Banking Crisis - Treasury Contents

Examination of Witnesses (Questions 2360-2379)


26 FEBRUARY 2009

  Q2360  Sir Peter Viggers: Do you share my incredulity that so much public money has been spent trying to rescue the banking organisations without more closely identifying the good assets from the bad assets? The parallel being Lloyd's of London which tried to deal with this matter by creating Equitas and relegating toxic assets to that area. I have had many discussions on this and felt that this was an area that was going to be examined but nothing seems to have been done.

  Mr King: There are two aspects to this. One is how the money has been spent and has there been an adequate investigation into the balance sheet. I do not think it is fair to say that the money has been spent in a way that is irresponsible because we did not understand the deep nature of the balance sheet, because so far no-one has been buying assets of an unknown value. The schemes that have been put in place have either been lending to banks with significant margins of collateral which have protected the taxpayer or injections of capital where the taxpayer has acquired ownership in the institution. I do think it is a shame that we do not have already a detailed examination of the balance sheet of the major banks and this needs to be done independently. It is no accident, I think, that the United States announced yesterday that is what they are going to do with 19 large banks. The equivalent number of banks here would be about four or five. We need to do that in order to get to the bottom of it. One of the problems, of course, is that a year ago people used the phrase "toxic assets" as if they knew what toxic assets meant. They thought toxic assets were anything related to sub-prime mortgage lending. Unfortunately, the assets which are generating losses now go way beyond that. The downturn in the world economy means that this distinction between toxic and non-toxic is a lot more elastic, so it is important to keep monitoring the balance sheet because the scale of potential losses keeps changing and at some point it will go down. Some of these losses may yet be written back into balance sheets once the world economy starts to recover. We are where we are and what is important now is that for this limited number of major banks we have a detailed independent asset-by-asset audit of what actually is on the balance sheet because only then can the Government really work out what is the appropriate price to pay for insurance or price to pay for the assets or how can you split a bank between "good bank/bad bank" and work out how much the taxpayer should be willing to invest in, say, the "bad bank".

  Q2361  Sir Peter Viggers: The amounts involved are so very large it still astounds me that more was not done in terms of analysis months ago. For the Royal Bank of Scotland, as I understand, six-sevenths of the losses are incurred in financial areas outside the United Kingdom. We had the most extraordinary situation of British taxpayers writing off some 2.5 billion which was finance advanced to a Russian oligarch. I find it quite extraordinary that more has not been done.

  Mr King: It is deeply shocking. All of us took pride in our banks being successful international banks and if you are a successful international bank you are going to be lending overseas and this is the consequence of it.

  Q2362  Sir Peter Viggers: Returning to the discussion we had about under-lap and overlap, and I think it was Lord Turner quoting Paul Tucker in evidence before us yesterday, if you are to have your revised contribution, a different pair of eyes looking at financial structures, do you have the resources to do that? Are you satisfied that you will have sufficient financial resources?

  Mr King: We put to the court of the Bank recently a revised budget which included significant increase in resources for looking at banks, for understanding financial stability, and that will be published in our annual report later in the spring, so you will see that. We have not gone in for expansion on the scale of the FSA, but then we are not responsible for looking at the details of individual banks. We are responsible for forming a broad view. My feeling is if you look back at the lessons from this, the most important lesson is to think big, stick to first principles. If you had just looked at the details of what banks were doing I think you would have got very misled. It is somehow just saying, "What on earth is happening to the scale of lending and the sheer complexity of instruments?" It is simple questions but where people must not be afraid of the answers, and I think that means very talented, very experienced people who are willing to speak out and that is not easy. It is not numbers here. The Americans had tens of thousands of people involved in monitoring their financial sector but it did not help one jot. It is not numbers, it is quality and the willingness to sit back and most of all take an independent view. It is no good being subjected to regulatory capture. This is a point where we have got to be willing to say, "What is going on in the City is not in the nation's interest" and that is not something which many people have asked the Bank of England to do in the past.

  Q2363  Sir Peter Viggers: You have described the loneliness of the regulator who might perhaps in 2006 or early 2007 have blown the whistle and taken the music away while the party was going. If anyone is to fulfil that lonely role, it must be the Bank of England, must it not?

