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To be published as HC 1125

House of commons



Treasury Committee

Appointments to the Interim Financial Policy Committee

Tuesday 7 June 2011

Michael Cohrs

AlAstair Clark

Evidence heard in Public Questions 1 - 182



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Oral Evidence

Taken before the Treasury Committee

on Tuesday 7 June 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr George Mudie

Jesse Norman

Mr David Ruffley

John Thurso


Examination of Witness

Witness: Michael Cohrs, Member of the Interim Financial Policy Committee, gave evidence.

Q1 Chair: Thank you very much for coming to see us this morning, Mr Cohrs, and thank you very much for volunteering for this job. Could I begin by asking you about your role, which you have rightly and helpfully covered in your written notes to us, on the European Advisory Board of Deutsche Bank. What does that role entail and what is discussed at those meetings that might be of relevance to the job that you are being considered for now?

Michael Cohrs: The Advisory Board is a group of mostly industrialists-I think I am the first banker to be put on the group-who meet twice a year for about three hours each time and they discuss topics. At the last meeting a review of the new Deutsche Bank headquarters was given to the industrialists. The industrialists talk about a bit about conditions they are seeing in the marketplace. It is not an executive body within the bank, and it is probably slightly misleading to say it is an advisory group because, in fact, no advice is given to Deutsche Bank. I view it as something that is quite interesting, but it is very clear to me that the work that I do on the FPC is far more important. It is also clear to me that, if I continue to do both, there are certain things that I will see and hear from the FPC, that it would be inappropriate for me to discuss in these two sessions each year at the Deutsche Bank Advisory Board.

Q2 Chair: Can you illustrate that?

Michael Cohrs: Sure. This week, in preparation for our first Financial Stability Report, we have been going through some of the risks we see. As part of that, I see non-public information on UK banks, which is highly confidential. For instance, I hear topics in the FPC about things that central bankers may be discussing. Those types of comment would be inappropriate to give to this group of industrialists. There are many confidential items that I have seen so far, as part of the work for the FPC, which it would be inappropriate to discuss in such a meeting.

Q3 Chair: The other related issue is to ensure that the fact that you have a continued interest in Deutsche Bank should not influence what you might say, or views that you might take on the FPC. You told us that your investments include a shareholding in Deutsche Bank arising from deferred bonuses. I don’t want to ask questions that are deeply personal, but I do think it is of relevance that we have some feeling for the proportion of your total wealth bound up in Deutsche Bank and I wonder whether you could give us some indication?

Michael Cohrs: It is a very fair question. These two topics were the first two topics that I discussed with the people who approached me for this role, because I do think that there is both a perception, and the possibility, of a conflict between my shareholding and these two roles. The proportion of my total wealth that is still tied up in Deutsche Bank shares is less than 10%, so it is not a very meaningful figure. What I have agreed with the Governor is that I have disclosed these holdings. These holdings are not vested. Whenever my holdings in the bank vest I have traditionally sold them, but I am happy to say that quite some years ago Deutsche Bank changed its remuneration structure to hold back bonuses, the way all banks do now, but we started doing this back in about 2002. So a number of my old bonuses still roll out.

What I discussed with the Governor was that when these vesting periods come up, which I have shown the bank, I will consult him in the first instance about whether I am allowed to sell. There are certainly periods when I know that I will not be able to sell. For instance, I am allowed to go to pre-MPC briefings, which I did on Friday. Having been to a pre-MPC briefing on Friday, I am now in a period when I would not make any financial transactions until the MPC meets and publishes its report. The same will be true in the FPC. We will have pre-FPC meetings that will then go into FPC meetings, which will be minuted. During those periods I would not be free to transact.

This is not dissimilar to what I did when I was at the bank. When I was at the bank I tended to try to transact only once a year in January, after year-end results came out and before we got too far into the year. That was the one time that I would transact for my personal account, and I would want to do the same thing here. I am very mindful of conflicts and I am very mindful of doing the right thing vis-à-vis my personal investments.

Q4 Chair: It sounds as if what we need is a code of conduct of some sort for members of the FPC because this may affect others, not just you. Although it goes way beyond this meeting this morning, it sounds as though this is something that it might be helpful if you and your colleagues could discuss with the Governor, with a view to coming forward and publishing such a code.

Michael Cohrs: I would welcome that, and I have ideas on how I think such a code of conduct could be conducted to satisfy you and other people that we were doing the right thing.

Q5 Chair: I have one more question, which concerns the new structure of regulation that you are going to be intimately involved in helping run, and the ICB, the work of the Vickers Commission. Do you think that the proposal he has come forward with on ring-fencing will have a particular impact on the way the FPC and the PRA conducts their work and, if so, how? How interrelated is the work of the FPC and the PRA and the work of the Vickers Commission?

Michael Cohrs: I think the work of the ICB is very important because it is very clear that there are structural issues with financial institutions that make it very hard to regulate them. It is not just the "too big to fail" argument; Lehman was not considered a very large institution, yet when it went down the world came to an end from a financial perspective. So I think the structure of financial institutions is quite important. The ring-fencing idea is a good compromise to try to protect the deposit-taking function within an institution, which I think is very important, because it is clear that having gone through the crisis, people of every country now believe that Governments are insuring their deposits. Whether it is true or not that is the perception. I realise that there are schemes in place and in this country you are insured up to £85,000, and so on, but I think there is a perception that if you put your money into a bank your deposit is safe. You want people to think that it is safe and there is a perception that the money is safe. Therefore, from a regulatory perspective, ensuring that that part of an institution is as strong as it can possibly be is very important. Ring-fencing is an interesting way to get there. It is not going to be straightforward, as I am sure that group of people have told you. Getting from their proposal to implementation and then regulating the implementation will not be easy, but I think it is possible.

Q6 Chair: How is this going to affect, if at all, the way you would go about your work on the FPC and the PRA?

Michael Cohrs: I am not sure it affects the work that we would do that much, in that we are trying to uncover big systemic risk and, regardless of whether we believe the deposit-taking portion of a bank is well protected, we will still try to speak up; when we see risk that we think will put financial institutions at risk it is our duty to speak up.

I am not sure it will have a big impact. However, it would be nice if-dare I say it-we get it wrong and we have another problem, that those deposit-taking institutions, or the deposit-taking part of an institution are very robust.

Q7 Michael Fallon: Your advisory board at Deutsche seems to meet twice a year. It is envisaged the FPC should meet at least four times a year. How often do you think it should meet?

Michael Cohrs: I am spending quite a bit more time in the FPC, thus far, and I expect that the interaction the FPC has will be monthly. That may be because, in my view, we are still in a period when markets are very volatile and things are still not very steady, so perhaps right now we are meeting more often than we will. We are also probably meeting more often than we will because we are getting up and running; we are getting to know each other, but right now I am spending quite a few hours each week on the FPC.

Michael Fallon: I understand that, but how often do you think the committee should be meeting formally?

Michael Cohrs: It is hard for me to say that now.

Michael Fallon: Well, what is your view?

Michael Cohrs: I would think once a month.

Q8 Michael Fallon: Once a month, I see. Could you define for us the role of external members?

Michael Cohrs: We are there in part to make sure that there is a minimum of group think, because we come to the issues with a slightly different view. I think we can be very helpful in making the work more understandable. The amount of jargon in the regulatory world is immense, and getting people to write and talk so that everybody can understand what is being talked about is something that the externals can do. Given that they are not embedded in the system, the independence of the externals means they are freer to put their hand up and talk about issues they see.

