Examination of Witnesses (Questions 20-39)
PROFESSOR ALAN
MORRISON, DR
ANDREW LILICO
AND DR
KERN ALEXANDER
23 JUNE 2009
Q20 Mr Fallon: But do the other two
of you agree that it should be done through Brussels or through
the Basel framework?
Professor Morrison: I am not sure
that it is feasible to do everything through Brussels, even if
it were desirable. I presume when you say "what is being
proposed', you are referring to the de Larosie"re Report
and one of the things that de Larosie"re suggests is this
European systemic risk council which would have the power in disputes
to apply binding decisions to the parties involved, and de Larosie"re
himself has acknowledged that that is going to involve sometimes
overriding macro-policy at the national level. This seems to me
to be a hard thing to accomplish for an institution that has not
got tax-raising powers and so on.
Q21 Mr Fallon: It may be hard, but
is it right, Dr Lilico?
Dr Lilico: I think that always
and everywhere the proper prudential regulator is the Central
Bank, so I would have a eurozone both micro- and macro-prudential
regulator which was the ECB and the European system of central
banks. At the UK level, it would be the Bank of England and, in
other Member States with their own currencies, it should be theirs,
so that is the way, I think, it should be done and the logic of
the current system is connected. The reason why that is not the
route being pursued is connected with the idea that the long-term
destination of the EU is that there should be a single currency
throughout the EU and that, because there remains that commitment
by all the EU Member States, it, therefore, seems logical that
you should have one European regulator.
Q22 Ms Keeble: I want to ask you
a bit more about the macro-prudential tool and the working of
it, and perhaps particularly Professor Morrison because I think
you advised the House of Lords Economic Affairs Committee on this.
What, do you think, would be the most effective tool?
Professor Morrison: It is hard
to say and I think we should not rush to judgment because we do
not have to get this right in the next fortnight, but I suspect
that the two most useful tools are likely to be one or a combination
of either capital requirements that flex with the economic cycle
or lending ratio limits, so loan to value ratios in the housing
market or loan to deposit ratios in the banking sector. If you
look at loan to deposit ratios in the banking sector over the
last seven or eight years, they expanded very rapidly, particularly
in institutions which have subsequently got into trouble, and
these are the big macro-indicators that one could predicate rules
upon.
Q23 Ms Keeble: The big debate, apart
from what the tool is, is who wields it. In the Economic Affairs
Committee's Report, the power would shift to the Central Bank,
which is what Dr Lilico also says. Is that your view and can you
justify it?
Professor Morrison: The decision
to use a macroeconomic tool, a macro-prudential tool, is something
that requires a knowledge of the macroeconomy and that is a knowledge
that resides in central banks, so it seems like a rational place
to put this power. However, this would require the right sort
of institutional framework and it is not clear that it could simply
be handed over to a Bank committee. The Bank is going to need
market intelligence, quite a lot of detailed market intelligence,
and that will require representation from the FSA because any
macro—
Q24 Ms Keeble: Which is not on the
committee currently.
Professor Morrison: Well, at the
moment there is no committee with a macro-prudential tool, but
the committee, as it is currently envisaged, is a sub-committee
of the Court of Bank Directors, which is really an advisory body.
My feeling is that, if one is going to actually have a policy
tool, it is going to be necessary to give the banks sufficient
close information about the markets and that information at the
moment resides partly in the Bank, but to a large extent in the
FSA because it is doing close, day-to-day prudential supervision,
so having some senior representation from the FSA on this committee
would be a good thing. The second observation is that any committee
like this which has the power to use some sort of macro-prudential
tool is going to run up against broader questions of economic
policy, and the Treasury has to have a representation too.
Q25 Ms Keeble: If you were to give
that power to the Bank of England, particularly given you have
identified those two particular issues, would you not actually
curtail or limit the way in which the FSA currently works in working
with banks around the way in which they operate, and would that
not actually impede the sort of proper management, supervision
and regulation of banks?
Professor Morrison: I am not sure
that it has to. The FSA has institution-specific information and
uses that institution-specific information to make decisions about
individual institutions: are they running their risk systems correctly,
do they have the right governance systems and so on and so forth?
Those questions can feed into broader questions of macro-policy,
but they are distinct. The macro-policy is about aggregate variables,
and what the FSA is doing is institution-specific. To the extent
that there is a danger that you would wind up double-dipping,
there is a cost associated with that. Having two institutions
attempting to do similar things and crawling over banks, there
is a cost and one should do everything one can to reduce that
cost, but, if that cost is what you have to incur to avoid systemic
crises, then it is probably a cost worth spending.