  Mr King: It is the regulator as well. I suspect the challenges that they will face will be a lot easier over the next ten years and it will be many years before banks have forgotten this episode and have got themselves back into a state of mind where everyone starts to think that it is acceptable to take more risks and then we will go back in the cycle again. The real challenge is to build into the institutions something which bequeaths to our successors our institutional memory of the dangers of relaxing regulation too much and of not having a framework which builds in some sand in the wheels to a rapid rate of expansion.

  Q2364  Sir Peter Viggers: On learning the lessons, are there any common features which distinguish the business models and practices of the survivors amongst the banks as opposed to the slain?

  Mr King: Lower leverage. Most financial crises in the past have been characterised by excessive leverage, borrowing, debt, and that has been true here too. I made that point in my Mansion House speech in June 2007 and was booed for making that point. I asked the question rhetorically. I said, "Are we really so much wiser than the financiers of the past?" The answer is we are not. It is excessive leverage. If you want a lesson from the regulatory area, one of the big lessons is that we developed a very sophisticated approach to regulation based on the models which firms themselves were using. You could argue about whether the models were accurate or not and in good times it did not actually matter very much whether the models were right or not, you got it approximately right, but what did matter was that when times were unexpected and things went badly wrong the models were useless and yet regulation was based on it. A simple approach to saying that any institution whose leverage ratio is above a certain number should be subject to much more detailed supervision might well be a step forward. It is not just restricted to banks, but it is mostly banks. Banks were the most leveraged institutions. One of the reasons why I think the UK authorities have tried to persuade our European partners not to get so excited about hedge funds is that hedge funds were not the most leveraged institutions, the banks were, and it was the problems that arose at the heart of the banking system. 40 years ago if you had asked any of the clearing banks coming before this Committee what fraction of their balance sheet was in liquid short-term assets they would have said about a third and the answer now is 1%. There has been a massive change in the balance sheet structure of our banking system and it is not surprising, therefore, that you make more money in banking doing that because you are using the assets in a riskier form and most years that generates a higher return, but it means that when things go wrong the costs are so much higher, so excessive leverage is the common theme. I do not think it tells you exactly what you would do as a result, but that is something we should remember and build into the system.

  Q2365  Mr Breed: Governor, you indicated a little while ago that you bemoaned the fact that you did not have a detailed enough information analysis of the banks' balance sheets and so on. Do you have a detailed enough assessment of the Treasury's balance sheet bearing in mind everything that has been piled on it in the last few months, not least, of course, today's announcement in respect of the Asset Protection Scheme? Are we moving towards considering whether UK plc ought to be put into administration?

  Mr King: No, we are not. I understand from a political perspective that you may want to make that point, but I really do think that is a wild exaggeration. For some reason that I have never entirely understood, the Office for National Statistics has decided that when the Royal Bank and Lloyds are added to the Government's balance sheet that they add the liabilities but not the assets, apart from the very short-term assets. That gives a wholly misleading impression. The debt that is incurred as a result of putting money into or lending to banks is not the same as debt that is incurred by spending money on goods and services where the whole debt is there to be repaid out of future taxes. Much of this additional debt will be repaid by selling the stakes in the banks or repayments of the loans that the public sector as a whole has made to these banks. Even if you were to take the view that these banks have absolutely no assets at all, which would be an absurd view in my view, the increase in national debt still leaves us way below the levels at which Britain emerged from the Second World War and we coped with that. I do think that public debt matters. We entered this crisis with levels of public borrowing which were too high and that made it difficult, but we have not actually engaged in as big a fiscal relaxation as many other countries in recognition of that fact. The Chancellor has very clearly recognised that there will need to be a path of fiscal consolidation in the future and it will take time and it will not be very comfortable, but we will have to do it. It is a million miles away from saying that we will need a path of fiscal consolidation to saying that the UK is like Zimbabwe where we should go into administration, that is wholly irresponsible, and I know you are not suggesting that.

  Mr Love: He was suggesting that!

  Q2366  Mr Breed: It was an opportunity for you to give that confident reply and I think it is important that we do realise that. Having said that, might not we get to a situation where the banks may well have come out of this situation long before the taxpayer?

  Mr King: There is no doubt that part of the process here in order to help the wider economy is to get the banks back into a position where they are recapitalised and can start to lend again and operate as normal—

  Q2367  Mr Breed: Business as usual.

