Financial Regulation: a preliminary consideration of the Government's proposals - Treasury Contents

Examination of Witnesses (Questions 765-807)

Q765  <Chair: Governor, we had Hector Sants before us on Tuesday and he was asked whether he felt, as the FSA had done, that the Bank had been as explicit in owning up to errors that it had made in the preceding three years. He sort of got to an answer saying that the Bank had, but it took him some while. I wonder whether you wanted to comment.

Mervyn King: Well, not particularly. It seemed to me—

Chair:> I'm going to oblige you to comment.

Mervyn King: You are? That's very kind of you. I did read the transcript of that and I must say that to describe your questions as leading would perhaps be an understatement. The words, I think, were yours rather than his. But the substance is this: from day one of this, way back in September 2007, we came to this Committee with quite a long list of lessons that we had drawn from this experience and things that needed to be put right. Initially that was about the need for a resolution regime for banks in the United Kingdom, from a change in the regulation of liquidity, changes in the regime for disclosure, later on capital requirements in dealing with banks, the whole regulatory framework, macro-prudential; a long list of things. Indeed, in response to your own Committee's report that came out in 2008, we have reformed the whole basis on which we provide liquidity insurance to the banking system. That is still evolving. We've introduced recently some new auctions that enable us to disentangle the incipient pressures on liquidity in financial institutions that we have relationships with. So I think we have a long track record of coming to this Committee and saying, "Yes, these things need to be changed".

1. Chair:> The reason I ask is that you are going to be in an unprecedentedly powerful position. You already chair the MPC, there is the FPC coming along, there is the Prudential Regulation Authority and, of course, the ESRB, of which you'll be vice-chairman—Lord Turner told us that—as well as being Governor. That is quite a long list of roles. In fact he suggested you might need a new diary secretary. My question to you though is how somebody in such an unprecedently powerful position can best be made accountable to Parliament and to the House of Commons?

Mervyn King: One footnote before I answer that question, which is no decision has been made on who will be vice-chairman of the ESRB. That is for the General Council of the ECB and the European System of Central Banks to decide, probably in December, but that decision has not been made.

Chair:> So Lord Turner was jumping the gun?

Mervyn King: He may well have been. The substance though is clearly an important one. But I'd like to distinguish between the individual and the institution. The institution of the Bank clearly will be more powerful with three bodies taking significant policy decisions: the Monetary Policy Committee—you've just met with the MPC—the Financial Policy Committee, to be set up fairly soon I would expect, and the board of the new Prudential Regulation Authority, which will come into effect once the new statutory framework applies at some point in the second half of 2012.

There are two kinds of accountability that matter on that, I think. One is on the policy decisions and judgments of those three respective bodies, where I think the principle is that those bodies should be accountable to Parliament and the public. They should not be accountable to the industry. They should be accountable to you. This Committee is the primary form of accountability and I think it is inevitable that there will need to be special hearings in front of this Committee for those various bodies.

The second form of accountability is accountability on resources, use of resources, management of the process. Do these committees have the right support? Are we providing the right framework of support for those three different bodies? In that, the Court of the Bank plays a very important role. It does so already in respect of the Monetary Policy Committee. It will do so in respect of the others. We have a smaller Court that is very actively involved. There is a highly professional Audit Committee, and the Chairman of Court spends much of his time inside the Bank of England. These people are deeply involved with ensuring that the Bank is managed and run efficiently and properly and we are transparent.

1. Chair:> So we should be taking a closer look at the Court?

Mervyn King: I think you certainly should be taking a look at the Court and inviting members of the Court to report, not on the policy judgments, of MPC, FPC or PRA but on the use of resources in the Bank and whether or not the Bank is well managed. That is their responsibility, and you're entitled to hold them to account because they are appointed by the Chancellor to carry out that role, very clearly. As far as the individual is concerned—

Chair:> I wasn't asking about the individual but by all means, do reply.

Mervyn King: What I hope you will see, and have seen both this morning and over the last 10 years, is that we have a pretty strong track record of ensuring that these decisions are taken not by the Governor, not by me, but by the committee as a whole. I have been in a minority three times as Governor on the Monetary Policy Committee. I think that is unprecedented for any central bank in an advanced country. We've demonstrated we can express different views and judgments because most people understand that these issues are ones that naturally result in different opinions.

Chair:> And we have just seen that this morning.

Mervyn King: So I think we have a good track record on that.

1. Mark Garnier:> I want to carry on on a similar sort of line questioning but more specifically to the FPC. There are going to be 11 members of the FPC, with only four external members. Do you think those external members are going to have enough clout to be able to hold everybody else to account?

Mervyn King: Their job is not to hold us to account, it's to contribute to a balanced judgment. I think they will. I think we've seen that on the MPC where it's four out of nine. I think with four out of 11, they won't all be internal bank executives. One of the seven, other than the four external members, will be the chief executive of the CPMA, the consumer protection body, and then you will have Hector Sants coming in as the chief executive of the PRA. So we have quite a range of different positions that people hold. I think they will have no difficulty in contributing fully. Of course that depends on having the right appointments, and no doubt you will want to look at those appointments when they're made.

Paul Tucker: The other thing that's worth saying here, if I may, is that this isn't a kind of internals versus only four or five externals. It's by having externals that changes the dynamic among the internals. The Monetary Policy Committee doesn't work on the basis of four externals and five internals. The big effect of having four externals is precisely to liberate the internals from a monolithic line management structure, and I think the FPC will be much the same. Having the externals there means that you just don't go along and say, "Well, it's absolutely clear what we ought to do and we all agree".