Q9 Michael Fallon: The original consultation document said it would be "important to ensure that external members are able to offer insights from direct experience as financial market practitioners". Why are you the only one?

Michael Cohrs: I don’t know the answer to that.

Q10 Michael Fallon: Do you think there should be more?

Michael Cohrs: As it is currently constituted, I think the group has been having pretty interesting meetings. I know that another person will be appointed, and therefore I think it would be a good thing if there was somebody else who has direct experience in the industry.

Q11 Michael Fallon: You say "the industry:" your own experience is in investment banking, should there not be some expertise from the retail side on the committee?

Michael Cohrs: Yes.

Q12 Michael Fallon: You think there should. How do you expect the FPC to work formally? If there are disagreements, would you expect to make speeches, for example, outside the committee, just as members of the MPC do at the moment?

Michael Cohrs: That would not be my personal style. If there were disagreements I would endeavour to talk and talk and talk and talk and keep the meeting in session to see if we could come to some common viewpoint.

Q13 Michael Fallon: You don’t see yourself as having a public role?

Michael Cohrs: No, I don’t.

Q14 Michael Fallon: Why shouldn’t the public hear about your work on the committee?

Michael Cohrs: I have never felt that that is an effective way to get the change that you want to happen with a body like this.

Q15 Michael Fallon: You don’t see yourself as accountable to the public for the work you are doing on the committee? You don’t see any obligation to explain to a wider audience what you are doing or why you are working in such a way?

Michael Cohrs: No. I think I am accountable, certainly within the bank, to the chairman, to the court, and ultimately to this group. However, if I want to ensure that points that I feel strongly about are adopted by the group, I am not sure that making a public pronouncement about them is the most effective way to ensure that we deal with the issue that I see.

Q16 Michael Fallon: Why do you think members of the Monetary Policy Committee make speeches around the country?

Michael Cohrs: I don’t know.

Q17 Mark Garnier: Mr Cohrs, how would you define "financial stability"?

Michael Cohrs: That is a very good question. It is probably easier to define what isn’t financial stability. I guess financial stability is that when things are very bad the financial institutions continue to function and the services that they are supposed to provide continue to be provided. In my view the most important service they provide is that they hold a deposit and people think their deposit is safe.

Q18 Mark Garnier: When you look back at the last crisis, we were 48 hours or 24 hours from not being able to get money out of ATM machines, and the Government had to step in to support the financial system. Under the definition you have just given me, that constitutes financial stability but it sounds pretty unstable to most people.

Michael Cohrs: It was certainly not stable. I would agree with that. If you look at most definitions they would include making sure your deposit is safe, making sure that payments happen, providing credit and equity to the marketplace, and providing insurance. The thing that probably was not happening during the last crisis, in the traditional definition of financial stability, was the provision of credit and equity into the market but, even under those definitions, it is very clear that we did not have financial stability. In part, the biggest problem was that Government did not have a choice in my view. There had been other crises when banks were in trouble and Government could say, "Look, we have two choices: we can either come in and maybe things will not be so bad or we can let the institutions struggle along and/or fail," but that is a viable option. In this particular crisis it feels to me that Governments felt-I think they were correct-they had no option. They had to bail out the institutions because the financial markets were so unstable. To me, that was the most frightening thing about the experience we went through in late 2008 to 2009.

Q19 Mark Garnier: Would it be fair to say that your definition-if you were to have one-is that intervention by a Government is an option as opposed to a necessity, and that is the definition of financial stability?

Michael Cohrs: We have to work towards that. We have to try to get structures and do regulation in such a way that Government has the option, as you said, as opposed to the necessity of having to bail out.

Q20 Mark Garnier: In his note to the Committee, Professor Goodhart suggested a number of early warning measures-I think there were four-where you have red lights coming up when things look too worrying. Do you think that is a sensible way for the FPC to operate, to have a set of indicators that it uses? If you do, do you think they should be published?

Michael Cohrs: We need to have something. I have to say, I am impressed with the mechanisms that I have seen in place for the MPC, for instance. The MPC is a very different matter different metrics can be used, but I am a fan of-if I can say it-dashboards; having a dashboard and looking each month at our dashboard and trying to figure out what is wrong. I am not saying that is going to solve all the problems but I think having a very systematic approach to this would be a good thing.

Q21 Mark Garnier: Do you think if that systematic approach was published, and people in the financial markets could have a look at it, that would, in itself, stave off financial instability?

Michael Cohrs: I think it would be helpful.

Q22 Mark Garnier: You are an investment banker by background. One of the requirements in the FPC objectives is not to exercise its function in a way that would in its opinion be likely to have significant adverse effects on the capacity of the financial sector to continue the growth of the UK economy in the medium term. How do you see that working?

Michael Cohrs: I think that is a very necessary thing to put in there, otherwise we could simply require banks to hold levels of capital and take so little risk that they were not providing the other function they are supposed to provide, which is to help companies in this country prosper. So it is a requirement. However, it is a very hard judgment because if we look at the last crisis, and the damage that has been done to the economy and to the people, the cost was so high that I suspect right now we will err on being conservative. I have to say, in looking at markets, I am a great believer in pendulums. When things are good the pendulum swings way too far one way and when things are bad the pendulum swings way too far the other way. We are clearly right now at a point in time, having gone through what we went through, where the pendulum is towards a very conservative approach. So I think we have to be very careful about not putting in place measures that are too draconian but, as I said, we don’t want to go through what we have been through again.

Q23 Mark Garnier: As our pendulum swings the other way, back to confidence and stability, how do you think the FPC should work in order to make sure that people are still conscious of the fact that a financial system is intrinsically fragile and there is still a risk, even when the party is in full swing again?

Michael Cohrs: I think history and understanding the history of financial crises is very important. We will always have financial crises. There have always been financial crises. I think studying past ones is quite interesting, because what you tend to find when you study the past crises is that they do not end as quickly as people think they do. The FPC has to always remind itself that even if things were to start looking better, there could be another problem around the corner, so we always have to be very cautious and careful. We have to be very mindful of some of the new innovations that take place, while at the same time recognising that some of those innovations have helped to provide positive things for the economy in the past. It is a fine balance that you have to strike, but I think it will be our tendency to be slightly overbearing-if I can put it that way-given what we have just been though.

Q24 Mark Garnier: My final question: in your opinion, what would be the definition of success for the FPC?

Michael Cohrs: I would be happiest if I was in front of a group like this, and you looked at what we had done and you said, "Look your judgments look pretty good". It is very hard to define success. I don’t want to say that it is no failures because I personally think we need failures; we just do not need failures that bring the whole system down. If we don’t have a failure it might mean that we have been overbearing-too overbearing-and stifled the economy, so that may not be a success. All I can hope is that we are thoughtful and we take judgments that people think were the best they could have been at the time.

Mark Garnier: Thank you very much.

Q25 Stewart Hosie: You said earlier that you were trying to find big systemic risk, and that mirrors one of the FPC’s objectives linked to the bank’s objective in relation to systemic risk. One of the ways in which you will do that, and monitor it, will be to look at the Bank of England’s Financial Stability Report, and I understand you are going through that process at the moment. What would you make of a Bank of England Financial Stability Report that said there was weakened credit risk assessment, impaired risk monitoring, low premia for bearing risk, high and rising leverage in the corporate sector, a rising systemic importance of large financial institutions, impaired market liquidity, and so on, but whose overview began, "The UK financial system remains highly resilient", written or published some, oh, five months before the run on Northern Rock and the first public sight of the beginning of the trouble in the financial markets? How would you respond to a Financial Stability Report that had these contradictions?

