Banking Crisis - Treasury Contents

Examination of Witnesses (Questions 2400-2419)


26 FEBRUARY 2009

  Q2400  John Thurso: Following on from that, if I may, Governor, because you have said some very interesting things today, earlier on you told us that we need to be focusing on credit and burrowing and leverage as an important indicator. You talked about risk and the balance of risk and you talked—and this is something you and I have discussed before—about remuneration and how inappropriate it has been. You have also talked about the difficulty of finding regulatory levers for all of this, which brings one back really to whether this is not a question of culture and philosophy. The problem is that the City thought of itself as the masters rather than the servants of commerce, and that we have actually moved from the old-fashioned, traditional British banking model of 20 or 30 years ago to taking in a great deal of the American model, that greed is good and short-termism, and above all we need a return to a culture which is more of the old and traditional and less of the new. Is that not a fundamental part of the problem?

  Mr King: The one thing I would pick out from that that I think is very important is short-termism. I think the nature of banking is bound to change over time as the world economy develops and evolves, and banks are very different institutions now than a hundred years ago but what is very important is that I think this pressure, this incessant pressure to achieve quarter on quarter increases in profits cannot possibly make sense in an economy which itself is inevitably somewhat volatile. What it does do is to undermine the ability of managements to put in place credible long-term strategies for building up business. It is no accident that many of the companies outside the financial sector that I meet when I go around the country that impress me most are those that are not subject to the so-called discipline of quarterly reporting to the City and the judgement of analysts on that. I do think that you have to have some method of accountability of managers to the owners of the company. It is not an easy system to devise and make work but the short-termist response I think has been damaging.

  Q2401  John Thurso: Can I put a point to you, and it goes from culture into the whole concept of what is being called narrow banking and the Glass-Steagall. This is something we have discussed and I put it yesterday to Lord Turner. It seems that there are quite a lot of very intelligent commentators and witnesses who favour a return in that direction. He said himself that whilst he saw the validity of the argument, he was not convinced by it at the moment. Is not the problem that, if you go back to risk, risk itself is not bad? Zero risk equals zero return. Taking measured risk, and it is the measure bit that is important. The culture that is required in the whole investment banking side is a riskier culture, giving greater rewards. The culture that should be in clearing, retail banking is a culture that is more prudent, and the problem is that it is the joining of the two cultures rather than any institutional problem that is really at the heart of the problem there. What are your views on that argument?

  Mr King: I think you have summarised the nature of the problem well, and I think the difficulty is that if you try to legislate to have two kinds of banks, you cannot legislate to have culture A in one type of bank and culture B in the other. All you can do is try to define it by types of activity. Instinctively, I find the narrow bank idea very attractive but the argument that is put against it, which I have reluctantly over the years come to accept has some real validity, is that if you try to restrict deposit protection and regulation to the narrow banks and say to people that if you put your money into a narrow bank it is safe whereas if you put your money into a wider bank, you take your own pot luck, the problem is that the wider banks, precisely because they are not regulated, will be able for most of the period to offer higher returns, and many depositors will not be strong enough to say to themselves "I don't think this is really prudent in the very long run. I will stick with my narrow bank." They will switch their deposits to the wider bank, those banks will be less well regulated, they will expand much more rapidly than the narrow banking sector, and indeed, they will become so big that when the crisis does come, the government will be forced to step in for concern about what will happen to the economy through a collapse of these big institutions.

  Q2402  John Thurso: Following that through, a point that is often made—and I remember we discussed it in June—is that we do not want to stifle innovation. As they say in Scotland, "I hae my doots about that one," because innovation has got us where we are, one might argue. There is a view that a certain amount of innovation is actually quite good but there is an element within the whole financial market that you do want to act in that way. At the same time, that whole element of trust and confidence which is so important is required for the everyday banking. Should we be saying that if you wish to engage in the taking of deposits, you will be regulated on your leverage at a far higher degree than if you wish to forego that and actually operate in the other areas? In other words, can we disaggregate, as we have so often said here, the money utility from the casino?