  Mr King: —well before the level of public debt will have come down to the levels at which we started, absolutely. The burden of this will take time.

  Q2368  Nick Ainger: Governor, it is recognised and you mentioned earlier about the complexity of the financial instruments which led to lack of transparency, unscrutinised risk and this was a major contributor to the current crisis. In his evidence to us Dr Danielson suggested that one way of addressing the issue of complexity and lack of transparency in the market efficiency with all these instruments was actually to end the over-the-counter trading of these instruments and actually put them across exchanges. Have you done any work on that? Is any thought being given to that within the Bank?

  Mr King: Yes, there has and I will ask Mr Tucker to reflect on this in a minute. The one point I would make to you at the outset is the key thing from our point of view is not so much that trading takes place on an exchange because there are many instruments, but it would be desirable for people to be able to transact if they wanted to but do not generate enough business to justify an exchange. What does matter is a clearing house so that we actually have a register of how many transactions there are, a method of ensuring that those who engage in liabilities on one side are clearly matched on the other side. One of the problems of Lehman Brothers failing, and it still is going to take many months to sort out the details of many of those contracts, was a most extraordinary outcome really that all these contracts were not done through clearing houses in a way that would enable the counterparties to get out of it. I think clearing houses rather than exchanges is the key from our point of view. Let me ask Paul to take that forward.

  Mr Tucker: I think the Governor has made the big point. Stepping back a second, if we are going to have a financial system, domestically and internationally, in which the capital markets play an important role, and I cannot foresee that going away and in that sense we are going to continue living in a very different world from the world that prevailed 30 or 40 years, then we have to ensure, and the authorities have to take an interest in the integrity of the functioning of those capital markets. I imagine that was the starting point for the evidence you received earlier. I think, in a way, the authorities across the world have perhaps been too timid on that front over the past 10 or 15 years because often for the banks and dealers, at least at desk level if not at CEO level, they will be slow in developing central infrastructure because it will tend to reduce the margins that they make on individual pieces of business. We should take an interest in that area. I absolutely agree with the Governor that the key part of this is central clearing houses. First of all, a health warning about that. What central clearing houses do is they bring all the risk into one place and, therefore, it means that the risk integrity of the clearing house, there is nothing more important. They are more or less invisible but if one of them gets into trouble, and perhaps over history two have got into trouble, capital markets more or less shut down. That is manageable provided the regulators and the central banks are on top of it. There is a debate now about whether credit default swaps should be cleared through a central counterparty, a central clearing house, and I think that they should. There is a debate about whether it matters whether it is in the EU or in the euro area of the EU or the UK or the States and it is a great shame that is intruding into that debate. What matters is that the global marketplace should get pieces of infrastructure that work and have integrity. There is potentially a role for exchanges as well. Clearing houses can ensure common margin standards, common valuations and greater transparency. Exchanges can do something else as well. For the most vanilla instruments they can preserve a little bit greater liquidity. It has been quite striking that during this episode the equity markets have been incredibly volatile but have not frozen at any point. If you go back to 1987 when the equity markets did freeze, they recovered rather more quickly than the over-the-counter markets have over the past year or so. Yes, we will be interested in this area.

  Q2369  Nick Ainger: Everyone is agreeing on this.

  Mr Tucker: Yes.

  Q2370  Nick Ainger: I think the FT carried an article that the Governor of the Bank of France is arguing within the Eurozone that perhaps Paris should be the centre of this clearing house and so on, but who is actually taking this forward? Everyone seems to agree that it is a good idea but who is actually going to make it happen?

  Mr Tucker: There are various industry groups pursuing it. The ECB, the Banque de France, the FSA, the New York Fed and the Bank are all involved in this. As you say, there are issues about cities and so on but those should be second order.

  Q2371  Nick Ainger: Thank you. Can I move on now to remuneration. Governor, a year ago you told this Committee: "I think that the banks have come to realise that they are paying the price themselves for having designed compensation packages which provide incentives that are not in the long run in the interests of the banks themselves and I would like to think that would change". That was 12 months ago. In October, Hector Sants wrote to the chief executives of the banks making a similar point. Judging by the announcement last night and this morning that Fred Goodwin is going to receive a pension of £650,000 a year for life from a pension pot of apparently £16 million from a bank which he led to a situation where today they have announced these huge corporate losses, has anybody been listening to what you said 12 months ago?