1. Mark Garnier:> Which means, therefore, that the choice of the externals is incredibly important. One of the criticisms of this whole new regulatory regime, although perhaps it applies less to the FPC than it does to the CPMA and the PRA, and the problem that people are worried about is that it is, broadly speaking, banking focused. The whole of this change of regulatory regime is focusing on a banking problem. There are a lot of people who are worried about the fact that it's too banking focused and choosing these four other members to be external members is quite crucial. You're going to need potentially people who really understand the insurance market. You may even need someone like Martin Lewis from moneysupermarket.com who will understand the social effects at the poorer end. Have you given a huge amount of thought, as yet, to the type of people you will be seeking out?

Mervyn King: There have certainly been discussions. Of course, this is not the choice of the Bank. The names of the four external members is the choice of the Chancellor, and he will select those in due course. But what matters is not that people are representatives of particular types of business, industry, and certainly not representing an interest. It can't be that. Indeed, conflict of interest is a major criterion in choosing the right people. They must be free of any conflict of interest. What we need are people who understand the financial sector but can think through what the issues are.

Remember, the purpose of the Financial Policy Committee in the end is to protect the real economy from the consequences of unnecessary fragility in the financial sector. That's the ultimate purpose of it. The PRA is there to regulate the financial sector and to ensure the stability of the financial system as a whole. But the purpose of the FPC is to make sure that what goes on in the financial sector doesn't threaten the economy as a whole.

1. Mark Garnier:> One thing though that might come out of that, given that you're talking about the financial sector and all the rest of it, is that it is therefore likely that we're going to find people from the City being those four external members. This could lead to accusations of cronyism or to a clubbable type of committee. How would you counter that?

Mervyn King: I don't think anyone thinks that the Bank of England is susceptible to cronyism or is excessively clubbable. I think we've always set out to do a job in public policy. One of the big changes at the Bank in the last 20, 30 years is that we are no longer seen as a body promoting the interests of the City. We are seen as a body carrying out a public policy role on behalf of the whole of the British economy. I don't know yet who the members will be but coming from the City is not of itself a qualification. Understanding financial markets and the damage that an excessive expansion and then contraction of the credit mechanism and the balance sheet of the financial sector can do to the real economy is what the FPC is all about. So we'll need to have people who can understand the consequences of that as well as having those who understand the financial sector.

1. Mark Garnier:> So there could be academics coming in, economists?

Mervyn King: There could be a wide range of people. What matters is not the sort of label we attach to them but the individual qualities they bring. One of your functions, I think, on the Committee is to make sure that the calibre of person is, indeed, appropriate to the task to hand.

1. John Thurso:> Governor, you are to be the chairman of the FPC and may or may not be the vice-chairman of the ESRB. But in either case you will have been involved heavily in both bodies. Do you think that decisions on macro-prudential policies at the European level, and indeed at other international levels, will impact on and possibly even undermine what the FPC do or can do?

Mervyn King: The macro-prudential role at European level could be extremely helpful. We will have, I hope, whatever happens in terms of positions, an influence on the debate and discussion and one way or another I'll be there, and the Bank will support this role and we will be able to discuss the macro-prudential questions in Europe. The ESRB will not have the power to instruct or determine what any national body can do. It may make recommendations of a rather generic kind, but I would hope that the analysis would leave them to make recommendations of a kind that would reinforce the ability of the FPC in its role, rather than contradict it.

1. John Thurso:> Can I just flesh that out? And it may be that I'm misunderstanding what the ESRB can do, but supposing they took a decision that the capital requirements, adequacy requirements, within banks as part of a countercyclical move were necessary and a judgment was made by the FPC in the UK that it was not necessary. You're saying that the UK's will would predominate.

Mervyn King: Indeed.

John Thurso:> In that situation, is there not a tension then or is that just going to be one of those things?

Mervyn King: There is a tension, but I rather doubt that the ESRB is going to say we have specific recommendations for each of the countries in the European Union as to what they should be doing this week to countercyclical capital requirements. I think it's going to be a much more generic issue about where the big risks lie. It may well be that they say this is the time when macro-prudential regulators around Europe should think about raising capital requirements and increasing those countercyclical buffers. They will have to be applied to individual circumstances, which is a national responsibility, but I would hope that the arguments would reinforce each other. I see no reason at all, based on past experience, as to why they wouldn't.

What I think is more relevant, and where I'm slightly more concerned, is that what I think we could slip into if we're not careful—and this is very much a matter for Parliament, it's not for us—is that if we have one European body saying that in the context of the Capital Requirements Directive, CRD4, the latest variant of it, there is a ceiling on how big these countercyclical buffers could be and then another European body, the ESRB, says, "Countries should be putting up their countercyclical buffers", what you don't want is a uniform ceiling on what can be done in each country, which prevents the national macro-prudential regulator from implementing the spirit of the ESRB recommendation.

I think it is going to be very important that at European level we ensure what the ESRB is capable of achieving, which is drawing to everyone's attention the risks and the need to take action about them, but that we don't, by accident, put in place some harmonisation requirements that prevent the national macro-prudential regulator from carrying out its task.

1. John Thurso:> That's a very important point that you raise, and I'm sure it's one we will come back to. Can I ask one quick question to Paul Tucker, please? The FPC will be required to report every six months under statute. The Bank already does a report. Is this just going to be the same report or are there differences?

Paul Tucker: First of all, I think it's worth saying that there will be a report of each quarterly meeting and then, as you say, we envisage a six-monthly report. It will take the current Financial Stability Report as the base, but I think it will end up being somewhat different because it will be explaining the decisions, and the analysis lying behind the decisions, that the FPC are taking.

The really big change here, and I do think the FPC is the big institutional change, is moving the Bank of England away from commentary to taking decisions, making concrete recommendations, and the FSR will have to move away from being a document where it's trying to set out an analysis in the hope that somebody with some levers somewhere will pick them up and use them, which sounds rather pathetic, in hindsight, doesn't it?

