Session 2010-11
Publications on the internet

To be published as HC 831-i

House of commons



Treasury Committee

Financial Regulation

Tuesday 1 March 2011

Mervyn King, Paul Tucker, Andrew Bailey and Andrew Haldane

Evidence heard in Public Questions 1 - 83



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Oral Evidence

Taken before the Treasury Committee

on Tuesday 1 March 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

John Mann

Mr George Mudie

Jesse Norman

Mr David Ruffley

John Thurso

Mr Chuka Umunna


Examination of Witnesses

Witnesses: Mervyn King, Governor of the Bank of England, Paul Tucker, Deputy Governor, Financial Stability, Andrew Bailey, Executive Director, Banking and Chief Cashier, Bank of England, and Andrew Haldane, Executive Director, Financial Stability, Bank of England, gave evidence.

Q1 Chair: If you are ready perhaps we will get started. Thank you very much for coming and thank you for agreeing to this split session so that we can cover these two very important issues that are on your plate at the moment; one the complete re-regulation of the financial services industry and the other, of course, the inflation issue, which we will come on to later on this morning. On regulation, will you tell us whether you think that the arrangements that need to be put in place in order to secure better prudential supervision can be achieved by amending the Financial Services and Markets Act or do you think the Government need to take a new approach? Are you confident that new approach is being taken?

Mervyn King: I think this is something on which you are more expert than us-the precise legislative process. I think it can be achieved. There are still issues to be debated and resolved in the new framework and it will take time to do that, and that is why I think it is still 18 months or two years before the new framework will come into effect. It can be done through amending FSMA. I think our preference would have been for a new Bill and Act, because I think it is easier to understand what is going on with the drafting of a new Bill, but I mean, to be honest, I think it has to be in your hands to suggest, because you are the people who have to go through the process.

Q2 Chair: I am asking you for a view. Are we going to get anywhere?

Mervyn King: I think we will get the right approach through the course on which we are proceeding. I think we feel it would have been easier had it been done through a new Act, but we are where we are, and I don’t think there is much point going back.

Q3 Chair: Just to be clear, you say, "We are where we are," so we are not getting new legislation; we are getting amendments to existing legislation?

Mervyn King: As far as I understand, we are going to get amendments to FSMA as the vehicle by which the new regime will be introduced.

Q4 Chair: You think that is the second best option, don’t you?

Mervyn King: Yes, I think it would have been better had we had a new Act but, as I say, we are not experts on that and it is those involved in Parliament directly who are better placed to make that judgment than we are.

Q5 Chair: Just on the question of timing, you just said 18 months to two years. Two years isn’t an option, is it? The Government have said that they want to bring the shutters down on this and have everything in place by the end of next year, which is now less than two years away.

Mervyn King: The difference between 1 January 2013 and 1 March 2013 is only two months, so 18 months to two years is the period that we are planning to achieve. I think there are good arguments for trying to make this sooner rather than later in terms of the management of the process. The Government have announced a major change in the way regulation will be conducted, and in order to give us a chance to change the culture and style of regulation and to prevent the resources in the FSA drifting away, from a management point of view there are some advantages in doing this quickly. One has to balance that against the advantages of taking time to get the legislation right.

Q6 Chair: I am asking you for your view on that balance. Thank you for setting out the question, but I would like the answer.

Mervyn King: Again, I think those with greater experience of parliamentary legislation should give that answer. I think if we can reach the big decisions by around the summer and have a very clear framework, then I hope Parliament could debate this legislation and introduce it over the course of the following 12 months, so it could be passed by the end of the parliamentary Session 2011-12, and then it will come into effect towards the end of 2012. I think that is a reasonable timetable, but I have no experience of the length of time it takes to take legislation through Parliament, whereas you do.

Q7 Chair: You are giving us very political replies. What I am after is something that means we can understand where you are on all this without having to read between the lines of the transcript afterwards. Are you saying that at the moment we have a process in place, which you are confident is going to deliver us what we need, even though we don’t have a new Bill, and that we are going to try and do this by amendment?

Mervyn King: We are already part of the way through the process, so I can’t be 100% confident at the end of it that we will produce something that we think is satisfactory. But so far, I think, the right decisions have been made, and we are part way through that process, which will culminate in legislation coming before Parliament.

Q8 Chair: If it turns out over the coming months that there are still a lot of big issues to resolve, do you think it is reasonable to say that we should take a look again at the 2012 deadline and let there be a bit of slippage to get this right?

Mervyn King: Well, it is certainly important to get it right, which matters more than anything else. If it turns out to be the case that taking longer is the only way to get it right, then, of course, that would be the case.

Q9 Chair: And you are going to speak up?

Mervyn King: It is not the case, so far. I think we have to wait and see, but clearly the important thing is to get the big questions right.

Q10 Chair: Let us turn to the big questions. Is there something fundamentally defective about the way the FSA has been doing this work?

Mervyn King: I think we have all learned from experience. In 1997, I was in favour of the change to transfer supervision to the FSA, and I have changed my view about the benefits of trying to put in one organisation consumer protection and market conduct on the one hand, and prudential supervision on the other. I think with the best will in the world it is very hard for any organisation to have those two very different types and styles of regulation in one organisation. I am in favour of splitting them-the so-called twin peaks approach. There are many ways you can implement that. The way we are doing it in this country is to create a new agency, which is going to be called the FCA, Financial Conduct Authority, and the PRO, which will be a subsidiary of the Bank. I think that is a perfectly sensible way to go. You could have a separate prudential supervisory authority, which doesn’t have to be in the Bank.

Q11 Chair: I am concentrating on the FSA’s role on the prudential side here in my question. Maybe I will pose it in a slightly different way. Do you think it is possible to do that part of regulation more effectively simply and cheaply than the FSA has hitherto?