  Mr King: I think is worth having a serious debate about this. My concern is not about the objective or the desirability of doing it. My concern is about the feasibility of doing it, because I think that what you call the casino type institutions will eventually find it quite easy to create deposit accounts into which people will find it very attractive to put money and it will be very hard to stop that. That has been the nature of the problem so far, that where you have two types of institution—in a sense, we have been through this for a very long time. If we go back to the 1970s, there were licensed deposit takers, there were unlicensed, there were some kinds of banks and second-tier banks. We have always struggled with these boundaries and in the end the trouble is that the bit that is not regulated very much always grows very rapidly because it can offer higher returns, and in the end enough people have their savings in those institutions that you and other parliamentarians feel we cannot just abandon them to their fate, because they did not decide what the risks were in these institutions. They were not really knowledgeable about what was going on, and these institutions are so important that, for systemic reasons, we have to rescue them. That is the problem, I think, and it certainly goes to the heart of the danger of having too big institutions.

  Q2403  John Thurso: It is not just about investment bankers at one end and retail bankers at the other. In the middle there are these guys who are playing roulette with weird instruments. If you look at long-term capital management and its collapse in 1998, it was basically all the arbitrage guys, who had made all the money, who then lost it, and of course, that was headed by the same team as the guy who was booted out of Salomon in 1992 for having done exactly the same thing. How do we get that lot out of the rest? Does it actually perform any function?

  Mr King: I am not sure if that would solve all the problems because there are plenty of imprudent and risky decisions that banks make which are not of the kind that require a degree in higher mathematics. Indeed, as someone said not so long ago, it is amazing that banks go to such trouble to find new ways of losing money when the old ones seem to be doing perfectly well, thank you. Look at all the losses in HBOS on commercial property lending. It takes us right back to the late 1980s/early 1990s, when a lot of money was also lost on commercial property lending. I think very high leverage inevitably entails significant risks. That is why banks are risky institutions.

  Q2404  John Thurso: So what we are back to is that we just legislate and say, "That's it. You can't leverage that much. End of story."

  Mr King: I think it is difficult to say there is one simple answer which means, if implemented, we can go away and forget about the problem. That will never be the case. When you get to a period in which—whether you call it the word culture or whether you call it the prevailing degree of animal spirits, that people are willing to take risks, then there are likely to be problems, and it is difficult to know whether you should stop them in terms of legislation or whether you should try to advise people and draw their attention to the risks. What would you have said, for example, to the young woman I saw on television some years ago saying, "I have decided to give up my company pension fund because shares go down in value and I have taken out a 100% mortgage to put all my money into a buy-to-let flat because houses only ever go up in price"? That is a very risky decision. Do you want to legislate to say that someone cannot do that of their own free will if they want to, or do you try to find a way of advising them not to, or do you in the end say that they have to accept the consequences of their own actions? These are not easy questions.

  Q2405  John Thurso: That is a good point. Is there not a significant difference between allowing one person, whether it be me or the lady on television, to make a catastrophic error of judgement, which is my problem and not the nation's, and allowing a number of large institutions and a system to take some catastrophic errors of decision which actually bring the country down? There is surely a difference between the two.

  Mr King: There is but of course, one of the most remarkable things about this crisis—and let me take Citibank as perhaps the best example here, the biggest bank in the world. When we went to New York four or five years ago all the banks in New York were saying "We will probably have to follow the Citibank model." "That is the question: do we follow the Citibank model?" Who were the people running Citibank? Some of the cleverest and brightest people you can imagine, with a wealth of experience in Wall Street, in government, in investment banking, in academia and in emerging market debt crises. They knew a lot about what had happened in the past. It was not in their interests to take risks that would turn catastrophic later on. They did not set out to destroy Citibank but they were as aware as any regulator of what they were doing and what the risks were, yet the outcome was a disaster for the bank. They did not intend it, and it is very hard in this situation for those kinds of institutions ever to guarantee that you can avoid what, once in a generation, looks like a catastrophic outcome. That is the challenge we are facing. How do you decide the infrastructure and legislation around institutions to trade off their ability to innovate and create new financial instruments and to avoid the catastrophic risks that can occur when things go badly wrong? I do not think it is easy to do that. I think we have to try. We have to learn the lessons from this and try to improve the system but, as I said in that speech in 2007, are we really so much wiser than the financiers of the past? Do we really think that we are going to come up with the answer that will prevent hundreds of years of banking crises, suddenly come to a halt? No, we are not going to be able to that. We can try to make it less likely, we can try to diminish the damage, we can try to get into a position where we can deal with the consequences more easily, but these are really fundamental questions about the nature of risk-taking in a market economy.

  Q2406  Mr Love: Governor, can I come to the Asset Protection Scheme? There has been some concern expressed by the banks that to pay the insurance fees related to the protection scheme will either cause further significant dilution of their shareholdings or lead to—and the words that are used are—"creeping nationalisation." Are you concerned about that?