1. John Thurso:> The big difference is you'll be able to report on what you've done.

Paul Tucker: Exactly, what we've done and why we've decided it. Then you will be able to say, "Well, hold on, does the analysis support what you concluded or did it lead to another place?" I think, for what it's worth, you'll be helped in that the public commentary around the FSR will get transformed over time.

1. Andrea Leadsom:> Andy Haldane and Paul Tucker, on Tuesday this week we heard Hector Sants telling us that he believed the next crisis would come from banks trying to push leverage away from their regulated entities and on to consumers. A specific example given was exchange traded funds where consumers may end up bearing the risk of leverage. Do you agree that that could be where the next crisis comes from?

Andy Haldane: Shall I start? I think certainly this goes back to a point that was raised, I think, earlier on by Mark. The last crisis was centred in the banking system and there is always some risk of fighting the last war. So, I think looking forward from now, there is some danger, as we tighten regulation of the banking system, that risk migrates elsewhere. You mentioned one possible avenue; there are others. Paul and others have spoken, for example, of the shadow banking system. There are vehicles or conduits off the balance sheet that can harbour leverage or maturity mismatch and can cause many of the same problems we saw banks causing during the crisis. So I think that is a real risk. It was a risk in the run-up to the crisis that was realised, and the risk hasn't been lessened by the crisis.

How best to address that? I think a key aspect of the FPC's remit is to look beyond the boundary, to police the perimeter and to reach a judgment on how great the risks are beyond the perimeter with a view then to making recommendations to Government about whether that boundary needs to be shifted, where the regulatory perimeter might need to be extended to prevent risks migrating and growing.

That is a problem, that regulatory arbitrage has been with us forever. It will be with us forever. The best we can do, I think, is to try and track it in real time and, where action is needed, for us as the FPC to make recommendations.

1. Andrea Leadsom:> Thank you. So, Paul Tucker, does that give you a concern that with the PRA regulating the banks themselves and the CPMA regulating orderly markets, where those two things meet is exactly where the next crisis might come? Is that something that would worry you?

Paul Tucker: I believe in twin peaks and so the splitting up of the FSA does not worry me. I have believed in twin peaks since the mid-1990s, before the 1997 election. That is widely known, although I'm not sure I've stated it so candidly to you before. But what does matter is that there's co-ordination. When you move everybody around, you shift the point at which co-ordination and co-operation is needed. The chief executive of the CPMA will be on the FPC. The whole point of the FPC, in a way, is to step back from the particular micro-regulatory mandates that are being given to the PRA, CPMA in the future and say, "Does all this fit together?"

One problem over the past 10 years—it may have happened if we'd been the regulator, who knows—is that the banks issued loads of subordinated debt that counted as capital within the banks and the insurance companies bought this debt as almost risk free as an interest rate hedge. So that didn't fit together very well. What has been missing, one of the big four lessons, is that you have to give somebody the mandate of stepping back and saying, "What is going on here?" Then if I may, coming back to your question about problems beyond banking, yes, that is something that I am concerned about. We think that domestically the FPC will help. We have encouraged the International Financial Stability Board to make this one of the themes of its work in 2011. A world in which we try and sort out the safety and soundness of the banking system or of the securities markets and then don't go on and say, "What are the behavioural effects of that?" would be naive.

I'd like to make one other particular point, because Hector mentioned ETFs. I do think that the inclusion of leverage in ETF structures is something worth watching. We talked about that, either in the last FSR or the one before that, and we think that in this country, and in America and elsewhere, it will warrant monitoring.

1. Andrea Leadsom:> Just very quickly then, for clarity, are you saying that the FPC will form the role of ensuring that there is the oversight of the activities going on in the PRA and the CPMA? Clearly what we had under the previous tripartite arrangement was a situation in the Northern Rock case where different regulators weren't quite sure where the accountability lay. Are you saying that under the new twin peak regime the FPC will fulfil that role and will be able to ensure that there is that co-ordinated leverage?

Paul Tucker: Where it bears on stability. Where it bears on consumer protection and the adequacy of services provided to consumers, absolutely not at all. Where it bears on the soundness of individual institutions, if they can fail safely, that will be for the PRA and the PRA board, but where it has a bearing on stability, yes.

1. Andrea Leadsom:> Just one very quick question for the Governor. The CPMA always suggested to me that it was a kind of consumer type of organisation. Do you think it should be called the MCPA in order to give proper weight to its markets' role as well as its consumer protection role?

Mervyn King: I don't think it's for me to say what it should be called, but what is very important is that you and others hold it to account for looking at both of those. They are distinct roles, and they are both very important. But what to me is the most important thing is that both are distinct from the style and type of regulation that is prudential regulation. Prudential regulation is not about enforcing the rules. It is not about checking whether people have complied with particular provisions. It's about judgment, it's about whether the balance sheets of the regulated institutions are creating too much risk for the system as a whole. The purpose of prudential regulation, unlike the regulation in either market enforcement or consumer protection, is not about checking whether the individual institution has or has not done something, will or will not fail, it's about the risks to the system as a whole. That's the sole purpose of prudential regulation. We will not be setting out to ensure that institutions never fail. Institutions will fail. The crucial point, as Paul said, is that they can fail without causing disruption to the rest of the system.

Chair:> I'm glad you took that question very seriously. Names and even acronyms carry resonance and so if you come to a view in the fullness of time, we'd be interested to hear it. Jesse Norman.

1. Jesse Norman:> Thank you very much indeed. The Government owns substantial positions in several of the major banks through the Bank of England. Do you mark those to market? Do you keep an eye on how much they're—

Mervyn King: No, that is the job of the UKFI and the Government. It's not for us.