Michael Cohrs: My response, and I have made this response to my colleagues already, is that the FSR has tended to have a laundry list of all the problems but it has not prioritised which of those problems we are most concerned about today. You have just given an example; all the problems were listed, but it is a little bit like when people put risk factors in what they are trying to sell you. They put all the negatives in a risk factor section and there are so many of them that you just wave it away. I think what we have to try to do is prioritise the risks we see and try to come to a judgment as to whether any of them, at a point in time, are risks that we want to highlight specifically and then do something about.

Q26 Stewart Hosie: How would you prioritise those risks? That was a small list but it pretty much mirrors all the problems that existed immediately prior to the South-east Asian banking crisis, which the Bank of England Financial Stability Report in 2000 identified and categorised. How would you measure up or rank the risks in a report like that?

Michael Cohrs: I think you have to try to think through which of the risks are most likely to cause a chain of events that you don’t want. It is hard for me to go back and tell you which ones in 2000 were the correct ones to emphasise. It is fair to say that virtually nobody on the planet saw what was about to happen and spoke out too forcefully about it. Even the people who say they saw it coming I have doubts about.

As I say, we are going through this right now and, in my own mind, there are certain risks right now that trouble me and which we need to speak out about. There are other things that I would say are on the laundry list in the FSR but I am saying to myself, "Those are things we don’t need to worry about today. We may have to worry about them in the future but not today." What I am trying to do is prioritise a bit more so that people who read this can see what we are thinking, rather than just give them all the things that could possibly go wrong.

Q27 Stewart Hosie: In that case, having done the review of the Financial Stability Report, how would you envisage your assessment being framed and what recommendations would you make or would you expect to be made? How forcibly or bluntly, if you thought there was a real risk, would you make recommendations for a particular course of action, depending on the risk itself?

Michael Cohrs: Mr Hosie, that is a very important question. I don’t want to sound indecisive to this group, but I am aware that in my old career I could take decisions and implement them very quickly. I am aware that doing what I am doing now is different. I am learning a little bit about this and things move at a different speed. So I am wondering how forceful one does have to be. There are certain things right now in the world that trouble me, and I am saying to myself, "Do we reach for our toolkit immediately-which we don’t even have yet, we are supposed to develop it-and start putting tools in place to counter some of the risks we see?" In my own case, I will have to learn a bit about the speed at which this sector moves, and I have to learn a bit about the fact that public pronouncements can be taken the wrong way. When the Governor or the head of the Fed or the head of the ECB makes certain statements, they do move markets and that can be troublesome.

Having said that-to go back to Mr Garnier’s point-the way that I will define my having not done a good job is if I am in front of this group in a couple of years and we have gone through what we just went through. I don’t want to be in that position.

Q28 Stewart Hosie: You said markets can move on the back of public pronouncements. Of course that is correct, but if you were certain that there was a particular risk, or a combination of risk and circumstances, which might lead us into a very bad place, I would not want you to be uncomfortable about moving quickly. What I want to know is that you would be certain enough in your own mind to either speak privately to the right people immediately, or to reach and build the toolkit, or to make the public pronouncement, if you saw something that you believed was genuinely systemically dangerous.

Michael Cohrs: I understand.

Q29 Mr Ruffley: Would you agree that the regulation of the financial system requires much greater transparency and openness than the existing system? That is not a difficult one.

Michael Cohrs: No. I am not sure I do agree with that because, again, in coming to this job, the amount of information available is staggering. It is high quality work. If you go to the Bank of England site, if you go to the HMT site, and read the reports that have been written in this country, and in the other countries, about regulation, about what we are supposed to do about the risk, it is staggering how much information is out there. The problem is making sense of it, because we are just overloaded with information. So I think there is a fair amount of information out there about what is going on. Now, would I like to see more when we do stress tests? Yes.

Mr Ruffley: That is what I am driving at.

Michael Cohrs: Absolutely would I like to see more when we are doing stress tests, to really understand every criterion in the model. If we put the models out that we are using, and let the various quants tear them apart, that could be quite interesting.

Q30 Mr Ruffley: Is it your understanding that that kind of publication, and making the workings behind your thinking transparent and open, is done at the moment or will you be arguing for more of that should you take up this job permanently?

Michael Cohrs: Mr Ruffley, you probably know more than I do but, as I understand it, there is a privilege-well, I do know this as a former banker-there was a privilege we had when we spoke to our regulators, that things we would tell them were held in confidence. I have more experience with continental regulators, with American regulators, although I did interact with the FSA, given that I was resident in London. On the one hand, that privilege meant we could go forward and give them information but on the other hand it didn’t go out to the public, and some of it probably shouldn’t have gone out to the public. I think a bit more transparency there would be a good thing.

Q31 Mr Ruffley: So you will be arguing for that?

Michael Cohrs: Yes.

Q32 Mr Ruffley: Will you, as an external member, be really independent and fearless in challenging what your other colleagues might say, if you disagree with them?

Michael Cohrs: I am not sure I would be fearless, but I certainly-

Mr Ruffley: You will not be fearless?

Michael Cohrs: I am not sure because I believe that you listen; I have a lot of experience working with groups, and quite often I go into a meeting with a point of view and if there is an intelligent discussion and you listen, sometimes you change your mind. You pick the moment when you attack or when you put your points of view across. I certainly have points of view, and I have some points of view that are not in keeping with my colleagues-we have seen this in several of our meetings already-and I am fighting my corner very aggressively.

Q33 Mr Ruffley: Would you speak out publicly if it was a serious matter on which you disagreed with them? After the due meetings and everyone expressing their view in a very civilised way-as you have characterised it-if there was something you thought was wrong, would you go public?

Michael Cohrs: Probably. Although you can all tell that I have an aversion to going public because I am just not sure how effective it really is. I will promise you, if I am not happy with what we are doing I will make a lot of noise within the committee in the proper way, within the bank in the proper way, and then to you if it is appropriate.

Q34 Mr Ruffley: I am going to give you an opportunity to tell us if you are fearless. Tell me the one big major mistake the Bank of England made prior to the crisis. Just one thing you thought they screwed up on.

Michael Cohrs: Northern Rock.

Q35 Mr Ruffley: How did they do that? The bank’s posture in the lead-up to Northern Rock, during Northern Rock as well, how was that wrong? This is an important question. I want to know, and I think this Committee wants to know, how fearless you are. You are going to be joining the Financial Policy Committee, and we want to know what you think the Chairman of that committee, Mervyn King, and his colleagues did wrong prior to the crisis.

Michael Cohrs: Let us be clear. When I said-

Mr Ruffley: I am inviting you to criticise your future colleagues.

Michael Cohrs: I understand, but when I said Northern Rock, the Bank of England was not responsible for regulation. However, Northern Rock should not have happened. It was an old fashioned run; the way the bank was funding itself should have been clear to the regulator and, I suspect, even the bank as an observer of the UK financial system. Alarm bells should have been ringing and it shouldn’t have been allowed. This was not complicated fancy derivatives, this was just old-fashioned; how you fund a bank and do the maturity transformation.

Q36 Mr Ruffley: That is interesting. So you are likely to make that kind of point when you meet Mervyn King and talk about recent history? I am sure it will crop up in the FPC. You will have that kind of free, robust discussion with him-will you?-from what you are telling us?

Michael Cohrs: Certainly, and probably even more so because I think I have slightly different lessons from the crisis than some of my colleagues do on the committee, and I have a slightly different emphasis as to what I think we need to put in place going forward, which I think is not as well established in the regulatory world.