  Mr King: Apparently not, but, as I said, we used the power of words, I made the point. The FSA did respond by saying that they would take this up and I think you will find that in the future the design of compensation packages will look very different because boards and management of banks will realise that it is not in their own interests to offer these packages. The real question about the pension for Fred Goodwin is not a debate now about whether you should undo a contractual entitlement, the real debate is how on earth was it that at the time shareholders, boards, the financial press, all thought it was a great idea to reward people in this way. These bonuses were absolutely astronomic. It was a form of compensation which rewarded gamblers if they won the gamble but there was no loss if you lost it. It is obvious that if you do that you will give incentives to people to gamble.

  Q2372  Nick Ainger: Everyone is talking about trying to restore confidence but this sort of event undercuts and undermines that confidence in the system.

  Mr King: What undermines it, I think, is the way people behaved in the past.

  Q2373  Nick Ainger: Do you think that Fred Goodwin should announce that he is going to take far less than that £650,000?

  Mr King: I am not going to jump on the bandwagon of a rather unappealing sort of vengeance, to be honest. He will have to think about his position, and others will. The real question here is not whether he is entitled to his pension, which I presume is a contractual entitlement, although I do not know the facts so I am not going to comment on that, the real question that we should be concerned with here is how was it the case that everyone thought that it was a good idea that executives be rewarded in this way. This is not just Fred Goodwin, it is not just banks, it is compensation in general where the executives at the very top have earned vast amounts of money beyond the dreams of ordinary people for doing a job which it is very hard, I think, to say justifies that kind of bonus because you can never impose a downside.

  Q2374  Chairman: As a Committee we are well aware of the utility element where in the branches you get people with 10% of their bonus on salaries of £15,000 or £25,000 a year and they deserve that, so we are aware of that segmentation element, Governor.

  Mr King: Exactly.

  Q2375  Mr Tyrie: Just on Sir Fred, would you be prepared to just go a small step further, as Governors used to do, and raise your eyebrows to the point that you are feeling that he should voluntarily consider a response to the criticism?

  Mr King: What I would much rather do is to spend my time here with this Committee trying to work out how we can reform a system that created something where you are drawing attention to only one individual case. You cannot blame one individual for the failings of a system and that is what we should focus on.

  Q2376  Mr Tyrie: I agree with that. I think you have made a number of very thoughtful remarks today. You have talked about the power of words. When I was last on this Committee I asked your predecessor to use the power of words to do something about the developing asset price bubble. This was in the context of the house price boom, which had already begun and was already 25-30% above its long-run trend. This is in 2002-03. I pressed your predecessor vigorously in order to try to persuade him to use the power of words and I have in front of me what he responded: "We are not expecting a boom-bust in the housing market. That is not what we are forecasting. I could envisage circumstances in which we might forecast that. That is not our judgement at this point." The problem is, is it not, that although privately there were a number of people in the Bank who were prepared to talk to me about this, publicly, it was extremely difficult to get anybody to use the power of words in the way that you yourself suggested this afternoon might in future be appropriate. What confidence can you give us that you are going to come out of the traps earlier?

  Mr King: Let me explain the nature of the problem. I did speak about house prices. I gave a speech in 2005 which had quite a big impact; it was all over the front pages of the usual tabloid press. I got a lot of letters saying "How dare you talk about house prices! I have failed now to sell the house I was on the verge of selling." There were a lot of comments that I should not be intervening and making comments about house prices but I did. It had an effect for a few months and then went away. I think one of the difficulties is to know how to judge this balance between not being seen to be scaremongering and being seen to present a realistic view of risks. We have the same problem now in talking about the state of the economy. Every time I give a speech on the economy I get a large number of letters from people who say, "You shouldn't talk down the economy. Your job is to talk it up, not talk it down." Then I come, and you very rightly say, "Wouldn't it be better if you gave a realistic view of your own judgement about the balance of risks?" The difficulty at the heart of it is that none of us know. Somehow people seem to think that we should know whether house prices are going to go on up or whether they will crash or whether share prices will rise, or whether the exchange rate will fall. We cannot do that. I think all we can do is talk about the balance of risks and the limits of our knowledge. Ever since I have been coming to this Committee, which is a long time now, I have always said in answer to many questions "I don't know" because there are many facts about the future I simply do not know, and we have to admit that ignorance and just talk about the balance of risks. I think my predecessor tried to do it. Every speech I have made since the inception of the Monetary Policy Committee has some reference to the need for the UK economy to rebalance, that rebalancing would be necessary, but I have no idea when that will be or how it will come about and I could not anticipate that.