1. Jesse Norman:> Thank you. You talked about conflicts of interest; do you think that creates the potential for conflicts of interest, either from a Government policy standpoint or from the position of the Bank itself?

Mervyn King: I think from the perspective of the Government, we've seen that in every European country in this crisis the Governments, in order to take stakes in banks, had to ensure that they were not violating the rules of competition at the European level, and I think the European Commission has done a very good job at enabling governments to deal with the financial crisis, while still ensuring that there is a proper competitive framework. No Government, I'm sure, wants to maintain permanent stakes in these institutions. It was necessary in the crisis in which we found ourselves in October 2008. I think there was no alternative to it at that point. The question is what is the best way over a period of time in the interests of the taxpayer to get out of it. I think that's a matter for Government.

1. Jesse Norman:> But in the very broad spectrum of decisions that the Bank is going to take with regard to the stability of the financial sector, can you be certain that, as it were, you'll be motivated purely by those factors rather than a desire to maximise the value of the stakes that the Government holds in the banks?

Mervyn King: I can give you an absolute assurance that the members of the PRA board and the Bank of England would be motivated solely by our concern for the stability of the system and the remit that the different committees will be given. We have always given enormous weight to the remit to the Monetary Policy Committee that we are given by Parliament, the remit that will come from you to the FPC and the remit that again will come from you to the PRA board.

1. Jesse Norman:> I'm very grateful for your crisp answers. Lord Turner has previously been very clear in his own mind in a series of lectures that he regards the huge growth of the financial sector over the last 20 years in this country as essentially distorted in many respects, and its ability to take high capital sums as rents out of the economy as, in some respects, rather dangerous. From a financial stability perspective, do you think there is a risk that the financial sector is too large compared with other parts of the economy?

Mervyn King: If you look backwards, what we saw that was far too high was the leverage in the banking sector and the financial sector as a whole. That made it fragile. That was the brunt of the problem. It was the extraordinary degree to which the leverage of the sector rose.

1. Jesse Norman:> So you don't take a position as to whether or not that occurs—the sector could be 98% of the GDP of this country and you wouldn't have a problem with it?

Mervyn King: The point I have made, and I think this is of fundamental importance, is I don't think it's for us, or indeed for any of us here today, to try and second guess the market as to which sectors should be big or small. But what is fundamental to that is that if you have a sector that has institutions that are too big to fail, too important to fail in my language, where Government feels it has to stand in to support them, then you get a distorted market incentive where those institutions can borrow money more cheaply than they would otherwise be able to do, and hence become bigger. That is a distortion and that bit needs to be removed. But if we can find an answer to that too important to fail problem then I think we should let the market decide what institutions can survive.

1. Jesse Norman:> Thank you. A final very quick question: Lord Myners suggested in testimony to this Committee that as part of the compensation of bankers it should be paid in subordinated debt in commercial banks and potentially other organisations as well. Do you think there is some wisdom to that idea?

Mervyn King: I'm not going to comment just like that on the form in which compensation should be paid. I think a lot of these problems go back to the question of if institutions are given implicit subsidies from the taxpayer because the people who fund them believe that they're too important to fail, that's when it becomes possible for levels of compensation to become excessively high.

I don't think we would have to worry about levels of compensation were we to believe that there were not implicit subsidies that are available to those institutions that, during a crisis, have turned into explicit subsidies.

1. Jesse Norman:> But you don't think that equity compensation might have given the leaders of the banks too much of a growth agenda, too much on building up the balance sheet?

Mervyn King: I think that the incentives that have been created by linking compensation to the rate of return on equity is clearly a distortion because it gives an incentive built in to raise leverage. Other things being equal, for a given return on assets you can increase the return on equity by raising leverage. I have never understood why people thought it was a sensible idea to base compensation in these institutions on the return on equity. Return on assets is a better method.

Jesse Norman:> I think it's very important you said that. Thank you very much.

1. Chair:> Extremely valuable. It's a subject to which I have no doubt we will return, unless you have something in particular you want to add briefly.

Paul Tucker: I was just going to say that I have aired that issue in two or three speeches, but on broadly the same lines as Paul Myners and the Governor has just now.

1. Mr Love:> Mr Haldane, can I turn to the issue of supervision? There have been reports in the newspapers that the Bank is considering a less intrusive form of supervision for the PRA. I understand that they may be a little wide of the mark, but perhaps you can set the record straight as to whether there is going to be a change in the style of supervision.

Andy Haldane: It's for the Governor and Andrew maybe to speak more directly about the plans on the supervisory front, but speaking to the newspaper article to which you refer, the issue here for me, for us, is not one of intrusiveness, intensity or not. This is more a question of degree. So I think where the risks are large it is appropriate that the regulation and supervision is appropriately intensive and intrusive. So, should we have been intrusive about a big bank taking over ABN Amro? Yes. Should we have been intrusive about the big portfolio of asset-backed securities that banks were holding on a mispriced basis? Yes. Should we have been more intensive about banks laying off their risk to a single insurer, such as AIG? Yes. I think those are all places where the risks are large enough where you want to take a very close look.

Equally, I think, where the risks are of a lesser scale, one of the ideas would be that we can afford in those situations to be somewhat less intensive and intrusive. So, a focus on the bigger risks and somewhat less on the smaller ones.

1. Mr Love:> Mr Bailey, Hector Sants said people should be very frightened of the FSA. Should they be very frightened of the PRA?

Andrew Bailey: It goes back to what Andy has just said. We will be intensive and intrusive on the things that matter. You don't set out to frighten people but they should be very clear that that's where we will be focused, and the one thing I would add there, building on what Andy has said, is that the thing that helps here in the new arrangements is that there is what I call the driving overall objective of the stability of the financial system. I'm not saying that to frighten people, but they should be very clear that that's our focus and it will be an intensive focus. That's what they should be clear about.