Q37 Mr Ruffley: Those are helpful answers. Can I move on to two final questions, one in relation to the supply of credit? One way to effect that is the capital adequacy requirements. Another way is more direct intervention, for instance requirements on loan-to-value on mortgages. What is your position on direct interventions in the supply of credit, like loan-to-value requirements? Are there other tools that you think should be used?

Michael Cohrs: Thank you. I think there are other tools. I am not even sure that capital is all that important when banks think about the credit they extend. There is a perception that bankers sit and say, "We have this much capital, let’s do some loans." That is not how it works. When I took over commercial lending at Deutsche, I was very troubled by the fact that it seemed like we were always there for our clients in good times but we always disappeared in bad times. It seemed to be a characteristic of that particular business, and I vowed to fix it and I did fix it.

In 2007 we announced to our SMEs that we would be there for them, and throughout the entire crisis the size of the loan book went up. It did not go down, it went up. We did that by hedging the credit book. By hedging the credit book we weren’t frightened by what was happening in the marketplace and we could stay open for business. It had nothing to do with our capital position; it had to do with ensuring that the risk we took didn’t affect us in a time of crisis. So there are other things you can do and I think this concept of getting banks to be there in bad times, when clients need them, is a very important point.

Q38 Mr Ruffley: That is a very helpful answer. What are the other tools that you would like to see used? You have mentioned the hedging that you put in place in your practical experience. I have mentioned loan-to-value requirements on mortgages-let’s leave capital adequacy out of this-what other tools can be used in a direct way?

Michael Cohrs: In my view, the most important tool is simple leverage because any time we get into the more complicated definitions the banks are making assessments about risk weightings, and whether they are making those risk weighting assessments correctly is an open question. To me, a very simple leverage ratio is the best way to deal with how stable a financial institution is. Leverage ratios had risen to extraordinarily high levels pre-crisis and it is quite simple-most people would say it is quite crude-but I would look at leverage ratios very carefully. Secondly, it is liquidity. The banks go down because they run out of money, not necessarily because they are insolvent, so having money in the bank is incredibly important. After those two, I think, the next thing is provisioning. We had gotten into a period when we were only able to provision against incurred losses, whereas the systems that have provisioning, which allow the banks to look forward to expected losses, do much better when times get bad.

Q39 Mr Ruffley: My final question: you will know, having read the Vickers report-you have read the Vickers report?

Michael Cohrs: Yes, I have.

Mr Ruffley: One of the options for reform is subsidiarisation. This Committee has taken evidence that that may take the form of separate balance sheets for casino banking on the one hand and High Street banking on the other-separate management structures and so on. You are familiar with the arguments. One thing this Committee is quite interested in is the propensity for banks to cheat when their back is against the wall. They may have separate balance sheets but there are ways around a subsidiarisation regime. What do you think of that?

Michael Cohrs: It is a concern.

Q40 Mr Ruffley: If we go on the basis that subsidiarisation is indeed what happens and we suppose that is the first big problem in your in-tray as an FPC member, what would you be saying about designing a system that would either reduce the opportunities for cheating or put in place regulatory rules to prevent cheating, and how would it be monitored? If you could just give us your thoughts on that.

Michael Cohrs: It is not an easy-

Mr Ruffley: No, which is why I asked it.

Michael Cohrs: You are asking me a very difficult question. I think you are absolutely right to be concerned about it because within a bank it is virtually impossible to split the balance sheet into pieces. It is all one balance sheet, and the banks run that way, so trying to create the ring-fencing is going to be an interesting challenge. Now, I have read the report. I have listened to their very lengthy session with you, which I thought was a very good session, and I think they are hard at work thinking about how they are going to put it in place, including the regulatory oversight that will be required to do it. I do think it is possible but it is not going to be straightforward; it is going to have to have a lot of regulatory oversight to make sure that-in your words-the cheating doesn’t happen.

Q41 Mr Ruffley: Do you think it is possible to design a system that can ring-fence the two operations of a universal bank?

Michael Cohrs: Yes, I do.

Mr Ruffley: Thank you.

Q42 Jesse Norman: To follow up on that last question, is it your view, Mr Cohrs, that it is impossible to split the balance sheets, and indeed undesirable to split the balance sheets? That is certainly one central reading of the idea of ring-fencing.

Michael Cohrs: It is virtually impossible to split them. We have tried to do it. Put it this way, Mr Norman: I have tried to do it with clients and you didn’t know where to carve up, because the balance sheet was one thing and it is so hard to know which pieces of it go where. Even when we tried to do complete demergers of banks, which I have worked on in the past, it was very difficult to do. I don’t know of any successful case study we can look to where a bank was effectively split up.

Q43 Jesse Norman: That is an interesting discovery. Thank you very much for that. Effectively, your view then is that the strong reading of ring-fencing is a bust.

Michael Cohrs: No.

Jesse Norman: That the idea of separating casino banking, so called-rightly or wrongly-and deposit-taking, is a bust?

Michael Cohrs: I misspoke. I think separating the bank into two pieces is very hard to do. I think you could ring-fence because you would allow the one balance sheet to exist, but then you are going to have to have very strict rules. The bank will have to treat the other piece as if it is an external client, and those rules will have to be enforced, so I do think-

Q44 Jesse Norman: With external boards of directors, presumably staff use of the treasury function?

Michael Cohrs: All of the above, right? I don’t know this because I don’t have privy into the way they work, but I wouldn’t be surprised if the Vickers group thought about a complete demerger and came to the view that I have come to in my practice, which is that it is virtually impossible to take a bank and demerge it completely.

Q45 Jesse Norman: Thank you. We are short of time but let me ask how well you think the financial sector was led in its response to the banking crisis and the public outcry to it. How would you evaluate it? Do you think there has been a failure of leadership or do you think it has been handled rather well?

Michael Cohrs: I think it was handled rather badly.

Q46 Jesse Norman: Rather badly. On a scale of 1 to 10, where would you put it?

Michael Cohrs: Somewhere near 1, if 1 is bad.

Q47 Jesse Norman: That is very helpful, thank you. By the way, I completely agree, I think it has been shockingly bad. Let me ask another question. You have worked for three extremely consensus-based organisations; Goldman, Warburg and Deutsche Bank. Can you give me an example of a time when you have fought an internal consensus, or taken a major decision yourself, in the face of significant threat or challenge from the organisation?

Michael Cohrs: One goes back to the discussion I was having with Mr Ruffley. I and my partner wanted to hedge our lending books. This was thought to be outrageous-that a deposit-taking institution would hedge its lending books-and we were warned that within Germany there could be a lot of concern about this.

Jesse Norman: Because it would reduce profitability in the short term?

Michael Cohrs: People thought that it would break the traditional concept that a bank takes in deposits and lends out money. All of a sudden the investment bankers were hedging the lending book. We were using the evil CDSs and other things to hedge our book. More traditional people within our bank said, "This is going to go down very badly. We mustn’t do this", but we were determined to overcome the cyclicality of the commercial banking business and the only way we could see to do that was to hedge the risk.

Q48 Jesse Norman: Using the same scale of 1 to 10, how well do you think the FSA and the Treasury performed in their response to the banking crisis?

Michael Cohrs: Rather badly.

Jesse Norman: Rather badly. We are down at 1 again, or thereabouts, are we?

Michael Cohrs: First of all, we should be clear: nobody did very well but I have to say, specifically, Northern Rock was a pretty shocking event. So I think that, in particular-

Q49 Jesse Norman: You share the view they were all implicated, essentially? It was a serious regulatory failure across all of those institutions as well as the bank?