Mervyn King: Yes, I do, and I think that is because having put the two types of regulation in the same body the mistake that was made with prudential supervision was to regard that as similar in style to conduct of business. There was a large amount of detailed investigation of relatively small things that weren’t going to have a lot of impact on the overall riskiness of the Bank’s balance sheet. There was a failure to look at the big risks that were being taken, and I think that what we aim to do in the PRA is to focus on the big questions, to have more senior people in the supervisory body interacting regularly with the large institutions to challenge the structure and nature of their balance sheets, to avoid getting bogged down in excessive detail, and to reduce some of the costs of regulation that resulted from a combination of an excessive focus on detail and, in particular, the cost of the IT systems that were there to support that.

I think we have a vision, which is being worked out now, in our transition planning that will lead us to assist and that in the longer run will reduce costs. We hope that that will focus on what turned out to be the important questions when it came to the concerns that led to the financial crisis.

Q12 Chair: That is a radically different approach, isn’t it?

Mervyn King: It is a radically different approach, and that is what we have been asked to do, I think.

Q13 Chair: Are you meeting resistance from the FSA on delivering this?

Mervyn King: No, we have discussed this very openly with Hector Sants. He has bought into this vision and that is what we intend to deliver.

Q14 Mark Garnier: Governor, a number of us were in New York and Washington a couple of weeks ago meeting with people and talking about the Dodd-Frank Act. As you know it is ferociously complex, but one or two commentators were saying that the Dodd-Frank Act is probably the Act they wish they had written in 2003 rather than one that is necessarily dealing with the issues that are facing financial regulation in the States from now on. What is your opinion on what we are doing now? Do you think that these proposals deal with financial regulation for the future or do you think that we are addressing what we wish we had done in 2003?

Mervyn King: Inevitably there is a need to look at what went wrong and correct that. I don’t think that necessarily means that you either are pretending that the next crisis will be similar to the one we have been through, or that the regulatory system should be focused entirely on the problems that we faced in the run-up to 2007-8, but I think that one of the lessons is that the kind of regulation that is needed to avoid a BCCR-type problem, which is to do with fraud, poor conduct and the need to have an intrusive regulator looking at conduct issues and the enforcement side of regulation, naturally goes with what will be the FCA.

Prudential supervision is rather different. This is about saying that most banks are all taking the same kind of risk, that leverage ratios have reached a point when we ought to be deeply concerned about the fragility of the system, and that is something that I hope the new arrangement of a combination of the PRA focusing on the big questions for individual banks and the new FPC focusing on system-wide developments will be able to give us a better chance of dealing with these problems than happened last time.

Q15 Mark Garnier: One of the things that crossed my mind on the many occasions during the course of this investigation into financial regulation is what the rule book is going to look like. I acted as a compliance officer under the old Securities and Futures Authority, I acted as a compliance officer under the Financial Services Authority, but under the new system what will the rule book look like? How is it going to be different from the one we have got at the moment?

Mervyn King: To be perfectly honest, I am not sure whether good supervision, as opposed to regulation of conduct and enforcement, is ever going to depend upon the detailed rules. It is going to depend on judgements exercised by supervisors, about the risks that are being taken on the balance sheets, particularly at the major institutions-

Q16 Mark Garnier: Supervision is the key, isn’t it? Because if we don’t have enough supervisors then you can have as many rules or guidance, or whatever, but you need to have sufficient supervision.

Mervyn King: You need to have the right kind of supervisors. I don’t think it is a question of numbers. I think it is a big mistake to think that the right response to this crisis is to say, "Oh, we should have had twice as many regulators or twice as many rules or twice as many requirements to submit data to the supervisors, just make the thing more bureaucratic". That isn’t the answer. The answer is to have the right kind of people supervising, and that is one of the things that we are looking at in the Bank and that Paul, Andrew and I have discussed, which is the need to build up a cadre of people who are willing, able and sufficiently self-confident and experienced to exercise that judgment, to confront banks and say, "Well, come on, don’t put us off with detail here, let’s just focus on the big risks that you are taking," and have that conversation.

To be honest, many of the bank chief executives that I have talked to about this are themselves worried that in the past when they have had meetings with the FSA they have met levels of staff who are, to be honest, too junior to engage in that kind of conversation and don’t challenge the senior management in a way that they feel they ought to be challenged to defend what they are doing. I think that is one of the important changes of style that we would like to bring about.

Q17 Mark Garnier: Can I just ask one last question? We have a twin peak model, which sometimes looks like the Alps, depending on which way you are looking at it, but we have got the FPC, which you are the chairman of, the MPC, which you are the chairman of, the PRA, which you are the chairman of, but you are not chairman of the FCA. If there is another financial crisis who do we pick the telephone up to? Who takes control of sorting out the mess?

Mervyn King: If it is a mess in the financial sector to do with risk and balance sheets, and financial issues, it is very clearly those bodies in the Bank of England that will be responsible for it and will be accountable to you.

Q18 Mark Garnier: If it is not?

Mervyn King: If it is to do with an issue of conduct or mis-selling or an issue of that kind then it is clearly the FCA.

Q19 Mark Garnier: I have to say this bothers me quite deeply, because at the beginning of a financial crisis, when the wheels start falling off the wagon, you don’t necessarily know what has gone wrong, and if there will be one person saying, "Well, my department is prudential regulation and balance sheets," and the other saying, "Mine is conduct of business," how will we know where the problem started?

Mervyn King: I think it was always pretty clear what the nature of the problem was.

Q20 Mark Garnier: But you don’t know in the future-

Mervyn King: When Equitable Life occurred-when there was mis-selling of pensions-everyone knew that it was a consumer protection issue. When Northern Rock got into trouble, it was not a question of consumer protection; it was a question about the balance sheet and the funding of the Bank. That clearly was to do with what will in future be the responsibilities of the PRA, which will raise issues to the MPC.

Q21 Mark Garnier: Governor, a nervous population were potentially 48 hours away from not being able to get their cash out. They have got to be absolutely confident that somebody will be standing at the helm of the next financial crisis being in control of the whole thing, irrespective of-

Mervyn King: No, if it is a financial crisis of that kind, it is the Bank of England, without any doubt. One of the things that will help us in future was not available at the time of Northern Rock. It was the single most important impediment to dealing with that problem, and it was the lack of a statutory resolution regime for the banks. We were the only G7 country that did not have such a resolution regime.