Paul Tucker: Fear is the language of securities regulation. You write a rule, you check compliance with it. If the rule isn't the right rule it should still be complied with because capital markets have to work within rules; if the rule is breached it requires punishment. This is not the function of the PRA or of the FPC. The language of fear may or may not—it will be up to its management and board—fit with the CPMA. It is not the right way of thinking about the function of the PRA or the FPC. Distance, respect, professionalism, prioritisation, all of those words, but we don't need people to fear us. We do need people to expect that we will take action without fear on our part when it's needed to protect the stability of our financial system.

1. Mr Love:> That sounds to me like there's a gap opening up between the style that the PRA and the CPMA will undertake.

Paul Tucker: No, I don't think so. I know Hector pretty well and the circumstances in which Hector made those remarks related, I think, to the other part of the FSA's business rather than to the safety and soundness of the core banking system.

1. Mr Love:> In terms of leadership, Governor, you are leader over all of this. What leadership will you give to the differences that are likely to emerge between the two supervisory bodies?

Mervyn King: Between PRA and CPMA?

Mr Love:> Yes, the PRA and the CPMA.

Mervyn King: I don't think that there are obvious differences in terms of their judgments, because they are dealing with very different aspects of the behaviour of financial institutions, and I see no obvious reason to suppose there would be differences in their conclusions. They'd be dealing with different problems. The style of regulation will be very different between the two, very different. As Paul has said, there's a good reason for that, which is that the issues are quite different and the appropriate style of regulation should differ.

My leadership will be based on a recognition that I have very strong people working under me. I will have three Deputy Governors: Charlie being on monetary policy, Paul Tucker on the macro-prudential and Hector Sants on the micro-prudential. They are supported in turn by three very strong people in Spencer Dale, you saw this morning, on monetary policy, Andy on macro and Andrew on micro.

1. Mr Love:> Let me just stop you because I'm being ko'd by the Chairman. Is there more than just the difference between who it is you are regulating or supervising? Is there a philosophical difference between bankers' attitude towards this and regulators' attitude?

Mervyn King: I don't know, because this is not a function of bankers versus regulators. This is about the central bank being concerned about the stability of the system as a whole. What is different from the CPMA is that they are not concerned as such with the system as a whole. They are concerned with the conduct of individuals and individual institutions within it. We are concerned with the stability of the system as a whole. We obviously do it through supervising individual institutions, but the objective is very clear. It's the stability of the system as a whole.

1. Mr Mudie: I'd like to take you back to Andrea's question, because I think we seem to be getting the regulatory system right in terms of the banks, and there seems to be an international consensus about the direction. What I'm not convinced about is how seriously we're taking the shadow banking system. Andy, you use the word "perimeter" as though we can build a fence and we'd watch that they would not intrude and damage our system, whereas Paul, I thought, indicated an awareness that that might not be enough by referring to the "International Settlement Board", I think it was, because it is an international thing. I need convincing, we need convincing and the ordinary public needs convincing that we're not tidying up the system and that's enough, given that there is a secondary system, which is twice as big as the visible banking system, and it seems to be unregulated. How can we convince people the crisis will not happen again if there is this massive secondary system working, and it's largely unregulated? I couldn't get an answer from Lord Turner a couple of days ago about how much it was regulated. Can we have any reassurance or is anybody working on it at international level?

Paul Tucker: Shall I take this? They are working on it internationally and I think this will get greater momentum during 2011 for precisely the reasons you say. Two or three points, if I may. First of all, some things have been done to strengthen capital markets. Stepping back, one of the roots of this crisis is the whole regulatory regime in this country and internationally did not keep up with the evolution of our capital markets. Some things are being done to strengthen this. eg the whole business of putting more of the over the counter derivative markets through central counterparties. This is an unambiguously good thing. It is a terrible tragedy that it's happening now rather than a decade ago. The reason that's relevant to your question is that some of the shadow banks will be part of that. It's not just for the regulated community. That's the case, both in the States and over here.

A second point is that some manifestations of shadow banking are effectively derivative of banking because their lifeblood is a liquidity line from the banking system. This is the most malign form of regulatory arbitrage in a way: where it's not consolidated, it depends on a liquidity line, but it's kind of offstage somewhere over here. The bank regulators can do something about that. The regulators, PRA, FPC, should not be allowing the banking system to feed and fuel a monster that is offstage.

The third point I would make is that there is a very big debate going on right now, particularly in the United States, about some forms of shadow banking. Other than the so-called Fannie and Freddie, the biggest form of shadow banking in the world is the money market mutual fund industry in the United States. This is about the same size as their banking industry, and it's not a domestic US thing. It has global implications. They fund the European banking system to a significant degree. The so-called President's Working Party, chaired by the US Treasury Secretary but bringing all their agencies together, has recently issued a report on options for fundamental reform of one kind or another of that industry. I think this is of first order importance to us, even though it's somebody else's domestic financial system.

The fourth point I'd make, if I may, is how one does horizon scanning in this area. Even if we get the right list of shadow banks or non-banks now, how on earth do we do that in the future? The Governor referred to three executive directors. I would add that I think the Markets Director of the Bank of England has a profoundly important role to play in the coming years and decades in knowing sufficient about what's going on, in partnership with the New York Fed, the two central banks in big financial centres acting as a radar service and bringing issues to the FPC and others, and having a bias to think something might be an issue, examine it and prod it rather than thinking that it's always a benign variant of capitalism.