  Mr King: I do not think in first order I am particularly concerned about that. I think the banks need to have this protection scheme and I think the taxpayer is entitled to take their share of the returns if they put in money to underwrite the balance sheet. The person who has been working most closely with the Treasury on the design of this is Mr Bailey, so perhaps he can comment.

  Mr Bailey: I would just echo the Governor's point that I think the taxpayer is entitled to expect that when the banks come out of this situation—which they should and will—when they recover, the taxpayer will be able to recover the amount of public money that has been put in.

  Q2407  Mr Love: Can I interrupt you? I do apologise. In relation to the Royal Bank of Scotland, it was widely trailed that the level of fees would be 4%. It has turned out to be 2%. Are you surprised at that decision?

  Mr Bailey: There are a number of variables in the equation by which you arrive at the overall outcome, of which the level of fees is one, and the so-called attachment point, which is the level of the first loss that the bank bears and the level of loss beyond that that the government shares with the bank, but in a ratio that is heavily towards the government, so you have to look at the whole thing to get the essentials of that.

  Q2408  Mr Love: Let me look at the whole thing. According to the scheme, they are taking on what the public certainly think—I do not know what the Bank thinks—are very high-risk assets: collateralised debt obligations, collateralised loan obligations, and included within this, the first loss, according to the RBS, is roughly 6% of the overall assets included. The residual exposure is 9% so the total bank exposure is 15% of the assets. That leaves a potential maximum of 85% for the public purse. Clearly, that will not all materialise but are you concerned about the balance that seems to be being struck in this deal?

  Mr Bailey: The balance that is being struck is the one that has to be struck to get the bank to a position where it is stabilised. Let me be clear. The amount of the pool of assets that has been announced is £325 billion. We do not expect £325 billion of assets to go bad. The whole exercise—and it is subject to the point the Governor and I made earlier about the need to do this very thorough due diligence over the coming period—is to isolate those pools of assets where the losses are most likely to be.

  Q2409  Mr Love: Can I stop you there because I want to come to the due diligence point in a moment. According to the scheme, the Government will charge £6.5 billion. It is providing an additional £13 billion of further capital and a potential further £6 billion. That is £25.5 billion potentially of additional capital. Does that not mean that in effect RBS has been nationalised? Governor, I would like your views on this.

  Mr King: I am not going to comment on the details because we did not get them until quarter to nine this morning. What I will comment on is the principle of this, which is that most of the major banks do need a very significant support, and in the case of RBS and Lloyds, that support essentially amounts to the Government putting in a majority of the base equity capital that is needed. In that sense, the Government owns more than 50% of the equity of the bank and it can make its decisions accordingly. I do not see a significant difference between that and outright nationalisation, except in the sense that the system we have now, which is that the Government puts in money and take shares, has the great merit of trying to make clear to everybody, particularly in the rest of the world, that nobody thinks that the Government should be involved in running these banks indefinitely and that the shares will be put back on to the private market and the banks will be back in the private sector. I think avoiding the actual process of formal nationalisation has great merit from that point of view but the economic substance is clear: the taxpayer has had to put in so much money to ensure the viability of these banks that it is now contributing a majority of the equity capital as well as a vast amount of public support in terms of lending to the banking system.

  Q2410  Mr Love: Can I just quote briefly from the press release, because it comes to a point that you raised earlier, I think in a response to Mr Cousins. It says, "In determining the pool of assets, banks will be subject to extensive due diligence on the identified assets." I would interpret that as meaning that we are at the start of the process rather than either halfway through or near completion. We do not want to get into semantics about that but are there any concerns that the due diligence process will take so long when we really need to get on with re-establishing trust in the banking system?

  Mr King: No, but the point I have been making very strongly to the Chancellor now is that you have to take the time to do the due diligence. The fact that we need to do something to shore up the balance sheet of the banking system—and that has to be done quickly, I accept—is not a reason for not starting the process of due diligence. You have to start it at some point in order ever to complete it. We have to do that. It will take time. They have already started it and have got some way down the road. This is a continuation of a process that has already begun, but it is vital, as you suggest, that the underpinning of that balance be put in place now, without any ambiguity, so that anyone that is thinking of lending to a bank will be able to do so secure in the knowledge that the capital position of that bank is completely secure, underwritten by the Government, and that the bank has access to the credit guarantee scheme to fund its lending. Only in that state can we possibly expect banks to start lending again.