Michael Cohrs: It wasn’t good.

Q50 Jesse Norman: That is helpful, thank you. Risk models are a real source of concern because, of course, the banking sector as one threw itself off the cliff because they seem to evaluate risks in the same way. You are responsible for systemic risk on the FPC. What do you do about mitigating that herd instinct, and spreading more diversity and innovation in thinking about risk?

Michael Cohrs: You make sure that you don’t spend too much time looking at those risk models. You go back to very fundamental principles. You always insist that you see nominal values not netted-out value so you can understand. You have to understand always the size of the long position, the size of the short position, because what you will normally get from the model is the very little tiny sliver that is theoretically not hedged, and if you think that way you will get into trouble. You have to try to dig into those models. You do not look at VaR too seriously. You look at VaR, it is a tool that means something but if you run your business based on VaR, which is the risk metric that most bankers use to run their business, it is supposed to tell you how much money you can lose on a single day, and it didn’t tell anybody within even a fraction of what they lost on some of those days back in the fourth quarter of 2008.

Q51 Jesse Norman: Final question. Given how badly the financial sector performed in its own leadership, and how badly and complicit the regulators were in the failure of the banking system, do you think there is a case for a proper wide-ranging commission that would look at all these aspects and try to reach a broad conclusion, rather than the rather bitty, patchy approach we have had?

Michael Cohrs: Mr Norman, two comments: one, I hope you take the point that I include myself in the bad leadership within the banking sector. I am not sitting here trying to throw stones at other people. We all responded to the crisis, particularly in the way compensation was dealt with after the crisis, in a not helpful way. However, I think if we want to move forward again, and I think we shouldn’t want to move forward too quickly, this was by all measures one of the worst, if not the worst, crisis that we have seen in many hundreds of years, particularly in the way it affected people who had very little to do with it. However, I am not sure what another study would accomplish. If a study would accomplish something, yes.

Q52 Jesse Norman: One thing it might do would be to look at whether compensation practices contributed to systemic risk, which is something that might fall into your remit.

Michael Cohrs: Mr Norman, we know the answer to that. It did.

Jesse Norman: Will that be part of your-

Michael Cohrs: Many banks have changed the structure of the way they remunerate, so I think-

Q53 Jesse Norman: Would monitoring that kind of threat to systemic risk be part of your conception of what the FPC should do?

Michael Cohrs: Absolutely.

Jesse Norman: Thank you for that.

Q54 Mr Mudie: When we met Vickers they did not suggest, for a moment, that it would be impossible to separate the banks-separate the retail side from the investment side-why do you think it is so difficult?

Michael Cohrs: Mr Mudie, I am mindful that there are some very impressive people in that group, so if they said that they could do it I may need to rethink. I have had experience in trying to demerge banks where a client came to me and said, "Look, we want to separate the investment bank from the retail bank. How do we do this?" We worked on it very strenuously and we came to the conclusion that it was virtually impossible to do, because we couldn’t carve up the balance sheet of the bank. It was one balance sheet effectively. Then the need to recapitalise both pieces was so great that, even in good market times, you couldn’t get enough capital into the two pieces. The IT had to be carved up-

Q55 Mr Mudie: Which bank did you do this with?

Michael Cohrs: I am happy to give that to you privately but it would be a client I worked with, which would be confidential.

Q56 Mr Mudie: Which bank were you with when you were doing it?

Michael Cohrs: I was with Deutsche Bank when I was doing this work.

Mr Mudie: Yes, and a client came to you and wanted to separate them and you found it impossible?

Michael Cohrs: Correct.

Q57 Mr Mudie: Was it impossible from Deutsche’s point of view or the bank’s point of view?

Michael Cohrs: We couldn’t give that client the solution that they were seeking.

Mr Mudie: You couldn’t?

Michael Cohrs: They are still one bank.

Q58 Mr Mudie: Vickers took refuge in costs. Then, when pressed by the Chairman to define the costs, first of all, they said they were under-published. Then they said they were not robust enough but they took the decision on costs. What do you see as the main costs of separating the retail bank from the investment side?

Michael Cohrs: The main cost would be that you radically change the funding cost of the investment bank when you take away the deposit-taking piece of the bank, so the main cost would be one of funding. However, for the actual cost of splitting the IT system, splitting all the elements of the balance sheet, the fees that you would encounter to do that would be quite high, so there would be quite considerable costs. I don’t want to give this group the impression that I think that ring-fencing is not a good solution. I thought that what Vickers came up with was clever, if it can be done, because it got away from the concept of a total demerger, which I think is virtually impossible to do. Yet it did something that I think is quite important, which is trying to build this wall around the deposit-taking part of an institution. I think that is very important.

Q59 Mr Mudie: In an answer on Northern Rock, you said you couldn’t understand why Northern Rock had not been picked up because it was a straightforward traditional bank. It was not dealing in-in your words-complex derivatives. You said earlier the important thing about financial stability was deposits and depositors. Don’t you think that the retail bank, if split, would be more stable than the complex investment side?

Michael Cohrs: Mr Mudie, it should be but if I look at this crisis-

Mr Mudie: What do you mean "it should be"?

Michael Cohrs: It should be because, you are absolutely right, we all think of deposit-taking banks as being riskless but they are not. In fact, in this crisis, a lot of deposit-taking banks that did not do investment banking experienced extreme problems, and a lot of investment banks that were taking huge risks didn’t have problems.

Q60 Mr Mudie: Which investment bank didn’t have huge problems?

Chair: JP Morgan.

Mr Mudie: Well, JP Morgan had problems.

Michael Cohrs: I am very proud of the fact-

Q61 Mr Mudie: They all had problems, didn’t they? It was where it stopped. JP Morgan was eaten up. Someone else has been eaten up, but if they hadn’t been eaten up the crisis would have wiped them all out.

Michael Cohrs: I think you are correct about that. I think you are correct that everybody was in trouble, but I am saying-

Mr Mudie: Yes. Well, how do you-

Michael Cohrs: Mr Mudie, may I-

Q62 Mr Mudie: How do you square that with your first answer, which was that there were investment banks that weren’t in trouble? Now they are all in trouble. They were all in trouble. They were all at it in varying degrees, and some were lucky that they were in a better position than others. You were lucky. You spotted the sub-prime earlier and hedged the sub-prime stuff, the swaps. Very, very lucky.

The Bank of England Governor has sat there and said he wished the banks would get back to traditional banking rather than casino-type behaviour. The casino-type behaviour is the investment side, the traditional is the retail, and you are saying you can’t separate them. Don’t you think you should separate them?

Michael Cohrs: There is a lot of appeal to a separation.

Q63 Mr Mudie: Yes. Mr Cohrs, the British Government was on its knees to the banks to lend a small amount of money, in terms of the banks’ deposits, to small businesses. They had to beg them. They had to get an agreement for them to do it. These are the small businesses that we are hoping to rebalance the economy on, but the British Government has to go on their knees, while the same banks are investing abroad through their investment arms. Does it make sense to you?

Michael Cohrs: No.

Q64 Mr Mudie: Is there not a cry for traditional banking to come back?

Michael Cohrs: If I may say so, it is not just traditional banking; it is getting away from the cyclicality of traditional banking because I do believe traditional banking, as I said, was always there in good times but always disappeared in bad times. If you are going to serve your client you must be there.

Q65 Mr Mudie: Is that an American experience? It is not a British experience.

Michael Cohrs: I think it is an experience that if you talked to-

Q66 Mr Mudie: Apart from a couple of banks that have been pretty doubtful, which banks folded in the last 100 years in the UK?