When I came before this Committee days after the failure of Northern Rock I made that point very clearly and your Committee-different members largely, but not all-took the initiative on that, produced a report, which led to legislation, and we now, in the UK, have what I think is probably the best resolution regime in the world, because we were able to put it in fairly recently. We need to think about whether it should be extended to other types of institutions and licensed deposit takers, but we now have a statutory resolution regime. That would have enabled us to deal with the Northern Rock problem over a weekend-the situation couldn’t be dealt with over a weekend, because of the absence of that regime. These are the things that matter. We have put some of them in place, and we think the new regime that we are debating now will take us up to two years to put in place, but we must get it right first. That is the next set of steps that we will need to take. The Independent Banking Commission will report later this year. There are many things that we need to do to ensure that this crisis does not occur again, and it is very, very important that we do that. But we have got lots of building blocks, and the ones that we are discussing this morning are part of it.

Q22 Jesse Norman: Thank you, Chair. Governor, I was surprised by your somewhat modest response, if I may say so, to the question of new arrangements and focus on process that you described in reaction to the Chair’s first question. If there is going to be new regulation, and amendments to FSMA, will you spell out where you expect most material differences to be?

Mervyn King: Yes. I don’t see it as a question of process. Indeed, I think many of the problems that we have faced in recent years have involved an excessive focus on process and putting in place procedures that people have to go through. We want to ensure that the individuals making judgments about what needs to be done to the major financial institutions in this country to make them sufficiently safe, are made by experienced people, such as Andrew Bailey here, who has played a major role since the crisis occurred, and a team of people that we are going to build up to make those-

Q23 Jesse Norman: What I mean is what substance is going to go into the new legislation? Introducing Andrew into legislation would be doubtless excellent for this country’s regulation, but I don’t think it is appropriate-

Mervyn King: Let me give you one specific example that I think will make an enormous difference. At present, before any individual regulatory Act can be made or changed, there has to be a detailed cost-benefit study and often consultation with the industry. Now that makes no sense for a regulator to have to go through all those steps. We should be accountable to you, and if people think the way we are conducting regulation is inappropriate, then we should be held accountable by you for not regulating the industry in an appropriate way. But we shouldn’t be accountable to the industry itself. That is one of the things that have gone wrong in the past. Our job is to make prudential judgments about the risks on the balance sheet.

The point of regulation is simply-this is a very obvious point-that we don’t think the banks on their own will necessarily make the right decisions in aggregate for how risky their balance sheets are. Our job is to make sure that there are limits on how much risk is being taken, which is one of the major functions.

Q24 Jesse Norman: Can I just clarify something on that for a second, and then obviously bring in Mr Tucker? The thought is essentially this: the PRA will be devoid of industry contamination, which has been taking place within the FSA at the moment?

Mervyn King: In part.

Q25 Jesse Norman: In part. Okay, that is helpful. Did you want to add something, Mr Tucker?

Paul Tucker: I just wanted to add another important example of change to legislation. The objective of the PRA will be different from the objective of the FSA, in particular, in respect of bank supervision. This is on page 46 of the Government’s consultative document. It frames the objective of the PRA in terms of supervising firms to ensure stability and that if and when they fail, the failure is orderly. That will move us away from a world in which the job of the supervisor is to crush the probability of failure, come what may. Firms will fail from time to time-maybe even the biggest firms will fail-and the job of the PRA is to ensure that that should happen in an orderly way. This is an absolutely profound change that Parliament will need to debate, but if Parliament agrees that, that will be something that only you in Parliament can do, and it will change the face of banking supervision for the next quarter of a century, frankly, compared with the previous quarter of a century.

Mervyn King: This is of fundamental importance. The objective of supervision is to recognise that banks will fail. Our role is not to stop them failing. Our job is to make sure that if they fail because of poor management, then they do not contaminate the rest of the financial or economic sector, but they are still allowed to fail.

Q26 Jesse Norman: In other words, the FSA, as it is currently constituted, has essentially been reinforcing a culture of "too big to fail" by not allowing an orderly failure regime to take place.

Mervyn King: The FSA wasn’t easily able to allow orderly failure in the absence of a resolution regime, and it was pushed to the point of a no failure regime. One of the most important functions of this Committee is to try to educate Parliament and the public about the need to have a regime, which is not seen as a no failure regime but a regime that does countenance failure, where the regulatory set-up is there to ensure that if an individual institution fails, it does not cause havoc with the rest of the financial system or the economy as a whole.

Q27 Jesse Norman: Right, but does that not point to a need for new legislation? How can FSMA possibly discharge the radical change in regulatory thrust that you are contemplating?

Mervyn King: It clearly requires new legislation, and there will be new legislation. It is just the form of it, as we understand it, will be to amend FSMA, which will include changing the objectives of the PRA and setting up the PRA. It is up to you to decide the form of that change in legislation, but it is not in doubt that there will be new legislation.

Q28 Jesse Norman: But I can’t imagine the Bank not wanting to make some kind of recommendation itself formally to the Government as to what form the new regulation it is expected to discharge will take. I mean Montagu Norman would not have felt this degree of punctilio, I think.

Mervyn King: No, it’s not that at all. You often say to us that we are straying into politics, well, this is legislation. You are the experts on this. What we are saying is that there has to be new legislation, that there has to be a new body and new objective and that that needs to be put into statute. Now the form in which that is done, whether that is an amendment to existing legislation or a new Bill and therefore Act, is not our area of expertise; it is yours.

Q29 Jesse Norman: Your criticisms of the FSA, by implication, paint it as a mildly dysfunctional organisation targeted on the wrong goals, are you concerned that the current pace of financial regulation is too fast at the moment, given, for example, that the Banking Commission has not yet reported and therefore we don’t even know what, as it were, the units of account to be regulated are going to be.

Mervyn King: No, I think in some ways you can argue the opposite, that since we feel the need to see a new system put in place, with new objectives and a new culture and style, there is much merit in doing that as soon as possible. But against that, of course, is the fact that, as you point out, that can’t be done without legislation and it is very important to take the time to get the legislation right. These two things point in opposite directions and trying to get the right balance is not easy.