Q26 Ms Keeble: What do you say to
the issues that David Blanchflower raised in his speech in Cardiff
where he argued that you could end up with the Central Bank having
to look sort of one way in what it did with interest rates and
the other way in what it did with the macro-prudential tool? As
he put it rather finely, "Central bankers might have one
foot on the accelerator while applying the handbrake", do
you think that is a risk if both tools rest with the Central Bank?
Professor Morrison: It is a risk.
One proposition might be that what the Bank needs to do in the
money markets could have an adverse effect on the soundness of
some banks, and that is one reason why another tool in addition
to interest rates is probably a good idea because, if you are
trying to use interest rates for both of those things, inevitably
you will be conflicted. One needs to be careful that the Bank
does not use one tool to cover up mistakes in another tool. At
the same time, there are trade-offs to be made here. If one foot
needs to be on the accelerator and one foot needs to be on the
brake, somebody needs to internalise these trade-offs and it seems
reasonable that there needs to be a body to do that, and the Bank
has the expertise probably to accomplish that.
Q27 Ms Keeble: What do you think
of the way in which things were handled recently with the quantitative
easing and could this not apply again, given, as you have said,
that we do not need to decide in the next fortnight, where the
Bank has the oversight of financial stability through the Banking
Act and the legislation is quite broadly drawn with quite a lot
left to secondary legislation and, therefore, it is well possible
for the Bank to refine its thinking about its tools more and then
come back when it needs the powers, as it did, for example, for
quantitative easing where it got the powers very quickly and was
able to take the actions that were needed, or do you think that
that is just leaving it too late?
Professor Morrison: I think we
should not leave it until the next crisis before the Bank asks
for the tools that it needs because we can design the tools at
greater leisure and get them in place before then, but the idea
that these tools should evolve rather than appear in a big-bang
way seems to me entirely rational. They are complicated things,
we have not been here before and it will require quite a lot of
thought and discussion.
Q28 Ms Keeble: It is quite unseemly
to see a sort of turf war, in a sense, between the Bank of England
and the FSA. How do you see it being resolved?
Professor Morrison: I do not know
how it will be resolved. If there is a turf war going on, then
of course that is an undesirable thing, but perhaps it is just
a debate. Hopefully, the turf war will resolve itself in a rational
fashion.
Q29 Ms Keeble: What do the other
two of you think about the issue about the macro-prudential tool
and who should wield it?
Dr Alexander: Of course the Bank
of England has got broad powers over macro-prudential policy,
interest rates and managing the currency, but we should not lose
sight of the fact that in the recent crisis we saw that systemic
risk arises not just from individual financial institutions, that
it can arise in the broader capital markets and in the over-the-counter
derivatives markets, for instance, in the AIG case, so the structure
of the financial markets is very important and that is where the
FSA comes in. The FSA has got the data and it is not just supervising
individual institutions, though it certainly does that, but it
also has oversight of the clearing and settlement system and exchanges
and this is where a lot of the systemic problems that we had arose,
and that is why, I think, the FSA is well-positioned; they have
got the data, they have got the oversight of the capital markets
and post-trading systems now and we should use that, and there
needs to be a better linkage and a better balance with the Bank
of England regarding the macro-prudential policy.
Q30 Ms Keeble: So would you agree
with the shared membership of the committee then?
Dr Alexander: Certainly. I think
it is surprising that they are not on the Financial Stability
Committee now, as set forth in the Banking Act, and I think it
is anomalous to think that you can oversee systemic risk in the
financial sector and not have your financial supervisor at the
table, providing data on the capital markets and on clearing and
settlement.
Q31 Ms Keeble: But you seem to be
quite comfortable with the FSA wielding the tool, or you think
it is a possibility?
Dr Alexander: I am comfortable
with the FSA doing that exactly. Well, they have got that responsibility
already. I think it depends on the jurisdiction. We have become
a bit path-dependent in our institutional structure right now,
so we have got the FSA and they are already regulating the capital
markets and clearing and settlement, so now the challenge for
policy-makers is to have better co-ordination between the Bank
and the FSA and to have the FSA on this Financial Stability Committee.
Dr Lilico: I think that the Bank
of England should manage the tool insofar as it is a part of macro-management,
but the thing I would add here is that there may be a case for
having a fully international component, so, for example, you could
imagine having an element of your counter-cyclical caps or requirements
or a capital buffer of some sort that was dependent upon a rating
which the IMF would give of the international economy, so I would
call it a `Defcon rating for the world', something coarse-grained,
like light red, dark amber, light amber, green, and then, dependent
on that, you would then have a component of the capital requirement
which would link it fully internationally.