Michael Cohrs: Mr Mudie, I am speaking from the client perspective.

Mr Mudie: Are you speaking from an American perspective?

Michael Cohrs: No, from a client perspective. Clients have always told me that their bankers were always there in good times and they couldn’t find them in bad times.

Q67 Mr Mudie: They are not even there in the good times in this country at the moment. Now, shadow banking: how seriously should we take it?

Michael Cohrs: It is very serious.

Q68 Mr Mudie: How seriously have we taken it?

Michael Cohrs: We haven’t yet taken it as seriously as we need to because, in fact, there weren’t as many problems in shadow banking as we thought there were going to be, because many people took the shadow piece of their bank and voluntarily took it back on to their balance sheet during the crisis. We could have another crisis where that voluntary bring-back of a subsidiary, which is not consolidated, doesn’t happen. Therefore, it is a big issue. I am also mindful that whenever we make regulation, it has to be agreed globally and it has to be agreed, to some extent, with an eye to how people will gain the regulation we put in place, because if we move risk out into areas that we don’t regulate we are not accomplishing much.

Q69 Mr Mudie: That is exactly it, but can we get tough enough regulation without dealing with the probability that those who are toughly regulated will move into the shadow banking world?

Michael Cohrs: I think regulation is moving that way. There are new requirements for certain unregulated entities to now start to register. So we are moving that way. I think the right question is, are we moving quickly enough?

Q70 Mr Mudie: Right. Witnesses before this Committee always use, "we are moving" or "we are going to" or "we are thinking about it". How quickly are we moving and are we moving thoroughly enough?

Michael Cohrs: It is a great question. If you read the New York Times you will see that the Americans are very fussed this morning, because it turns out that all the regulation that they thought they had put in place has not been put in place. They thought they were moving very quickly, yet it is not moving that quickly. We thought we were moving very slowly because it looks as though in this country very little has been put in place, but actually I think we are moving at a pretty good pace here. We must be mindful-and I am very mindful-of the fact that the interim FPC has a lot of work to do; we don’t yet have tools, we don’t yet have legislation, all those things. I am taking the viewpoint, and I would hope that you would agree with this-if you confirm me-we are supposed to act as if we do have powers and we are supposed to speak up and get on with it, although part of getting on with it will be helping to determine what the final FPC really looks like. There are big concerns in the financial world, as we speak, and we must deal with those issues today rather than tomorrow.

Q71 Chair: Taking up what you have said about the lessons that you take from the financial crisis, you told us that we can’t separate balance sheets, and more recently you told us that there is a lot of appeal in the separation. Is that your key recommendation?

Michael Cohrs: It is not my key recommendation.

Chair: But it is a recommendation?

Michael Cohrs: It is something we need to study very carefully.

Q72 Chair: That is a very cautious reply. Are you prepared to go a bit further than that? A moment ago you told us there is a lot of appeal.

Michael Cohrs: It does have a lot of appeal. The problem is that the sector was interconnected in a way that none of us imagined. That was the real problem. When Lehman went down it should not have caused the world to come to an end; it was a relatively small bank. But the way banks have become interconnected is something that we don’t understand very well, and it is the interconnected nature of the financial sector that worries me, which keeps me awake at night, because you don’t know when something very tiny goes down where it is going to ripple through the system. That to me is the key.

Q73 Chair: You are making the case for separation without being prepared to say you are a separator.

Michael Cohrs: I also said that having tried to separate in my investment banking career, I found it impossible to do.

Chair: Yes, which makes the ring-fence even more difficult to operate.

Michael Cohrs: It may make it an interesting way to go.

Q74 John Thurso: On a number of occasions this morning you have said, "Certain things trouble me greatly", and you have mentioned risks that are out there that are not being addressed. In your view, what is the single biggest risk to financial stability that is troubling you out there at the moment?

Michael Cohrs: Sovereign risk.

Q75 John Thurso: How would you see the FPC setting about dealing with that?

Michael Cohrs: Understanding where our banks are marking their sovereign risk positions; whether they are provisioned for those positions; how they have risk-weighted those positions, and understanding the interlock. It is fine to say you are not exposed to this country or that country, but if this country does have a default how does that ripple through the banking sector, the other sovereigns? Things like that. It is a very complicated puzzle: understanding exposure but, most importantly, understanding provisioning and how things are marked.

Q76 John Thurso: One of your dials on the dashboard would be a fairly important one. It would be sovereign risk?

Michael Cohrs: Today it would be right, front and centre.

Q77 John Thurso: Right, front and centre. You also said that the objective of your work as a group is to uncover big systemic risks. It is possible to argue, as many have before us, that one of the biggest systemic risks was the sheer size of banks, that they were too big to fail; indeed, you said yourself that in previous crises Governments had the opportunity, or the option, to consider allowing banks to fail, which was not an option in this crisis. If you and your colleagues on the FPC came to that conclusion, how do you set about putting that across?

Michael Cohrs: I don’t know, because it is a huge problem. I think everybody agrees that it is a problem, but nobody has come up with credible ideas on how we will fix it globally. In my view, it doesn’t do us much good to fix it within our country if it is not being fixed elsewhere because, ultimately, elsewhere affects us, through the operations they do here or through the ripple effect. It is a major issue. I think part of what I have tried to do is look at countries that did relatively well. One country that did really well in this crisis was Canada. I think Canada has some interesting lessons for the rest of the world in how they run their financial matters.

Q78 John Thurso: Of course, they had their banking crisis five years earlier than everybody else so they had kind of dealt with it, hadn’t they?

Michael Cohrs: They partly had their financial crisis back when we were doing privatisations in this country, and they underwrote them and they didn’t know what underwriting was. That was 20 years ago. They do have a mortgage market that is structured in a way that some would say doesn’t allow people to get the mortgages they need, but others would say it is a very robust mortgage system. They had a very strict definition of how much capital was required; they had very strict leverage requirements; they had very strict funding requirements, and they enforced their rules.

Q79 John Thurso: Can I turn quickly to another subject that has also come up? Michael Fallon asked you about it, and other people, and at one point you said you have an aversion to going public. I think that is because you assume it would be you stepping out of the group to make a public comment, rather than winning an argument in the group, but there is another side, which is, if you look at the MPC, it has done a great deal to educate the public by giving speeches and having a partially public debate, so that people understand the issues, their gravity and why conclusions emerge. Do you not think it is incumbent on the FPC to engage in the same process of education and that it is a necessity for you and your colleagues to make some remarks in public, so that there is some understanding of the process you are going through, rather than a completely confidential set of discussions where-like the smoke from the Papal chimney-you arrive with a solution and nobody knows how you got there?

Michael Cohrs: Mr Thurso, you make a very strong argument, and I may need some coaching on how one effectively takes things into the public domain because it is not a skill set that I have developed over the course of my career.

Q80 John Thurso: It might not be you but there needs to be dialogue with the public, you would agree with that?

Michael Cohrs: I would agree with that.

Q81 John Thurso: My final point is the concern that we are always fighting the last war rather than the next one. In many respects, the structures that were created post-1997 were supposed to deal with some of the problems we have seen in the past; the independence of the bank, the monetary policy, the way regulation was changed-all sorts of things. In many respects, we are now changing right back to how we were before. Among the things we will have now is virtually everything going through the Bank of England and the Governor chairing virtually everything. We have almost gone from a king to an empire. What dangers do you see in that and what should be done to ensure proper checks and balances?