Chair: Before I bring in Andy Love, Chuka Umunna wants to come in on this point about "too big to fail".

Q30 Mr Umunna: Can I just follow up on what you were saying? You said our role is not to stop them failing. Are you concerned, Governor, that last year Hector Sants seemed to be suggesting that the PRA should have a low tolerance for the failure of high impact firms?

Mervyn King: I don’t think that is where we are now, and I think it is very clearly understood that the purpose of the legislation and the approach-I think the consultative document makes this pretty clear-is that our objective in regulation, as Paul has said, is not to put in place a no failure regime; our objective is to put in place a regime in which, if there is failure, then our job is to make sure that it doesn’t contaminate the rest of the financial sector and the economy as a whole. That is our purpose. It isn’t to protect management from its own failings.

Q31 Mr Umunna: So he was wrong when he said that.

Mervyn King: I can’t remember the words that he said, and I don’t like to say things to people when words are quoted possibly out of context. What I do know is that Hector is completely in line with the document and the position that we have taken here.

Paul Tucker: And there is an international debate on how to improve resolution regimes in order to handle the largest, complex global firms. There is a G20 debate, a European debate and a national one. The technology still needs to improve on that front.

Q32 Mr Umunna: How do you see the PRA’s approach significantly differing from that of the FSA to date?

Mervyn King: In terms of-

Mr Umunna: In terms of this issue of failure and whether to allow-

Mervyn King: I think as we have said, since the objective will clearly be different if you pass the legislation, because the objective has to be framed in legislation, then it will be possible to behave in a different way and to adopt a different style of regulation, as I have explained, in which we are focusing on the big risks that institutions are taking and spending less time worrying about some of the details.

Paul Tucker: It means in respect of each firm supervisors have to think with a resolution team in the Bank, "What will happen if this firm fails? Is this firm organised in a way that will permit failure? Is the statutory regime there that will enable smooth failure?" A crucial element of this-this applies not just to the biggest and most complex firms but to small ones-is rapid payout under the deposit insurance scheme? If one of your constituents has got their current account with a small bank or building society, but it took three months or six months to get a payout from the deposit insurance scheme, then your constituents would be in a terrible situation. It is incredibly important that the insurance scheme should be able to pay out, we think, within a week. That debate is carrying on in Europe.

My point is that when the objective changes the supervisors have to come into work and think about those things, the end game, as well as thinking about, "Does this firm look healthy today?"

Q33 Mr Umunna: Can I just ask, linked to that, about something that came out of our trip to the US, the importance of liquidity management? There has been a lot of talk about capital reserves, but not quite as much talk about liquidity requirements. I am presuming the PRA is going to have a quite big role in this. Do you agree that when Basel in 2008 was looking at the issues that needed to be addressed to prevent a crisis from reoccurring, you see liquidity as being a pretty critical issue too?

Paul Tucker: Yes, absolutely. I mean this is one of the great gaps in the international apparatus over the past 25 years. Historically there was an attempt to fill it in the mid-1980s that failed. There is now a proto Basel accord on liquidity, and that will be refined and put into place over the next three to four years.

Q34 Mr Umunna: Do you think the FSA’s current requirements, which in some senses go further than Basel because you have to have a liquidity buffer sufficient to maintain three months’ stress as opposed to 30 days-which Basel requires-are appropriate? Do you think they go too far? Do you think it is a problem that there is a disjunct between what Basel is requiring and what the FSA is requiring?

Paul Tucker: The details of the new Basel accord in this area aren’t pinned down yet. As they become pinned down then the FSA will need to think about how it wants to converge its regime into the Basel regime, but it’s quite hard for them to do that when the Basel regime hasn’t got all the i’s dotted and t’s crossed.

Q35 Mr Umunna: No doubt you are aware that many of the banks are quite concerned that the requirements, which are being imposed by the FSA in this respect, seem to be tougher than Basel 3. Do you think they protest too much?

Paul Tucker: Well, I think they raise a legitimate point in general. I think it’s quite hard to evaluate who has the better side of the argument when, as I say, the details of Basel are not finalised.

Q36 Mr Umunna: Finally, do you think the emphasis on how a bank can be wound down is likely to lead to quite large restructurings of our banks going forward as the rules change?

Paul Tucker: I think it could over time, yes. I think that’s possible.

Q37 Chair: Governor, can I just take you back to what Hector Sants said. It is very important here that, if we have a radically different approach, it is clearly understood and accepted, and it does seem that you are coming forward now with a radically different approach, which is more targeted and less costly.

Mervyn King: That is what we want to do, yes.

Q38 Chair: What he said was, and I am quoting, "For high impact firms, even with resolution tools-"

Mervyn King: Sorry, who is this quote from?

Q39 Chair: Hector Sants. I just want to be clear whether this is no longer policy and that, at least once you are running the show, this is not going to be how things will be run, "For high impact firms, even with resolution tools, the PRA will have a low tolerance of failure".

Mervyn King: We will not set out to have a specific tolerance of failure. We will set out to ensure that we can resolve firms in such a way that if they were to fail because of bad management, rather than being protected by the taxpayer, they will be allowed to fail and we will try to minimise the damage that might be caused by that failure on the rest of the financial sector and, most importantly, on the economy as a whole.

Q40 Chair: So we can shred that part of the speech.

Mervyn King: I’m not shredding anyone’s speech. I’ve just stated our approach.

Q41 Chair: That is what it looks like to me. What we now need to know is who is running the policy in the interim?

Mervyn King: It is very clear that FSA has a statutory and legal responsibility, including to you, for supervising banks until the new legislation takes effect.

Q42 Chair: Does that policy hold until we get the new legislation?

Mervyn King: That is a question you have to ask them. We are not doing supervision, and we will not do so until the new legislation takes effect.

Q43 Chair: Do you think there might be a merit in having a memorandum of understanding to sort out who is running the policy in the interim?

Mervyn King: I think the difficulty with that-I have some sympathy, as I said before, from the management point of view, if you are thinking this as the Government announce a big change in policy, which Parliament endorses, then the sooner you get on with it, the better. From that point of view the faster we make the switch the better. The difficulty is, of course, getting the legislation right to support that.

