; the creation of such a scale is actually quite complex. Chairman: Okay. Q1091 Jim Cousins: Looking at the events of this summer and, indeed, the autumn as well, would you expect a bank approaching the Bank of England's credit facility to inform you? Mr Hancock: We would not be at all surprised if they did not, given the hugely sensitive nature of that discussion. Q1092 Jim Cousins: You seemed to imply earlier that you would have such an expectation? Mr Madelain: What I said is that---. I said earlier that--- Q1093 Jim Cousins: A lot earlier. My memory is quite good. Mr Madelain: I said earlier that we were expecting systemic support to be made available to the bank, yes. Q1094 Jim Cousins: No, you said that Northern Rock had told you that they had approached the bank. Mr Madelain: No, I did not say that, or if I said it I should have--- Q1095 Jim Cousins: If you did say that--- Mr Madelain: I do not think I meant to say that. Q1096 Jim Cousins: You did not mean to say it? Mr Madelain: No. Q1097 Jim Cousins: Would you expect a bank approaching the credit facilities of the Bank of England to tell you? Mr Prescott: I think they would only do that at the very last minute. Q1098 Jim Cousins: They would only do it at the very last minute? Mr Prescott: Yes. Q1099 Jim Cousins: How many banks have in fact told you that they have approached the credit facility of the Bank of England? You have just said to this Committee that you want very high standards of transparency. I have asked you a rather simple and obvious question and you are dumbstruck? Mr Madelain: No, I think the answer to your question is--- Q1100 Jim Cousins: How many banks have told you that they have approached the credit facilities of the Bank of England? Mr Hancock: I think, certainly from S&P's point of view--- Q1101 Jim Cousins: How many banks have approached S&P's to tell you that they have approached the credit facilities of the Bank of England? Mr Hancock: I think that would have to be something, if we even have the information, that would have to remain confidential, given the sheer sensitivity and confidential sensitive nature of banking. Q1102 Jim Cousins: Do you take the same view, Moody's? Mr Madelain: We also take the same view. Q1103 Jim Cousins: You would say the same thing to the French Finance Minister, would you? Mr Madelain: I am not sure I understand your question. Q1104 Jim Cousins: Christine Lagarde, do you tell her that it would be confidential if a bank told you that they had approached the credit facilities of the Bank of England? You would tell her that too? Mr Madelain: We would, yes. Q1105 Jim Cousins: A brave man. You do see the point I am making. If such a simple and obvious point as the one I am putting to you is lost in these mysteries so that you neither know whether some bank has approached you to approach the credit facilities of the Bank of England, nor would you tell us if they had, means that, frankly, the public cannot have a lot of confidence in anything you say or do, can they? Mr Hancock: I think certainly information that we are hearing on a confidential basis and retained confidential within the rating agency, we incorporate into our rating opinions, but we do not necessarily disclose that information on the part the client. Q1106 Jim Cousins: But if you want a high level of transparency and you are very happy and you are very welcoming of all the efforts that are going on in the United States to increase that, why are you telling us that you neither know, nor would you tell, if a bank approached the credit facilities of the Bank of England when it is an obvious, important contribution to the markets? Mr Bell: We are bound by confidentiality with our clients and of course follow the code of conduct. Q1107 Jim Cousins: If you are bound by confidentiality then all your ratings are suspect? Mr Taylor: I do not agree with that. One of the guiding principles of the IOSCO Code of Conduct that was applied to us was how we treat confidential information and how we keep that information to ourselves. So, in complying with the IOSCO Code of Conduct, we would be able to answer the question on a specific-name basis. We answered it by saying nobody has approached us, we have not had any information that that happened, so we have answered your question, but if it was confidential information we could not do it. Q1108 Jim Cousins: In your case nobody has told you that. Mr Prescott: Yes. Q1109 Jim Cousins: What is the case with the other two? Mr Madelain: I would make two comments. Q1110 Jim Cousins: We have actually been told no-one has approached them. Has no-one approached Moody's? Mr Madelain: I cannot make such a comment. Q1111 Jim Cousins: So we do not know whether anyone has approached you? Mr Madelain: What I can tell you is two things. Q1112 Jim Cousins: Fitch are willing to tell us that no-one has approached them; you are not willing to tell us that no-one has approached the credit facilities of the Bank of England? Mr Madelain: It is not that I am not willing. I am not informed in a way that I can tell you that. Q1113 Jim Cousins: You would not come to this Committee today and not know whether a bank had approached the credit facilities of the Bank of England and they had told you. Mr Madelain: I believe it will be the responsibility of the bank to communicate on that. Q1114 Jim Cousins: What is all this stuff about transparency and "we welcome it" and "we want more of it", when I ask you a very simple question and total confusion and mystery comes? Mr Hancock: I would repeat what Fitch said, that we operate the IOSCO Code of Conduct, and that is very specific on what we can say and cannot say in terms of confidential information. Q1115 Jim Cousins: If your code of conduct prevents you from telling the market such a simple and obvious issue about whether a bank has approached the Bank of England credit facility (and I have not asked you who, I have just said how many and you are not willing to say), then I do not think your ratings are worth anything? Mr Madelain: Our ratings will reflect that information. Q1116 Jim Cousins: If you had had such information, it would be reflected in the ratings? Mr Hancock: We reflect all relevant information that we have in our ratings, even if we do not disclose confidential information. Q1117 Jim Cousins: But you are not willing to tell the Committee whether a bank has approached you to tell you that? Mr Hancock: Correct. Q1118 Jim Cousins: You are not willing to tell the Committee whether you would expect a bank to approach you and tell you? Mr Hancock: I think, as I said in the earlier question--- Q1119 Jim Cousins: Would you expect a bank to tell you that? Mr Hancock: I would not be shocked if they did not, given the nature--- Q1120 Jim Cousins: In that case, how can you tell us it is reflected in your ratings? Mr Madelain: The rating reflects information that is made available to us. Q1121 Chairman: Let us move on. As a general rule, can we say that rating agencies do not change a rating until something happens? In other words, you use historical data. Mr Hancock: I am sorry, could you repeat that? We could not hear. Q1122 Chairman: Rating agencies do not change a rating until something happens; in other words you use historical data to assess the ratings. Mr Hancock: No, not necessarily so. We certainly have our opinions about the future and we incorporate our opinions for the future into our ratings. They are forward-looking instruments. Q1123 Chairman: Some submissions have indicated to us that the credit ratings side of your business has quite a high margin, something like 50%. What margins does the credit rating side of your business have? Mr Taylor: I do not actually have---. It is a disclosed number in our public accounts. I am more than willing to provide it to you. Q1124 Chairman: Roughly. Mr Taylor: It is certainly less than 50%. We have a different business model, perhaps, to our competitors. Mr Drevon: Approximately 50%. Mr Bell: Unfortunately, different from the other ratings agencies. Standard and Poor's is part of McGraw Hill, which is a listed US corporation, and fortunately McGraw Hill does not break out that number, so under US securities laws I am informed that I am not at liberty to disclose that information. Q1125 Chairman: So if I wrote to you, could I get that information: the credit business side of your business? Mr Bell: The McGraw Hill Corporation, if it were to disclose that number, would have to do it in accordance with the regulation on selective disclosures. I am not an expert in American securities. Q1126 Chairman: Moody's you are 50%? That is the only answer we have got. Mr Drevon: Approximately, yes. Q1127 Chairman: Okay. On Basle II you heard Professor Buiter saying that no-one any longer trusts the rating agencies' judgment of the creditworthiness of complex structured instruments and, therefore, that puts a huge hole in Pillar 1. Do you agree with that? Mr Drevon: No, we do not. There is no, I think, proof that investors have lost confidence in rating agencies. In fact, over the summer we have done a number of outreaches to investors, including very large conference call conferences, and there is still a large degree of interest from the investor community on our opinion about credit risk. On Basle II, perhaps I can refer to our earlier comment, which is that we are not in favour of using ratings in regulations. Q1128 Chairman: You are all aggressively now related with downgrading mortgage-linked securities. I think it is because of that that Professor Buiter has made his comment. It seems that it is a legitimate comment that he has made. Mr Bell: I think it is a legitimate comment, but I would echo the words of my friends from Moody's, which is that during our interaction in Europe with investors, what we have found is that there is a sense that, yes, the ratings in the US sub-prime did not go the way they were expected to go, but that has not led them to lack confidence in all our work in structured finance. Equally, with Basle I, as Moody's have always said, we were not in favour of being incorporated in Basle I, we did not think it was appropriate. Q1129 Chairman: At the moment, in terms of complex structured products and the downgrading you have, do you think you still have the confidence of the market in terms of your judgment of creditworthiness of these structured instruments? Mr Bell: I think that the market, quite legitimately, is asking questions which I think it is incumbent upon us to answer. Q1130 Chairman: So it does not have full confidence in you? Mr Bell: I think the market is diverse. I think some people continue to have trust in us. Q1131 Chairman: Largely speaking - we are addressing the generalities - you think that the market does not have full confidence in you at the moment? Mr Bell: The market is not one single entity; therefore it is not a binary answer. Q1132 Chairman: But a large part of the market does not have full confidence in you. Is that right, Moody's? Mr Drevon: No, in fact if the market did not have confidence or was not interested in ratings, it would ignore completely our downgrades. It has been the opposite. The downgrades have a significant impact on the market and therefore--- Q1133 Chairman: You are keeping this whole confidence in the market. You are coming here and telling us that? Mr Drevon: Again, I think the proof will be in the future. Q1134 Chairman: I am really asking you for the present. We get lots of submissions into the Committee, and the reason I am putting that comment to you is that most people put that to me, and that is why I am putting it to you. Fitch, do you have the confidence of the market? Mr Taylor: Actually I think we do. A comment I made earlier was that investors