Michael Cohrs: The danger is whether we have created systemic risk in an individual person, of course. The advantage is that there is a communication flow, and that is another of the major concerns that I bring to this position. I am under the impression that communication flows in many countries-but in particular this country-did not work very smoothly during the crisis. Now there is a memorandum of understanding that sets out who is doing what to whom, but communication to me is very important. It is a huge advantage that the Governor sits in so many seats and then has access to the people who matter in Europe-another of my concerns is whether we will be marginalised by what the Europeans are doing-so he sits on that seat as well. Overall I think the advantages of having that person able to see everything, and able to communicate everything, outweigh the disadvantages of either group think or not having enough time to focus on one particular item. Overall the system has advantages.

John Thurso: Thank you.

Q82 Chair: When the central Bank gives liquidity support to a financial institution in trouble, do you agree with Willem Buiter-when he gave evidence to us he made this point-that that is effectively a fiscal transfer?

Michael Cohrs: I guess, in the traditional sense, yes, but it is clear that central Banks in the last several years have virtually required their constituents to come and take money, to try to take away the stigma of taking the money. Then the money was repaid very quickly, so I am not sure in those cases that it is always.

Q83 Chair: If it is a call on the taxpayer, do you think it is right that an institution that does not have an elected politician chairing it should take those decisions?

Michael Cohrs: It probably is right that they take them because I would think that, from the taxpayers’ perspective, they would want the advantages of independence to outweigh the accountability, or accountability to the taxpayer, argument. I also think that if these things are done properly, the cost to the taxpayer can be minimised through the independent function of the central Banks.

Q84 Chair: If I could just reinforce the points that have been made about the need to provide a public explanation of decisions of the FPC. We have just been through a colossal crisis and what the public need now, and what we are going to need in the years ahead, is reassurance that a full and thorough debate is taking place within the FPC about how to protect them from a future crisis. I hope you will take it, as I am pretty sure it will be the view of the whole of this Committee, that we expect the FPC, and the membership of the FPC, to play that role, in much the same way as the Open Market Committee of the Fed plays that role with respect to monetary policy and likewise the MPC here. Would you take that thought away with you from the hearing today?

Michael Cohrs: I will.

Chair: Thank you very much for coming before us today. We need more practitioners aboard and, as you pointed out yourself, you are only one of them on that committee at the moment and we will need more in future. Thank you very much indeed.

Michael Cohrs: Thank you.

Chair: We will now take a five minute break.

Examination of Witness

Witness: Alastair Clark, Member of the Interim Financial Policy Committee, gave evidence.

Q85 Chair: It is now 11.15am; we are running a little bit behind schedule. Thank you very much for coming before us this morning. Given that you were at the bank 36 years, can I begin by asking what evidence you can provide that you are an external member?

Alastair Clark: First of all, literally, I left banking four years ago, so I am no longer associated with the bank in any other sense than the FPC. In the last 20 years or so of my time at the bank I was principally concerned with the question of the structure of the financial sector, regulation of the financial sector. That involved a good deal of exposure to practitioners through other authorities based in the UK and overseas, which I think has given me a reasonable picture of the context and an opportunity to form my own views on many of the issues that I think are on the agenda today.

Q86 Chair: Do you think the public will see you as an outsider? As an independent member?

Alastair Clark: No, I suspect they may not entirely.

Q87 Chair: So there is a perception problem with your appointment?

Alastair Clark: There could well be. I would accept that, yes.

Q88 Chair: Do you think that there should be a larger proportion of independent or external members on the FPC?

Alastair Clark: I would not have fewer, put it that way. Picking up a point that arose in the previous session, I think there will be a strong case for having at least an additional, and possibly more than one additional, practitioner member.

Chair: Yes, but that was a question of what the external people have done before they come. It is not the question I am asking, which is how many independents should we have?

Alastair Clark: I would not have less than four. If it were five, or six even-five would certainly be justifiable.

Chair: What is your preference?

Alastair Clark: I do not have a well-formed preference. I would say five would be perfectly okay, and would be something closer to the fairly narrow balance on the MPC between externals and internals.

Q89 Chair: I am surprised you do not have a preference, bearing in mind that there is nobody better placed to ask, except possibly the Government, for a view, bearing in mind that you are already operating a shadow FPC. You are telling us you think four, five, six? Some other number?

Alastair Clark: If I may say, I think the crucial thing is who the five or six are-what qualities they bring to the job. Four may be perfectly okay if you have four absolutely exceptional individuals. Six may be inadequate if they are not of that calibre, so I don’t think it is a question of the absolute number as much as what they can bring to the discussion.

Q90 Chair: To what extent have you been involved with the design of the regulatory structure outlined in the Government’s recent consultation document?

Alastair Clark: I have been involved, as you know from my submission before this meeting. I have been working at the Treasury since September 2009 in the International and Finance Directorate as an adviser, and quite a substantial proportion of the time has been devoted to the question of-precisely as you say-the new structure of the regulatory arrangements.

Q91 Chair: I am trying to put this as gently as possible, but don’t you think that will also compound the appearance of being an insider, even after you have left the bank in a formal sense?

Alastair Clark: I think it does contribute to it, yes.

Q92 Chair: Do you think it is reasonable for people to conclude that for practical purposes-for the purposes of accountability-you are an insider?

Alastair Clark: I don’t think it is, and I think those who know me probably would respect the fact that my opinion is not going to be determined by having worked for the bank for 30 years, or having worked for the Treasury for 18 months.

Q93 Chair: The members of the FPC from within the bank are going to be expected to speak for themselves, even though they are still in the bank. How different is what they are going to say going to be from what you are going to say on the basis of your previous experience?

Alastair Clark: Because I think the internal members, whether it is the FPC or the MPC, necessarily absorb the institutional view of issues, in a way that I think the external members by design do not. Indeed, I would say two of the key contributions that the external members can make are, first of all, to ask awkward questions, which may be difficult for the internal members of either of those committees to ask; and secondly, to bring a perspective from outside, which may be difficult for the internal members to represent.

Q94 Chair: Do you think that internal members of the bank will be inhibited by the fact that the FPC is chaired by the Governor?

Alastair Clark: I think it can condition the way that things are discussed, yes.

Q95 Chair: Because of this Governor or the governorships generally?

Alastair Clark: In any executive relationship of that kind it is different from the relationship between the Governor, in this case, and an external party who has no career or other axe to grind, in the contribution they make as an individual to the discussion in the committee. They are not angling for any particular position in the bank or any particular regard within the bank.

Q96 Chair: Doesn’t that make the demonstrable independence of the external members even more important?

Alastair Clark: Yes, it does, and I think-

Chair: If I may say so, I am trying to be as polite as possible, but it is something we are having great trouble demonstrating this morning.

Alastair Clark: Ultimately it can only be demonstrated through actions and through what I say, whether it is in public or what is recorded in the discussion that takes place in the FPC.

Chair: None of the questions that I have just asked have any bearing on my personal views, on the basis of your CV, of an outstanding contribution you may have to make to the subject matter itself. I am sure you understand that these questions have to be asked.

Alastair Clark: Absolutely, yes.

Q97 Stewart Hosie: You were Executive Director for Financial Stability at the bank from 1997?

Alastair Clark: From 1997 until 2003, yes.

Q98 Stewart Hosie: Until 2003, and you sat on the Financial Stability Board?

Alastair Clark: Yes. It went through various incarnations, but yes there was a committee within the bank, which operated in that way. There was no Financial Stability Board in the sense that it now exists internationally. There was a Financial Stability Forum, which existed for part of the time.