1. Mr Mudie: That is reassuring to this extent, it's an indication of an awareness of the problem. The worry I have is the dates you mentioned. I don't think that they are realistic in terms of getting agreement, particularly given the American political situation, and I fear that it will run out of momentum and we'll be satisfied with a public edifice.

Paul Tucker: Yes, it's a risk. For what it's worth, my personal view on this, and I spend a lot of my time, as my colleagues know, at international meetings on this with Adair Turner, is so long as unemployment remains unacceptably high in this country, the rest of western Europe and in America, I don't see the momentum behind it weakening.

If you sit round the Financial Stability Board table, we still feel, quite rightly, under pressure from the G20 Finance Ministers and the G20 leaders, to make the system safer. That's why the agenda internationally for 2011 is a development in the direction that you describe. Are we bound to get it right? No, we're not. If I may say so, I think your focusing on this as a committee is quite an important part of the process going forward.

Andy Haldane: Can I just add, just re-echoing Paul's points, it's clear from the crisis that our fleetness of foot on things like monitoring risk and in regulating risk needs to change gear fairly fundamentally. So an example: the Basel agreements. Basel II was 10, 15 years in the making, and the cake was not palatable once we'd finished. Basel III in regulatory terms has moved through at warp speed, so we're close now to having an agreement, basically in the course of 12 to 18 months. I think that pace of change, that fleetness of foot in both what data we collect and how our regulation operates, needs to be carried forward importantly into the future otherwise we'll miss the next risk.

The second point, just very quickly, is however we shouldn't always, I think, jump to regulation being the solution. So, there are parts of the financial system that operated rather well outside of the regulatory net. Hedge funds, which were the bogeyman going into this crisis, have been a part of the financial system that has performed relatively well, partly because they were able to die and then spring up without causing very much collateral damage to the manner in which—

Mr Mudie: You're not cheering me up here, Andy, if hedge funds is the best you can do.

Andy Haldane: The general point, though, is before we leap always to regulate that which we see moving, we should ask ourselves the question: is what they're doing, can we link it back to a malfunctioning of the system, to the flows of credit, to the flows of payments? If we can't, it might be better left outside of the regulatory net.

Chair:> The Governor, on numerous occasions, has told us that there are limits to what can be achieved by regulation, and also that there are costs to getting it wrong, and no doubt we will come back to that on a number of occasions. It would be very helpful for the Bank to think through how those points can be articulated in more detail in the debate of regulatory structure in the months ahead.

1. David Rutley:> In your evidence to the Committee over the years, and particularly the last few sessions that I've been at, you've been very clear about the purpose of the Bank of England, what it does and doesn't do. You've demonstrated that again today. With the new structures that come into place with the new regulatory framework, what makes you feel comfortable that you'll continue to have that same clarity of purpose given that much wider remit?

Mervyn King: I think that's one of my primary tasks as Governor, to give that leadership to ensure that we do. I think a key part of it, and what has been very helpful over the years, is that in monetary policy the fact that you in Parliament gave a clear remit to the Monetary Policy Committee in my view was fundamental to the Monetary Policy Committee operating as an effective body. We didn't have to sit round and work out what our objective was. We were given the objective. I think it's important that you give us a clear remit for both the Financial Policy Committee and the PRA. I think, broadly speaking, as I've described it, it is fairly clear and I think they reinforce and complement each other. We saw as a result of the crisis that monetary policy became more difficult because of a severe instability in the financial system. Equally, over the years one of the causes of instability in the financial system has been highly volatile monetary policy creating instability in the macroeconomy.

So I think if we can succeed in these three different areas they will all naturally reinforce and complement each other. To that point of view, they're all part of the same overriding vision of delivering one word to the British economy, and that's stability.

1. David Rutley:> Do you think you've been given a clear enough remit for FPC and PRA?

Mervyn King: They're still discussing what the wording will be but, broadly speaking, I think we're going down the right lines, yes. But, of course, in the end, you in Parliament will debate and agree that wording.

1. David Rutley:> In terms of your priorities then going forward, as you see the landscape, which isn't completely constructed yet, what are your top priorities and how would you communicate any change of priorities that you see as the landscape changes yet further?

Mervyn King: The first priority of the Bank is to make sure that we meet the inflation target and communicate effectively the reasons why we believe that inflation is presently above target, and that we think policy is on track to deliver monetary stability. The second is to explain the transition to the new arrangements, because we can't determine the actions or the views of the FPC or the PRA board until they're set up and created. Only they can do it.

It's clearly a big transitional job. I know people think of this as being a major extension of the Bank's responsibilities and in a formal way it is, and that's why there needs to be new accountability. But of course since October 2008, we have been deeply involved in the management of the liquidity and regulation of major banks in this country and worrying about stability of the system. So, in practice, I don't think what happens today is that different from what has been going on. Andrew could say more because he's been deeply involved in it.

Andrew Bailey: You don't want me to tell you the whole story since autumn 2008, but that's right. It comes back to the fact that we have now two big responsibilities as the central bank today, which is the age-old responsibility of being the lender of last resort and providing liquidity to the system. Now we have the formal responsibility of being the resolution authority, which of course then creates a regime in which you can handle bank failures. Both of those things reside in the Bank of England now, and they have to be properly tied up now to the objectives of the prudential supervisor. One of the big things we're doing in looking and designing how the PRA will go about its job is to do exactly that; tie those up so that we understand why we're regulating banks. We understand that we can deal with them if they do get into trouble and all that fits together. That's critically important. We can do that now in a sort of integrated approach.

1. David Rutley:> In terms of the new structures and the relationship with the Treasury, obviously it's going to be very important that you have the proper level of accountability, and the Treasury is going to have a role on the FPC, one non-voting representative. Is that enough? Should the Treasury have a vote? Some people say it should. And should the Chancellor ever be in a position to be able to overrule the FPC?