I am not sure that an MOU in and of itself could change the problem we face but, again, you’re the experts. The FSA and its board have a statutory responsibility for discharging responsibilities for bank supervision. It is not obvious to me that they can get rid of that simply by signing an MOU. You would haul them up here and say, "Come on, you have got the statutory responsibility. You can’t just give that away through an MOU."

Q44 Chair: Have you discussed an MOU with the FSA and the Treasury?

Mervyn King: We haven’t, no, because we thought there was not much point in it unless we could. There has to be some form of legislative transfer of responsibility from FSA to the Bank. Now there was initially some discussion about just transferring the whole thing, lock, stock and barrel, to the Bank, but I think that would have been a very bad idea, because the idea that the Bank could take charge of consumer protection, independent financial advisers and enforcement conduct is absurd. We don’t have the ability or capability to do that. What we want is to split that kind of supervision from prudential supervision at banks.

Q45 Mr Love: Governor, I want to try and pin you down on this issue of legislation. You keep telling us we are the legislative experts. You have answered-

Mervyn King: I hope you are.

Q46 Mr Love: Let me say that in our interim report we come down fairly firmly-in fact, very firmly-in favour of both taking the time necessary and having a completely new Act. We are clear about where we stand, but I am not clear about where you stand, because you mentioned a few moments ago we need to get on with it. Of course, that is the challenge, because a balance needs to be struck, but you need to be clear, because you are at the centre of this new framework. What do you think? What does the Bank think?

Mervyn King: We would like to move as quickly as possible consistent with your judgment about how long it will take to get the legislation right. In the long run, it is very important that the legislation is right here. It is very unlikely that you will find lots of spare time to amend or change legislation in the future. We need a clear legislative framework that will serve us for many years. If you think you need more time to get that legislation right, I defer to your judgment.

Q47 Mr Love: But what we are looking for is your judgment on the matters related to making sure that we get the legislation right.

Chair: Come on then, Governor, you are doing negotiations and we want to know whether this is going to be okay or not.

Mervyn King: Every now and then when I come to this Committee, you point out in a very polite way that I am involved in this and that and something else. You are trying to lure me into something where you are the experts.

Q48 Mr Love: We are trying to lure you into giving your expert opinion as to the person and the organisation that will be at the centre of this new framework.

Mervyn King: I don’t think I can be clearer than the following: other things being equal, I would like to move quickly, because that will enable us to put in place a better and improved regulatory regime, but I accept that we need to take the time to get the legislation right. We have to get the legislation right. If the experts in this think we need to take longer than is currently proposed, I defer to that judgment, but I am not an expert on how long it takes Parliament to debate a Bill or amendments, or how much time you can create for the legislative process. This is your field, not mine.

Q49 Mr Love: I understand that, but there is a clear difference of view. The new consultation document, which I think you have in front of you, states quite clearly that there will be amendments to the Financial Services and Markets Act and that we will go at the speed that is necessary. This Committee, and therefore through us Parliament, thinks that we ought to take time in order to get this right. As you say, we won’t come back and re-amend the amendments, so we need to get it right. Which do you favour?

Mervyn King: Our instinct in this process was always to have a new clean Act of Parliament that is set out in words that we-and possibly the general public-might understand. That is much harder to do when there is big change in the regulatory regime that takes the form of amendments to an existing piece of legislation that was introduced to put in place a wholly different style of regulation. Now we are told by those who know that it is possible to bring about this new style of regulation through a process of amending existing legislation. I am not an expert on whether that is right or not; you are. But I am quite happy to defer to the judgment of this Committee if you feel it is better to have a new Act and to take time. I certainly wouldn’t challenge that.

Q50 Chair: We are going forward on the basis of these amendments. We are not going forward on the basis of what-

Mervyn King: Indeed, the Government have decided that they are going to proceed on the basis of amending FSMA, and they have set out a way in which the changes described in this document can be achieved by amending FSMA.

Paul Tucker: The bits that are completely new-the bits of legislation on the Financial Policy Committee-will read like a new Bill or a new Act, because there is nothing in FSMA to amend. It will just be a whole set of new clauses. On prudential regulation and conduct regulation, there will be a series of amendments. Will we engage with the Treasury clause by clause on that? Yes, of course we will. But we don’t know whether it’s easier for you to scrutinise amendments or a new Bill.

Q51 Mr Love: The reality is-our view is very clear-that we want to look again at the whole area and, yes, of course, there will be new parts to that. What I am anxious to get from you, Governor, is having heard what the Committee has to say, will you take that into account in the responses you make to the consultation document and the discussions you will have with the Treasury?

Mervyn King: We have already made it clear that our preference would have been for a new Act, which was clear from the outset. There is nothing new in that. But we didn’t win the day on that argument, and now we are going down a different path. Probably the best thing to do is to carry on down that path but leave you to ensure in Parliament that the process of legislation is effective. I am sure we can rely on you to do that.

Q52 Chair: Having just had a colossal financial crisis where, partly as a result of defective legislation, it sounds as if we are creating the very conditions for another crisis, aren’t we, with further defective legislation? You are describing a pig’s ear of a legislative process, aren’t you, Governor?

Mervyn King: I have a set out a very clear vision of what the new system of regulation should be. How we put that in legislation is not for us. That is for you and the Government to discuss. If you have a clear view that it should be done in a different way I am not going to gainsay that. But you have to take that up with the Government, not with the Bank.

Q53 John Thurso: Governor, I have one last question on this vexed issue. May I say that I am touched by your idea that we are experts in legislation, as we are more often the masters of unintended consequence? The critical thing in this is that we get it right.

Mervyn King: Absolutely.

Q54 John Thurso: In order to achieve that, the people drafting the legislation in the Treasury have to get it right to start with. Are you confident that you and your team have put to them sufficient information that they can deliver a first draft that is workable? That is the critical question. Has your input gone into where it matters at this stage?

Mervyn King: We made the input, and I am happy with the input that we have made. Whether it will be accepted is something I can’t say.