  Q2411  Mr Love: Can I take you a step further? Although bad banks have been rather cast in a shadow because of the real difficulty of pricing the assets at this particular time, there is a lot of people that think that the insurance scheme, which is being replicated, I think, in other parts of the world, is only a first step towards a bad bank. What is your view on that matter?

  Mr King: I think the Chancellor has been clear on that and wishes of range of options. The important thing to do at this stage was to start the process, which had already begun, and began before today, of examining the balance sheet, underpinning the capital position of the bank. Once we know what the balance sheet is like, then it is possible to think about how you would price assets, whether you want to split the bank into good bank, bad bank. There are a range of options that will become available at that point but you cannot wait until that point; you cannot do nothing; you have to underpin the balance sheet now. A split between good bank/bad bank is certainly a feasible option down the road. That remains to be seen. The differences between that and insuring assets are a matter of degree; they are not qualitatively different.

  Q2412  Mr Love: From the sound of things, you are attracted by the idea that when we get further down the road, when we know better what the shape of these assets is, a bad bank purchase scheme may be the sensible way to go.

  Mr King: I am not sure if I am keen on the taxpayer rushing in to buy assets without knowing what the price is. That is why we have to wait for the end of the process. At the end of it, I am certainly attracted by a process that cleans up and restructures the bank's balance sheet. That is absolutely vital. That was the lesson from earlier banking crises. We have got to get to grips with this and realise that balance sheets have to be cleaned up, and only at that point will you have a good bank that people will have confidence in and can return to normal. The sooner that happens, the better but we have to be prepared to take the time to do the forensic analysis of the balance sheet first.

  Q2413  Chairman: Thank you. Paul Tucker, with regard to the financial stability responsibilities, how many extra staff have you taken on or are you taking on?

  Mr Tucker: We are taking on just over 20 staff to run the special resolution regime and half a dozen to support the payment system oversight function, because that is being put on a statutory footing. That is where the increase in resources is being focused so far.

  Q2414  Chairman: Are you content with those arrangements?

  Mr Tucker: In terms of the new statutory functions, I am content. Andy's area has expanded somewhat over the past year beyond that but, as I said in my written evidence to you and in my confirmation hearing, this is something that I shall want to look at with the Governor and with Andy, Andrew and other colleagues, as I get my feet under the desk.

  Mr King: The financial stability area has already increased by around 20 people over the past year. We have done that already in large part.

  Q2415  Chairman: Governor, just on the bonus aspect, is there a bonus or performance-related pay structure within the Bank and are the lower paid staff on the same scheme, with the same conditions as the senior staff?

  Mr King: Yes, some years ago the Court of the Bank decided that it wanted to increase the proportion of remuneration that was offered in the form of performance-related pay, and this is related not to financial performance but to very clearly defined objectives, set for each member of staff at the beginning of the year. We pay something like 7% of the total compensation in the form of a bonus. The same scheme applies to everybody apart from the Governor and two Deputy Governors, for whom there is no bonus at all.

  Q2416  Chairman: Why is it you can get out of your bed in the morning without a bonus and the rest of the banking industry cannot, without getting ten or 20 times their basic salary?

  Mr King: You would have to ask them.

  Q2417  Chairman: You are quite happy to get out of your bed in the morning for a basic salary?

  Mr King: I am extremely well paid and I get out because I love the world of public policy and I enjoy it.

  Q2418  Chairman: The issue of bonuses, certainly from the evidence we have received so far, is that there is a recklessness about the situation, because they are dealing in the short term, dealing with other people's money but, irrespective of success or failure, they are rewarded.

  Mr King: I think there are jobs and jobs. One of the things I found somewhat distressing about the lives of many people who worked in the City was that so many of them thought that the purpose of a bonus and compensation was to give them a chance to leave the City, to do something they really wanted to do, having built up enough money to give them the financial independence to do it. I think that is rather sad because actually, there is nothing more rewarding. I am well paid, make no doubt about it, and so are most people at the Bank compared with many ordinary people around the country. Having more money is not going to motivate us. We enjoy the job. We are privileged to have this position. It is that which motivates people to work. That is why people in the Bank worked all night and all weekend when Bradford & Bingley was resolved without any overtime payments.

  Q2419  Chairman: Governor, the Financial Times this morning said that you were going to announce at our Committee the contents of your letter to the Chancellor requesting permission to start quantitative easing. I have not heard anything of that so far.

  Mr King: No, I have not read the Financial Times yet. I must find out. I always find it helpful to follow the media to know what we are going to be doing.

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