Banking Crisis: regulation and supervision - Treasury Contents

Examination of Witnesses (Questions 20-39)


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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