Q55 John Thurso: Would you come before us and tell us what has not been accepted that you would have liked to have seen?

Mervyn King: We will certainly do that once we see the Bill.

Chair: Write to us immediately.

Q56 John Thurso: Can I turn to Mr Tucker? In the list of strategic goals that the court approved for strategic priorities for 2011 is No. 3, which is to discharge the Bank’s enhanced role for financial stability. What is your key priority in delivering that strategic objective?

Paul Tucker: Of the key priorities over the past year, the main one has been what we have ended up talking about this morning, which is regulatory reform. Another one has been the complete reform of resolution regimes internationally to handle the largest and most complex companies. Another one has been an outcome from the Basel capital call review in the G20, which was a step forward. A fourth internal priority was to ensure that the different directorates of the Bank are joined up. Financial stability is all about synthesis; it is not just about markets, analysis or supervision. If we are to make a success of this, the approach has to be porous and co-operative.

Q57 John Thurso: One of the bullet points it is interesting you didn’t mention just now is to design and promote more resilient financial market infrastructures. What do you regard within the market infrastructure as being insufficiently resilient at the moment?

Paul Tucker: As more over-the-counter derivative activity goes through the so-called central counterparties, we are going to need to ensure that the central counterparties are more robust than in the past and, in the event of a counterparty failure, can unwind very complex derivatives books without unleashing chaos. The central counterparty brings all the risk together in the centre. It would be a cataclysm, frankly, if one of them failed, and we need to ensure that there are standards that make them resilient, and international standards to that end, which Andy’s people lead on, within the UK and with the FSA are being developed.

Q58 John Thurso: Do you think that the Bank’s arrangement for scrutiny of the markets for that purpose is sufficient?

Paul Tucker: As things stand today, the responsibility for supervising clearing houses and settlement systems lies with the FSA. The Bank of England oversees payment systems and the payment system bit of other pieces of infrastructure-LCH central counterparties. We feel that we have sufficient powers to do our statutory responsibility. In the context of the Bill, we have been seeking an amendment to the powers that the FSA currently has, so that we can oversee central counterparties more effectively in the future. In terms of human capital, I think our markets area, our banking area and our analytical area puts us in a fairly good position.

Q59 Michael Fallon: Mr Tucker, the Government have proposed an additional power to balance financial stability with the effect on medium and long-term growth expressed in this rather torturous double negative in paragraph 121; how is that going to be workable in practice?

Paul Tucker: We didn’t resist this for the following reason: when we are doing monetary policy, we don’t believe that there is a long-term trade-off between inflation and growth and employment, but in financial stability it is different. We could ensure that there wasn’t a financial crisis in this country over the next 100 years by completely repressing financial activity. There is a trade-off that we have to balance, hence these words.

The other thing that the consultation document says-we welcome this-is that the Government will ask Parliament to make a provision for the Government to give us a remit on our financial stability objective. A point that you made in your report is that no one on the planet knows enough about financial stability to boil this down into a quantitative target. We have felt strongly that the regime should make scope for learning on our part, on the Government’s part and in the broader community. I can’t give you, Mr Fallon, a precise answer to that today, but what we and the Government are planning to do is make provision for the Government to articulate where they see the trade-off, and for us to respond publicly to that remit.

Q60 Michael Fallon: It is for the Government to strike the balance between financial stability and medium-term growth, and for you to work out how to accommodate that.

Paul Tucker: It is for the Government and Parliament to decide what the objectives of any regime are, yes. We feel completely comfortable with that, otherwise we start to abrogate to ourselves the responsibility for deciding society’s end objectives. I mean that is exactly analogous to the monetary policy regime. We don’t choose the target. The Government choose the target and report it to Parliament, and we in the MPC have the job of meeting that target.

Q61 Michael Fallon: That is now how it is worded, is it? It says, "This does not require or authorise the committee to exercise its functions in a way that, in its opinion, would be likely to have a significantly adverse effect on medium or long-term growth".

Paul Tucker: The objective-the trade-off-is made here. We, on the FPC, would have to say, "We’ve got a problem. There are two ways of curing this problem. Do we think one can deliver the objective of stability with least impact on the trend growth rate?"

Q62 Michael Fallon: Governor, the additional powers that are proposed in paragraph 237 include a broad power of recommendation. You used to complain to this Committee that your power previously was limited to what I think you described as sermons in church. This is a recommendation. How will it have a binding effect on other regulators?

Mervyn King: Because what it will do, I think, is to force. It says here that the PRA and the FCA have either to comply with the recommendation or explain in public why they have not done so. That didn’t exist before. I think if it had been the case that regulators had had to defend what they were doing and ignore the recommendations of the FPC then I think that would have changed the incentives for regulators.

Q63 Michael Fallon: Can’t you do better than that? Aren’t we just going to get back into this blame game between the Bank and the PRA and the FCA? I thought the whole point of this was to put you in charge. Wouldn’t you rather have the power to direct? Aren’t you going to be the super-regulator?

Mervyn King: There is a power of direction, which will allow the FPC to require the PRA or the FCA to implement certain macro-prudential tools. To the extent that Parliament delegates certain instruments or tools to the FPC, we will have the power of direction to require the regulators to implement that on individual institutions. That is a pretty powerful weapon.

Q64 Michael Fallon: What is the point of the recommendation? Could you explain to us the difference between these two sub-paragraphs?

Mervyn King: Because I think the recommendations would be there. Let’s suppose, to take the example Paul gave, that all of us learned that there was an area of financial behaviour that we thought was posing a risk. It hadn’t been anticipated when you in Parliament chose the instruments that you wanted to delegate to the FPC and it was something that we wanted to raise. We could immediately recommend that something be done about it, even if there FPC didn’t, at that stage, have the power to direct the PRA to use specific instruments to deal with it. As Paul has said, new instruments will be devised in the future that we can’t even imagine today-let alone frame the regulation of-and we need to have the ability to talk about and recommend to regulators that they deal with some of these problems.

Subsequent to that, if we think it’s important enough, we might come back to this Committee and say in our judgment the set of instruments available to the FPC should be expanded, and we would like you in Parliament to consider adding those extra instruments. But short of that, before you have done that, I think we do need the ability to have a broad power of recommendation, and I think it is quite important that the PRA and FCA must either comply or explain.