  Q2377  Mr Tyrie: In a separate exchange with me your predecessor also said that he did not have the resources to collect the necessary information. This is a point that you have alluded to indirectly with respect to bank liquidity, that you have no power to demand that information from banks. He also said that he did not have enough staff, or he implied that he did not have enough staff to collect this stuff. There was a reduction in the number of staff in the Bank dealing with this area. Is that now being rectified?

  Mr King: It is but I have always been baffled as to why it is that when I come and talk about managing areas properly, Members of Parliament say, "Why don't you spend more money on it?" I thought most of the time we should be trying to make sure that we run our organisations efficiently. It is not numbers that matter here. We have well over 100 people working in this area of financial stability and always have had. We have made a change to that by increasing the numbers given our new statutory responsibilities for special resolution framework, for regulating payment systems and, over and above that, for the work that we will do in monitoring banks given our statutory objective, but I go back to it: I do not think adding numbers in itself solves the problem and I do not believe the difficulties we faced in the past ten years have anything at all to do with numbers. The ability to understand whether or not the housing market would crash, whether or not the stock market would continue to go up or not is not a question ... You cannot hire an extra 50 people and say, "Go and find out the answer." It is not that kind of question.

  Q2378  Mr Tyrie: Governor, your comments on the limited utility of both regulation and committees is well taken and that is more or less what you are saying. You made a very interesting speech, and you have already referred to one of the points, on 20 January about how to deal with asset price bubbles in the future, in which you talked about the additional policy instrument to stabilise the growth of the financial sector balance sheet, which you alluded to a moment ago. But in response to George Mudie and others you have not taken that very far forward. I wonder whether you could—not necessarily today—take it forward and commit to producing an early paper on this which you could submit to the Committee.

  Mr King: Absolutely.

  Q2379  Mr Tyrie: It would be setting out a number of things, if I could go through the things. First of all, we have to find a way around the international problem you have described, that you could be undermined by another bank abroad deciding to ignore those levels of capital requirements. Secondly, you have to do something, in my view, and make a proposal about who is in charge. One of the problems that we have had in this whole area is we have had this tripartite committee without the public, and the informed public, including the City, having the confidence that one person is in charge. Would you be prepared to come forward with a proposal on that, setting out what the structure should be? At the beginning you were reluctant to. In fact, I did not write it down but I think you said something to the effect that you did not want to get into too much detail about who should run it—I think that was the phrase you used. Perhaps you could also reflect on how Basel II has illustrated some of the weaknesses of trying to get international agreement and how we can go forward with this particular proposal, bearing in mind that experience.

  Mr King: I will be very happy to do that and no doubt in our speeches as well we will be contributing to the debate, and I am happy to discuss that with you. I want to try to distinguish between some different areas here. In terms of trying to prevent the build-up of leverage and the growth of credit in the economy, it really is the amount of credit, borrowing, that you need to focus on and that, I think, is a question of trying to devise instruments which will go directly to the heart of the total lending by the banking system. That is one area. I think that is different from asset price bubbles, and I would like to give you an example as to why my predecessor and I both share the view that it is quite easy to talk about asset price bubbles but very, very hard to know what to do about it. In the early days of the Monetary Policy Committee there were those who said, "There is an asset price bubble stocks. These prices of shares are rising rapidly. This does not look sustainable. What on earth are these companies? Where are the assets? Why don't you raise interest rates to lean against the wind in the bubble in the dot-com market?" Then some other people said, "Hang on a minute. There is also an asset price bubble in the exchange rate. Sterling is too high. No-one quite understands why sterling is so high against the euro. It is damaging the export industry. It is not sustainable so we ought to lower interest rates in order to deal with that asset price bubble." Well, we only have one interest rate. You cannot have different interest rates for different asset price bubbles unless you go back to the system which existed in the old days, with segmented capital markets and margin requirements for all those who want to buy stocks and so on.

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