Q32 John Thurso: The Committee recently
visited the US. There were three specific areas that were raised
with us: size; interconnectedness; and the business model that
the banks were pursuing. Do you think that the FSA has got each
of these areas properly covered?
Dr Alexander: Well, on size, we
were discussing capital adequacy earlier and what types of rules
we might adopt to apply capital standards, and I think that one
of the rules should be linked to the size of the bank. Larger
banks pose a larger systemic risk to the financial system and,
therefore, they should pay a tax for how big they are, and smaller
banks perhaps do not need such high capital charges as they pose
less systemic risk. Interconnectedness brings us to the capital
markets and how they have certainly become complex, they are interconnected,
and we have seen how liquidity risk can now arise in the broader
capital markets, not necessarily with individual banks, and I
think that is why securities regulation has always focused traditionally
on conduct of business rules and only focusing on segregating
money for client accounts and that sort of thing, but now we see
that securities regulators need to focus more on the systemic
aspect of their oversight of capital markets. The third aspect,
I am sorry?
Q33 John Thurso: Business models.
Dr Alexander: We have seen a major
failure of corporate governance in financial institutions. In
part, some of it is regulatory arbitrage responding to regulation,
but a lot of it too is an over-focus on shareholder wealth maximisation
at the expense of the broader social risks that financial institutions
take.
Q34 John Thurso: But do you think
the FSA are sufficiently alive to these issues and working on
them?
Dr Alexander: I believe that in
their recent discussion papers they seem to be aware of the problem
and seem to be aware of their past mistakes in having a too market-sensitive
framework of regulation, so now we see of course the Turner Review,
so I think they are on the right track in addressing these issues,
but now follow-through and political support are going to be necessary.
Q35 John Thurso: Professor Morrison,
please add to that if you want to, but specifically on the question
of size, in his recent Mansion House speech, the Governor said
that any bank that was too big to fail was, I think he said in
the words of a famous economist, broadly too big to exist, they
are too big. Do you concur with that view and should we be taking
action to regulate the overall size of banks?
Professor Morrison: Quite a lot
of banks seem to be too big to fail either because they are too
big systemically or too politically sensitive to fail, and the
expression `too big to fail' dates back to the mid-1980s when
Continental Illinois was identified as too big to fail by the
US regulatory authorities, and they said at the time that another
ten banks—I cannot remember the exact number—were
too big to fail. It is probably just a fact of life that banking
is such a systemically important activity that some institutions
are going to be too big to fail, so the question is how one should
respond to the fact that institutions are too big to fail. The
critical effect of being too big to fail is that the people who
finance you anticipate bail-out and your cost of capital reduces.
So there may be an argument for becoming very big because that
makes you very effective, you are able to give better support
to customers and you have more information about the economy and
you can do things efficiently and all of those good things, but
there is also an argument about becoming too big because, when
you become too big, your funding becomes cheaper. For that reason,
I agree with Kern, that something needs to be done to make it
costly to become too big and in that way you are making the right
trade-off. When you become so big that you anticipate bail-out,
some of your costs of funding are transferred to the taxpayer
and the Deposit Insurance Fund and you fail to internalise that
and, to that extent, there is a failure of markets, so reimposing
those costs on institutions via, I do not know, bigger capital
requirements, which is one way of doing it, but it is not the
only way of doing it, is not a bad idea. That would probably mean
that many banks cease to be as big as they are anyway and, if
we get this right, the ones that remain big will be making the
right trade-off; they will be generating sufficient efficiencies
to make it worthwhile imposing those costs.
Q36 John Thurso: We have really got
two separate situations, one where the system is working perfectly
adequately generally, the markets are working well, and one where
an institution, through a set of poor judgments, finds itself
in trouble, so you have got a strong basic system and one bank
failing, and probably in that situation quite big banks could
be managed through a failure and allowed to fail in a managed
fashion. However, what we have gone through is something where
the entire system has broadly been in considerable distress and,
therefore, institutions failing within that compound the problem
into the entire system. Should we, therefore, be regulating on
the basis that it is the systemic failure that is the most important
thing to guard against rather than necessarily the individual
institution?
Professor Morrison: I think we
should and, even at the level of the individual institution, we
should worry about things like capital charges becoming so big
and that, realistically, if one of the major clearing banks in
this country were to fail at any time, it could expect support,
so that needs to be dealt with, but you are right to say that
the key concern is multiple failure or many banks ceasing to have
confidence in one another and being unprepared to lend to one
another because the knock-on effect on the real economy is profound,
and that is the place where things like macro-prudential regulation
come in and this sort of thing could happen with many small banks.
Many small banks making the same mistakes adds up to one huge
systemic problem and that is why we need an overall perspective
of the financial system.