Q65 Michael Fallon: I understand that, but I just want to be clear whether you think a broad power of recommendation is strong enough.

Mervyn King: I think it is strong enough in the areas that we can’t at present define sufficiently clearly to put into legislation. Where we can, then of course the power of direction will apply.

Q66 Chair: Just to be clear, it will be extremely important for you to have some means of communicating with this Committee, if you feel that the power of direction you have is inadequate.

Mervyn King: I think one of the regular conversations, which the FPC or the team from the Bank representing the FPC, will want to have with your Committee as we go forward is precisely on that point.

Q67 Mr Ruffley: Just on that point, Governor, what is the role of the Treasury if the policy tools that you have are insufficient and the PRA and the FCA are not taking you seriously? I can’t imagine that would happen, but suppose they disagree with you. What role would the Treasury have? You would be able to go to the Chancellor and say, "Listen, I need some more powers."

Mervyn King: Yes, that is exactly what we would do, and we would say that openly to your Committee. Either the Chancellor would disagree and not put proposals to Parliament or he would put proposals, and I think the view of the members of this Committee would carry a lot of weight when the matter was debated in the House.

Q68 Mr Ruffley: I don’t see a problem. You could just make a big fuss with the Chancellor, and it would be very public.

Mervyn King: It wouldn’t be a big fuss. We would just go along and say, "Look, the world has changed. We think we need a new power. These are the arguments for; these are possibly the arguments against. Will you please decide?"

Q69 Mr Ruffley: Sure. Part of this discussion is about accountability. You have spoken, and your colleagues have spoken rather well, about the new improved accountability, but I am not entirely sure whether the buck stops with you or whether you are the super-regulator to which Mr Fallon has alluded. Can I just get one or two things straight? In the old regime-the regime that we are operating under at the moment-when the crisis happened, we saw there was a failure of regulation. How many senior regulators either in the Bank or in the FSA were dismissed, retired or were otherwise moved on? Can you give me a number-not their names, just a number?

Mervyn King: There were no regulators in the Bank of England, because we had no regulatory responsibility. On the FSA, I think that’s a question you will have to put to the FSA. I think it is pretty clear that some people’s careers were certainly affected, but I think that is a question you have to put to the FSA.

Q70 Mr Ruffley: You said at the time of Northern Rock that if you had had a resolution regime you could have sorted it in a weekend.

Mervyn King: Yes.

Q71 Mr Ruffley: I think we all agree that that was a huge policy tool that was not at the disposal of the Bank at the time of Northern Rock. Who did you speak to about the absence of that resolution tool, because it was a huge gap in British policy making-you have said yourself that we were the only country in G7 that didn’t have it? Wasn’t it your job, as Governor, to point that out? It was a huge hole.

Mervyn King: And we did. Indeed, we had various war games with the FSA and the Treasury in the years running up to the crisis where we made that point. I remember very clearly making that point forcefully at the end of one of the exercises, and the FSA and the Treasury completely agreed. Indeed, work was going on in the Treasury to create a resolution regime. That work stream had been started, but I certainly didn’t say, "You know, hang on, unless you put this in place by July 2007, I know that in August there is going to be a major problem."

Q72 Mr Ruffley: But we were an outlier. We were the only country in G7, so well before 2007 didn’t some bell ring in your mind-

Mervyn King: Absolutely, and we said this very clearly. But there are enormous questions of priority when it comes to introducing new legislation. I think it was not unreasonable for the Government to take the view that, important though that was in principle, there were many more urgent things to do with the health service or defence that required legislative time.

Q73 Mr Ruffley: I was struck by your comment that we were the only major industrialised western economy not to have that-

Mervyn King: There is one very interesting aspect of that, which is every other G7 economy introduced a resolution regime only after problems in their own country. Not one of them learned from the experiences of the others.

Q74 Mr Ruffley: I merely make that point because that was a whacking great gap, and everyone’s wise after the event. But it could have saved a lot of misery.

Mervyn King: Absolutely.

Q75 Mr Ruffley: Could I just move on from that and refer to something you said a few moments ago? On the new resolution regime, which is good and important to have, you said that there are lots of building blocks, so other key policy tools will be given to the Bank under this new regime. Will you identify the big building blocks that we don’t have at the moment?

Mervyn King: I think, from our point of view, the most important was that it became clear with the benefit of hindsight that there were gaps and missing instruments in the policy framework. That monetary policy was able to keep the economy growing at a sustainable rate with inflation low and close to the target. There were undoubtedly improvements that could have been made in the individual regulation of banks, but we have discussed that and this consultation document is designed to improve that. That is one of the building blocks. But an absolutely key one was that we didn’t take any action on the enormous expansion of the financial sector balance sheet. In the five years running up to the crisis, two thirds of lending by UK banks did not go to households or companies; it went to other parts of the financial sector. What we were seeing was an enormous expansion not so much in employment in the financial sector but in the size of the balance sheet based on borrowing. Leverage went up to extraordinary levels. That was the area that nobody was given the task of looking at and dealing with, which is why the Financial Policy Committee, in my view, is there to fill that gap between the macroeconomic management of the MPC and the microeconomic, microprudential supervision of individual banks.

Q76 Mr Ruffley: That is the other-

Chair: One last very quick question and a quick reply, please, Governor.

Mr Ruffley: On the "too big to fail" argument, I am not talking about the cash bailouts to RBS and Lloyds, but you did a very good paper suggesting that there was a £100 billion a year guarantee in 2009 that basically the British taxpayer gave to the big banks as a result of not allowing them to fail. They could borrow in the money markets cheaply and they could lend much more expensively. How is that going to be unwound, do you think, so that we do get to a position where banks can fail?

Mervyn King: Let me bring in Mr Haldane, because he is the author of that work.

Q77 Chair: A brief reply. I am sorry we are running tightly to time.

Mr Ruffley: It is an important question.