Mervyn King: I think not. I think there is a very clear division of responsibilities and this is why I think to give the Treasury a vote puts the Chancellor in a more difficult position because he might then feel accountable for the decisions of the FPC, and he's not. He's accountable for setting the remit of the FPC, with the agreement of Parliament, and you hold the FPC to account. The fundamental area where the Chancellor has the overriding power of decision is on any action that involves the use of taxpayers' money. Any use of public money is a matter of decision for the Chancellor. One of the arrangements that I've discussed with him, that is a new proposal in the consultation document, is that there be a very clear formal requirement on me, as Governor, to give the Chancellor adequate information and time to reach decisions on anything that could be said to involve public money. He should be accountable fully for that and responsible for it.

When it comes to the decisions on the regulation of individual institutions or the decisions about the instruments that you will give to the FPC about, for example, countercyclical capital requirements, those are the responsibility of the FPC and shouldn't be second guessed by the Chancellor. They have to be decided by those bodies. If you don't like the idea of those bodies taking those decisions, then please don't set up the FPC or the PRA board. But if you choose to set them up, then let them do their job. But where public money is concerned there will be arrangements in place to ensure that the Chancellor always takes those decisions.

1. David Rutley:> One final quick supplementary: are there any things in the relationship with the Treasury that you're uncomfortable with at the moment or think need to be further clarified?

Mervyn King: There's a lot of detail still to be sorted out on the drafting of the legislation for both the FPC and the PRA. A lot of detail is being discussed as we speak. So I think we'll have to see how those discussions go.

1. Stewart Hosie:> Paul, you are Deputy Governor for Financial Stability and Hector Sants, as the chief executive of the PRA, will be Deputy Governor for Prudential Regulation. Will there be any overlap between you two and the roles?

Paul Tucker: I hope so. Formally, I will be on the PRA board. Hector, the person holding that job, will be on the FPC board. You may be surprised that I say I hope for overlap, but, as I've said before, I feel very strongly that one of the problems in the previous system was that there was underlap. Underlap is terribly comfortable for bureaucrats because nobody accuses each other of turf in a world of underlaps. It's just terribly bad for society. We need to tolerate a little bit of overlap, while being careful about efficient use of resources for the obvious reason, which is that—this is true of any financial system, but it's particularly true of our financial system with a relatively concentrated banking system—lots of the questions of the resilience of the system as a whole are going to come down to questions about the resilience of individual institutions.

Going back to Mr Mudie's question, you can't become so dazzled with that proposition that we don't look beyond the individual institutions, and so we're going to have to find ways of bringing PRA insights on individual firms into the FPC, while ensuring that the FPC remains focused on what only it can do, which I think will be mainly the job of the Governor and partly my job.

1. Stewart Hosie:> I'm very pleased to hear your comments on avoiding underlap. I share Andrea's view about the huge gaps that existed in the tripartite. What then happens to the existing financial stability function at the Bank under the new structure? Does it merge with the Financial Stability Division of the FSA, does it become a secretariat of the PRA or the FPC, because there's clearly going to be a great deal of experience in the existing financial stability function at the Bank?

Paul Tucker: Little bits of all of that. In the first place, not only the financial stability directorate of the Bank of England—in fact the Bank of England's financial stability directorate does not map one-to-one into the Bank of England's financial stability mandate, but both that directorate, Andy's directorate, Paul Fisher's directorate, who is the Markets Director, Andrew's, and at times Spencer Dale's, the monetary side, will need to feed into the FPC and they will need to think of themselves as serving the FPC in the way that the monetary analysis and markets parts of the Bank think of themselves as servicing the MPC.

The second part of your question is are there people or functions within the FSA that would perhaps most naturally become part of the financial stability, small "f", small "s", part of the Bank of England rather than the PRA? In my view the answer is yes, because there are people in the FSA who understandably, given the tripartite structure, aren't working on the prudential supervision of individual firms but are trying to pull it all together to make the FSA's contribution to the tripartite on stability.

1. Stewart Hosie:> That's again very helpful. I take it the work is underway to identify the individuals, their roles, where they would sit and the lines of communications, so that's done and dusted as best it can be.

Paul Tucker: That will be down the road a bit. The priorities right now are the much bigger shift of staff to what Andrew will be involved in the PRA.

1. Stewart Hosie:> Can I ask a slightly more general question? Governor, you spoke about how a bank or financial institution might fail, and we have the new resolution regime in place. A lot of the talk about managing this is at the very high level with managing out systemic risk. I'm concerned that when I hear that sort of language, and we heard it from Lord Turner and Hector Sants as well, I'm not hearing an awful lot of talk about how we manage specific risks in specific institutions to try and manage out their failures in the first place. I'm not filled with confidence, and I suspect the general public most certainly won't be, if we have an elegant failure of a bank. I think we'd rather have all of you in all of the organisations mitigating the risks from happening in the first place. How does that work?

Mervyn King: I think this would be a profoundly mistaken view to pursue, to be honest. If you felt that our job was to ensure that the management could never take decisions that led to the failure of the institution, then what you're asking us to do is to be a shadow management of that institution. It is very important that management fears failure, that they can be thrown out of their jobs, not by us but by the shareholders, and that if necessary, an institution can be allowed to fail in a way that does not disrupt the financial system as a whole, such that retail depositors are protected, their accounts can be switched to another bank.

If we do not have that then you are basically saying that our job is to ensure that all the institutions that we regulate are, in some sense, too important to fail. I can't understand why, if that's the case, they're in the private sector at all.

1. Stewart Hosie:> I'm not suggesting that at all. But I do wonder, and I suspect the general public will wonder or hope and expect that the regulators and the supervisors will manage or at least supervise sorts of things such as products and the levels of leveraging—I am not talking about specific decisions—much better than they were previously.