Q37 John Thurso: In that case, Dr
Lilico, I think you answered earlier that you were not in favour
of separating the utility bank from the casino bank, but is not
one of the key problems that we have that each has imported into
the other the worst aspects of their cultures and that one of
the primary functions of the utility bank, which is to take, hold
and safeguard deposits, is at odds with the risk-taking culture
of the merchant bank? Should we not explore a return to something
closer to Glass-Steagall?
Dr Lilico: First of all, I do
not think that any bank should be too big to fail, though unfortunately
politicians seem not to agree with me, and the markets can anticipate
that, so I do not think that you have as clean a scenario as the
one you described before in which you are going to have a kind
of ordinary time and the rest of the time because what will happen
is that, if people anticipate that, if they get large enough,
they will be bailed out, then the market will react to that, so
you will get mergers that are driven by the desire to become too
big to fail. I actually think that that is something which should
be now considered as an issue in merger law, so the possibility
that a merger is motivated by the aim to gain the taxpayer. I
think another kind of consequence connected with that is that
you will tend to use higher levels of leverage because in bail-outs
the experience we have seen is that bond-holders are spared, so
you are better to have a capital structure in which you have a
larger proportion of debt and less equity, so you will have increased
pressure for leverage in the capital structure and, insofar as
prudential requirements try to act against that, you will try
to find lots of `get-arounds' for that. I think another thing
is that in terms of the investment banks and the others, it is
valuable to consumers if they can participate in the gains from
the use of their money so as to maximise returns because then
they are going to get higher deposit rates. The one kind of thing
that I would think is worth considering is the following: that,
in order to make it easier to allow institutions to fail, it would
be useful if you really did have somewhere where you could just
store your money because that is not what a bank is. Banking is
an intrinsically risky activity, so bank deposits should not be
regarded as risk-free because those monies are being used in intrinsically
risky activities and, if you insure them, that creates an instability
at the very heart of the capitalist system. On the other hand,
if you wanted to have the possibility of allowing people to lose
their deposits, I think it would be useful if they always had
the option of a form of account where they could not use their
deposits, so I would recommend that every bank licensed to take
retail deposits should be forced to hold, what I call, a `gilt
aggregator account', so this is a fully gilt-backed account which
you are not able to employ in fractional reserve banking and with
this one the only kind of insurance needed of course is against
fraud, and then, if anybody wants to take their money out of that,
then the bank has some notional charge for storing the money,
so it is basically like a sort of safekeeping kind of banking.
If you take your money out of that into high-yielding timed deposits,
you should be read the Riot Act by the bank and told, "You're
no longer insured" and that kind of thing, so that is the
extent, so I think the way to deal with this issue is entirely
internal to banks, to have a very limited opportunity for people
in any retail institution to have a pure safekeeping kind of account.
Q38 John Thurso: I think there was
actually a Private Member's Bill in the Lords that proposed very
much that type of account for banks. Can I ask you, Professor
Morrison, one last question. If it is not thought desirable to
actually just separate the parts as a kind of brutal way of achieving
an end, is there any merit in looking at the licensing system,
such that each bank brand must have a licence and each brand licence
has capital requirements, so that a big bank company that had
many brands would actually have all of the components? One of
the things that I observed with the RBS failure is that Coutts,
which is wholly owned by it, actually was very well capitalised
and could have been hived off at any moment separately, so, if
you had the component parts of a super-group each licensed, as
in fact RBS did, but HBOS did not, you would perhaps be able to
have more stability. Is that something that has any particular
attraction?
Professor Morrison: It is hard
to know, without crunching the numbers, exactly what the effect
of that would be. I am sure it would generate a greater degree
of stability and it would also generate some costs simply because
capital cannot be employed quite as efficiently, you have idle
capital sitting in some institutions, and that is the argument,
to the extent that there is one, against—
Q39 John Thurso: You talk about capital
efficiency, but are not capital efficiency and high risk synonymous?
Professor Morrison: Not necessarily.
If you are taking a high risk, then you need to get a high return
and, if you are getting a high return in return for your high
risk, then, purely economically, you are being efficient. The
trouble in banking is that much of the risk and much of the return
is beneath the surface. Some of the risk is being borne by deposit
insurance funds and being borne by taxpayers and is not correctly
accounted for by the people taking the risks, so, to that extent,
people, particularly when they are highly indebted, as Dr Lilico
said, when institutions are very geared, they have an incentive
to take excessive risks, but having capital that could be employed
productively not being employed productively is inefficient and
there is an opportunity cost to doing that. The question is: how
do you measure that cost because there is a gain as well, which
is the reduction of systemic risk, and that is something that
is terribly hard to measure?
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