Andrew Haldane: Of course. I will be as brief as I can. Let me mention three initiatives that relate to lowering that implicit subsidy. One is requiring the largest and most complex banks to hold larger chunks of loss absorbing capital to lower their probability of failure. A second initiative would be to ensure that in the event of failure there can be wound down the parts that can be wound down, and those parts that need to be kept upright remain upright, which are the so-called recovery and resolution plan work streams. The third dimension, which is one that Paul spoke to, is when those banks are of a cross-border nature we need much better rules of the game for knowing who goes where and who does what, and the Financial Stability Board is working on an agenda to meet that. There are three initiatives that speak to removing the implicit subsidy that markets and rating agencies currently attach to the biggest banks.

Q78 Mr Ruffley: Sorry, I just want to ask you a question, if you don’t mind. Is it possible to get a written submission on that, because we have been cut short?

Paul Tucker: We could send you the FSB communiqué, on that because the package that Andy has described was set out in the G20 summit in November.

Q79 Stewart Hosie: Can I go back to the issue of supervision? When you were faced with the Hector Sants quote about the low tolerance of failure, you said that your job wasn’t to stop banks failing. Paul, you have said that you would work with the Bank’s resolution teams effectively to prepare for failure rather than the avoidance of failure. I understand that, but what do you imagine the general public will think when they hear people like you from the Bank as supervisors and regulators effectively preparing for failure rather than engaging active supervision to minimise the risk of it.

Mervyn King: I think this goes to the heart of the debate about the structure of our banking system. People putting money into deposit accounts in banks either need to be told that the money that they are putting into their accounts is going to be invested safely and won’t be invested in risky activities, or the taxpayer is going to have to stand behind to give a guarantee or they may lose money. I think this is a big question for Parliament, because this is an issue about the structure of the banking system. Of all the building blocks that I have talked about, we have got the FPC, the change in the regulatory regime for regulating banks and the introduction of the Independent Banking Commission in September. The IBC will, I am sure, have things to say about the questions, about how on earth we can create a system in which retail depositors can believe that their money is safe without the taxpayer giving a guarantee to the people who run the banks. We have to confront that question, which is perhaps the single most important question that we need to confront.

Q80 Stewart Hosie: I have no problem with that at all, which is why I support our holding larger capital reserves, minimising leveraging and all that good stuff. I have no problem with that at all.

Mervyn King: Individual retail depositors are protected through the FSCS, and the deposit protection scheme, now up to £85,000 per individual account, per individual bank, is a means of saying to depositors, even if the bank fails your money will be safe.

Q81 Stewart Hosie: Indeed, but it is not just the actual failure of a bank and the potential loss of money that is at issue here. Even if the most modest non-systemic bank collapses, it can-and it has-contributed to a systemic crisis in confidence, which is the most damaging thing that can happen to the banking sector. That is why I am still concerned that the PRA, as Hector Sants said and as you have said, will spend more of its time on resolution and less time on the avoidance of failure. I am trying to understand why you think that the prudential rules and regulation of the big banks should be done at the expense of the act of supervision lower down the chain. I don’t see a contradiction.

Mervyn King: I must have misspoken; I am sorry. I did not say it would come at the expense of active supervision of the smaller banks. What it will come at the expense of is excessively detailed scrutiny of individual actions taken by the big banks. It makes no sense to second-guess the management across the board. If we are going to second-guess the management of supervisors it is to challenge them about the big decisions that they have been taking.

I think resolution is fundamental, because the failure of a small bank should not have systemic implications, if the small bank can go through a resolution process in which the depositors wake up on Monday morning and know that their accounts are safe and that they have been transferred to another bank. We have proved this. We did it-Andrew Bailey did it, leading the resolution of the Dunfermline Building Society. If we could have done the same thing for Northern Rock, then there wouldn’t have been the run on the bank that occurred.

Q82 Stewart Hosie: Can I say I am very pleased with the answer you have given, that high-level regulation and prudential supervision will not be at the expense of active supervision? I will be brief, because I am a little short of time. I take it that you effectively agree with this Committee in what we said in our last report, namely that the PRA would need to have a strong justification for reducing the supervisory effort in such low-impact firms.

Mervyn King: Yes.

Q83 Chair: Governor, you are a member of the Court of the Bank of England; you are deputy chairman of the ESRB; and you are chairman of the FSC, the MPC and the PRA board. Are you at risk of becoming a single point of systemic failure?

Mervyn King: No, and the reason is that the power is not given to me, as an individual; it is given to the committees. I am member of the Court, but the Court is there to act as an oversight body of what I and other people in the Bank do, so it examines. I have an interview each year with the chairman of Court who quizzes me on my performance. He sets me objectives for the following year, which is an oversight process. In terms of the three policy areas of the Bank-the MPC, the FPC and the PRA-I am only one on each of those three committees, and we have a proven track record. On the MPC, I have been in a minority on three occasions as Governor. I don’t believe that that damaged the credibility of the committee or my own personal credibility. We understand that in those difficult judgments it is perfectly reasonable for people to take different views. Unless we can devise a decision-making process that accepts that it is reasonable for different people to hold different views and come to a judgment about how the group, as a whole, reaches that decision then, frankly, there is no way you will ever get a rational decision-making outcome. I don’t think that I personally am a point of systemic failure.

As far as the Bank is concerned, I think it is inevitable that if you are going to have something like the FPC doing macroprudential regulation, it needs to be in the central bank, which is why the ESRB has as its voting members predominantly central bank governors. The area that you could think about being outside the Bank is the PRA, which could be somewhere else. But I think for perfectly sensible reasons the Bank has been asked to take it on, and it will be a subsidiary of the Bank and be part of our general responsibilities. But each of these three decision-making bodies will be directly accountable to this committee and it won’t just be me who comes; it will be a group of people. I expect that when it is the FPC and the PRA, there will be many occasions when I won’t come at all, and you will be talking to other members of the committee and the PRA. I don’t think that that is a point of systemic failure; I am confident of that.

Chair: Busy though you will be, we will still want to see quite a bit of you, Governor. Thank you very much indeed for the evidence you have given this morning on this. We are running a little behind schedule, so we will take a 10-minute break and resume on inflation.