Mervyn King: Let's be careful what is at stake here. We will not be regulating individual products; that's for the CPMA. If banks are taking a lot of risk with leverage that we think is creating risk in the system as a whole, then we will put a stop to it. We would like to have the power to be able to limit leverage directly. We will certainly raise capital requirements on individual institutions if we think those risks are excessive.

But our focus will be on those big risks and not on trying to chase round each and every individual institution to make sure that everything they do is sensible. That was what failed around the world. The one thing we know was that we were not short of the numbers of regulators; there were lots of them all over the world. They failed to spot the big risks. It's not numbers that helps here. It's having quality people who will sit back and prepare to challenge the chief executive, look in the whites of his eyes and say, "I don't believe you when you tell me your balance sheet is safe. An extra requirement on your capital, please, until you can convince us that you're not taking a set of risks". That's the kind of judgment that will be required, and it is very different from the style of regulation that we've seen, at least over the last decade or so.

1. Mr Umunna:> I'd just like to ask you, Governor, about the regulation of the actual activities that our banks engage in. Earlier this year, at the World Economic Forum, Bob Diamond, who has reached some notoriety for various different reasons, argued very strongly in favour of maintaining universal banks. The impression I get from the comments that you have made, Governor, is that you clearly disagree with him on that. If I just quote to you some of your Mansion House speech in June last year, where you said it's not sensible to allow large banks to combine High Street retail banking with risky investment banking or funding strategies. I raised this issue with Lord Turner when he appeared before us on Tuesday. I was just wondering whether you could perhaps on the record clarify for us exactly what your position is on this. Do you take a position that is akin to, say, Glass-Steagall, which we had in the States, that required a complete separation of investment from retail banking, or do you take the position of, I think, the Dodd-Frank Act, which is that you should simply take proprietary trading out of it, or are you in the place that it appeared that Lord Turner sits in where he said the important thing was that you can have all these activities but you need to erect firewalls between certainly the retail part of what a bank does and the rest of its functions? Where are you on this and is my reading of you clearly disagreeing with Bob Diamond correct?

Mervyn King: I'm going to repeat what I said before, which is I think firewalls are important because at one level it's very hard to say to people, "Your deposits are certainly safe", which is what we do want to say to retail depositors, and allow the same balance sheet to take highly risky activities. It's not possible to tell people that highly risky activities can always support safe deposits. Somebody has to be there in order to square the circle, and at present it tends to be the taxpayer.

That's the principle; we need to think about the nature of the firewalls. How to do that? I don't think Glass-Steagall is terribly relevant now because that is something that was put in place in the 1930s to separate particular types of activity. The principle of thinking of firewalls is important, but I don't want to take a strong position on how, in practice, that should be done until the Independent Banking Commission has reported. They've been set up to look at these issues. I don't want to make life difficult for them by saying this is what they should say in their report. I want to wait. There are difficult issues here. The principle is not institutional separation, it's separate balance sheets. The firewalls have to be between different balance sheets for different types of activities. That's the principle. What that means in practice, I would like to wait and see what the Independent Banking Commission has to say and at that point I will be very happy to come back to you and discuss it with you.

I'd say one last thing, which is we can afford to take the time to do this. There are other areas where we need to work more urgently, but in terms of these longer run structural questions of where the banking system goes, we have time to sort this out. At present the banking sector is headed still in the direction of contracting the size of balance sheets. The time we need to worry is probably 10, 20, 30, 50 years down the road when the memories of this crisis have faded and people haven't put in place the lessons we should draw from it.

1. Mr Umunna:> So in some senses, I suppose, those who have been characterising your position as being one against universal banks have been slightly over-egging the pudding?

Mervyn King: I have quite deliberately avoided saying that this is a detailed specification of what should happen. What I've tried to set out in my public comments is an analysis of what went wrong and what is wrong with our banking system. I've tried to be clear about that. What we should do about it, I would like to leave that for the moment to the Banking Commission.

1. Mr Umunna:> Delaying comment, which is a perfectly sensible position, Governor. Just one other question. You gave a speech, I think in October, where you talked about the size of the top 10 banks and how they have reached 450% of GDP, and there has obviously been a concentration as well in the market. Do you think that concentration has resulted in reduced competition, and do you think that contributed to the financial crisis?

Mervyn King: I don't think reduced competition as such contributed to the financial crisis. Whether it led to less effective competition, particularly at the retail level, is something that again the Banking Commission is looking at. What I think is the most important thing about this is that Britain is very well placed to be a successful international banking and financial centre. There are many reasons based on history, a wide range of ancillary institutions, legal, insurance and other, that contribute to being a successful financial centre. But what this crisis has shown more than anything else is that a country that has a very large banking system relative to the size of its GDP cannot afford to allow the too important to fail problem to be one where every now and then, even if it's only every 50 years, the taxpayer ends up standing behind the banking system. That is what is happening in Ireland today. Their banking system was too large for their economy to cope with when it got into serious trouble. The same was true in Iceland. The reason why Switzerland has introduced such large capital requirements for its big banks is for exactly the same reason. And I think one of the big lessons for the UK is we should be a major international financial and banking centre. We have every comparative advantage but it is vital for the health of the British taxpayer and the economy that we can ensure that it's structured in such a way that it isn't, in future, too important to fail.

Chair:> That's a very interesting and important set of exchanges on which to end. I'm very grateful to you for coming along today and particularly for being prepared to stay for what is just a little under three hours, and answer our questions, which I am sure will be noted very carefully by people outside this room. Thank you, Governor. Thank you to all four of you.

Mervyn King: Thank you very much, Chairman.

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Prepared 3 February 2011