had not been focused on credit over the last couple of years. Sub-prime is a very specific situation. It is about 3% of the credit market, to keep it in perspective. Do you want me to answer the question? Q1135 Chairman: Of course? Mr Taylor: So investors have not been focused on credit. I think in the last few months they have refocused massively on credit. We have never been busier in terms of dealing with investor inquiries, investor discussions, so I absolutely think they still see value in what we do. It would be completely arrogant to say we cannot learn lessons from what has been going on, but I do think investors continue to value the core product of what a rating is. Q1136 Chairman: I would suggest maybe to people in the market that could come across this that there is a hint of arrogance in that answer, but there we are. The Bank of England Financial Stability Report, October 2007, says that it is unclear whether the ultimate bearers of risk have sufficient information of an underlying credit risk in the product, in particular, the more complex instrument in which they invest, and investors may have become over-dependent on rating agencies' assessments of risk and also could have misinterpreted ratings, assuming that they provide information on a range of risk, such as liquidity and market risk in addition to credit risk. Do you agree with the Bank of England's statement there? Mr Bell: We have always been very clear as to the nature of our ratings. Q1137 Chairman: I am asking the question: do you agree with the Bank of England's statement here? Mr Bell: We believe that certainly some investors---. We do not believe that the investors misunderstood the rating, i.e. we do not think that investors actually believe that a rating was trying to encapsulate a price or liquidity component. However, we think that, in the absence of any other indicators, undoubtedly a number of investors used the rating as a proxy for liquidity or pricing components. Q1138 Chairman: So the Bank of England are on to something here then. Mr Bell: I think, yes, but I do not think it is a misunderstanding of the rating. We used the rating for another purpose because we did not have the other tools, so we thought this was as close as we could get. Q1139 Chairman: Do you disagree when the Bank of England say that investors may have become over-dependent on the ratings agencies' assessment of risk? Mr Bell: That is entirely possible. We have never advocated that investors should buy--- Q1140 Chairman: What about Europe when you look at the Bank of England? Mr Drevon: With respect to the last point, yes, I think we agree that it is quite possible that some investors took the rating as a proxy for the risks. We do not disagree with that. Q1141 Chairman: Fitch? Mr Taylor: I agree. It is a valid point. Q1142 Chairman: The Bank of England has some suggestions for improvement in the Financial Stability Report, saying that it is in the rating agencies' best interests that investors have a good understanding of what ratings mean, and to that end, for example, agencies could publish expected loss distributions of structured products to illustrate the tail risks round them. Would you agree that is worth taking up? Mr Drevon: I think it is something that we would be ready to provide and we do provide in some cases. The problem is that the market also is looking for simple messages. If we start providing complex answers, very statistically based, I am not sure it will necessarily respond to the investor needs. Q1143 Chairman: Okay. The second one: agencies could provide a summary of information provided by originators of structured products. Information on the extent of originators' and arrangers' retained economic interest in a product's performance could also be included, and that may satisfy investors that incentives were well aligned or encourage investors to perform more thorough risk assessments. Do you agree with that? Mr Taylor: I think it is a call for the originator of the transaction, as opposed to us. What information is sent out to the market is really a function of the person originating that transaction. It is a confidential information issue again. We would be happy to see it. Q1144 Chairman: Agencies could provide explicit probability ranges for their scores on probability of default, and that would provide a measure of the uncertainty surrounding their ratings. Mr Bell: It is an interesting idea. I think the problem is that, expressing an opinion about the future likelihood of default, if you try to encapsulate it in a two decimal point percentage, it is probably providing spurious scientific fact. Q1145 Chairman: Agencies could adopt the same scoring definitions. Converging in a single measure would reduce the risk of misinterpretation by investors. Mr Bell: We take the view that there is benefit in having different agencies trying to encapsulate different risks because it provides a greater spectrum. Q1146 Chairman: So you do not agree with a single scoring? Mr Bell: No. Q1147 Chairman: You do not agree? Mr Bell: We do not think that it will help investors. Q1148 Chairman: Rating agencies could score instruments on dimensions other than credit risk. Possible additional categories include market liquidity, rating stability over time or certainty with a rating that is made? Mr Drevon: Possibly. We are looking into that. We are not sure if everything is feasible. Chairman: Those are suggestions from the Bank of England and I would suggest, given that they are from the Bank of England, the rating agencies should take this seriously and maybe, rather than set up a working party, come back with your views to this Committee on these suggestions from the Bank of England, and we will let you do that, so that we have that information in public as a result of your submission. That is all. Thank you for your evidence this morning. |