Q99 Stewart Hosie: Between 2003 and 2007, what was your main role?

Alastair Clark: I was designated adviser to the Governor. Much of that boiled down to-how shall I say?-repositioning the bank in its relations with the City.

Q100 Stewart Hosie: In what regard?

Alastair Clark: The bank had accrued over a considerable period all sorts of roles, approving, for example, appointments at Lloyds Insurance, various issues in relation to the Takeover Panel and various issues in relation to the sponsorship of the City. Mervyn, when he became Governor-I think with good reason-felt that it was time to look at these various relationships again and see how appropriate they were for the bank, as it then existed or now exists.

Q101 Stewart Hosie: Once you left the bank, as you say, in 2009 you then went to the Treasury, again advising on financial stability matters. In the period between 2003 and 2007, I take it you were keeping very much up to speed on what was being done.

Alastair Clark: Yes, I was a member of Watching the Bank; it is called the Executive Team, which is essentially a group of the Governors and the Executive Directors who, in a broad sense, were responsible for what the bank did across the piece.

Q102 Stewart Hosie: In relation to that-you were in for the other session, the question is very similar-we had the 2007 Financial Stability Report, which highlighted risk after risk after risk after risk, and then those risks were finessed away: "The UK financial system remains highly resilient", the document said. What did you make of that, in hindsight, when we began to see the run on Northern Rock and then the wider collapse of the financial sector? Did you look back on it and say, "Could we have done more in relation to the risks that the bank had identified?"

Alastair Clark: I think the answer to the substantial question is that I believe we could have done more. We could have done more mainly in the sense of being slightly more adventurous in identifying and talking about the risks that were building up. A number of the things you mentioned in the previous session, and they have indeed been mentioned in previous editions of the FSR: questions about the dependence on wholesale funding; search for yield; illiquid markets; some of the instruments that we used in the search for yield, and so on. Many of those were mentioned but nothing very obvious happened as a result.

Q103 Stewart Hosie: You are now going to be in a position-you say this in your remarks-where you have the experience to look at "the practicalities of setting up arrangements to identify, monitor and analyse the same sort of risks and other options for mitigating or responding to them when they appear" or when you think they are going to appear. How can we know you are going to be, as you said, more adventurous this time, in this role, than the bank was collectively in the past?

Alastair Clark: Mainly learning from experience. I think the experience has been that being too coy is not necessarily a sensible strategy. The counter-argument, which again emerged earlier this morning, is that you have to be quite careful about the "calling fire too often" problem. If you are constantly giving the impression that everything is about to topple over, first of all, it will not by and large, and secondly, when you do have something substantial to say it tends to be discounted. There is a balance to be struck.

That said, I think one of the weaknesses in the arrangements that we have had recently is that the connection between diagnosis and action was not as tight as it should have been. I think that was true as between the bank and the FSA. I think to some extent it was true within the FSA, where again quite a number of the risks were identified by their analytical function. That was not, in many cases, translated into action by the sharp-end regulators.

Q104 Stewart Hosie: That is exactly the weakness because the risks were identified but nobody-particularly not the FSA-appeared to take a decision to say, "There is increased vulnerability in this area as a consequence of X, Y and Z". You are now in a position to make a recommendation and to help develop a tool to make the call that action must be taken. Assuming you do not call "Fire" too often, how do we know whether you are right or wrong on the call? How do we know you will have the confidence to say, "Here is a substantive problem; there is a big vulnerability, a big systemic risk, and here is the action we recommend that you take"?

Alastair Clark: I do not think any words that I can say this morning are going to provide a cast-iron assurance on that. What is done will have to be on the basis of what happens. As I say, people do learn and I think they will draw the balance between flagging concerns, or acting in some other way, not just commenting on them but changing regulatory requirements, or conceivably imposing some restrictions on firms if there isn’t an obvious response. I think there will be greater willingness to do that.

There are two things. First of all, the FPC as an institution, as a part of the arrangements, is designed to a considerable extent to make sure that that kind of view does have greater weight; that somebody is looking at the overall risk and is making sure. As you know, the FPC has, in relation to the PRA, both a comply or explain power but also, under certain circumstances, a power to instruct. I think that is partly, in response to the point we have just been discussing, about the lack of connection in the past between the aggregate picture and what happened to the individual firm.

Q105 Michael Fallon: As we have now established, you have been 40 years either with the Bank of England or with the Treasury. How can you be an external member of anything? You are the ultimate insider, aren’t you?

Alastair Clark: I don’t know about ultimate, but I was an insider certainly. I don’t think that is irremediably the case. People can learn from their experience and after four years away from the bank, I may have formed or developed views, which were not ones I had in the bank or ones that are held by the bank now.

Q106 Michael Fallon: The Government’s objective originally was to ensure that "external members be able to offer insights and direct experience as financial market practitioners". You have never practised.

Alastair Clark: That is almost true. I was a director of a clearing system at one stage, and I have had a certain amount of experience at that level but, by and large, you are right.

Q107 Michael Fallon: Were you surprised to be approached to be an external member when you do not have external experience?

Alastair Clark: I wouldn’t say surprised. The point you raise was one that occurred to me as soon as the question was put. I don’t think that every external member of the committee needs to have precisely the same background or experience, and they don’t all need to be practitioners. For what it is worth, I think there would be great advantage in expanding the practitioner independent group within the committee.

Q108 Michael Fallon: How do we know you are really independent?

Alastair Clark: "By their actions shall you know them", I think. I can say that I am independent. I think those who have had some contact with me will have a view on whether that is likely to be the case or not. For others, I think it has to depend on what is done.

Q109 Michael Fallon: Mr Cohrs told us earlier that it should have been very easy for somebody to spot that Northern Rock’s lending model was seriously flawed. Did you?

Alastair Clark: Yes, I think we did, in the sense that if you look at the financial stability review in 2006, probably, there was reference. In fact, I recall that there is some comparison of the degree of external funding that was taken by a number of institutions, including Northern Rock. As I recall, Northern Rock came top of the league in terms of its dependence on wholesale market funding. That was what sank them. It was the withdrawal or the non-availability of capital market funding or wholesale market funding. I don’t say for a moment that every component that led to the crisis was identified and neatly boxed up. Of course it wasn’t, but on that particular issue, yes, it was identified. What did not happen as a result was somebody saying to Northern Rock, "We are uncomfortable. This is an excessively vulnerable strategy that you are pursuing, please cease and desist".

Q110 Michael Fallon: If you were aware of all this, why didn’t you tell anybody?

Alastair Clark: The bank was not the regulator of Northern Rock.

Q111 Michael Fallon: What did you do? You were the adviser. You were an adviser on the financial sector. You spend all your time advising on financial stability. If you were aware of the potential for Northern Rock, which got into difficulty first, who did you tell?

Alastair Clark: It was known within the bank, it was known to the FSA and it was certainly known to the Treasury as well.

Q112 Michael Fallon: You told the Treasury?

Alastair Clark: The Treasury saw all the documents that I refer to.

Q113 Michael Fallon: But did you advise the Treasury of this potential problem?

Alastair Clark: I did not personally advise the Treasury because I think the-

Michael Fallon: But did the bank advise the Treasury that Northern Rock was likely to get into trouble?

Alastair Clark: I frankly don’t know what advice was given to the Treasury by the Governor or others at that time.

Q114 Michael Fallon: What we need to try and establish is how independent you are likely to be. As you said, you will be judged by your actions. Can you give us an example of where you seriously disagreed with the Governor during your time as a principal adviser on these matters?

Alastair Clark: Yes, I seriously disagreed with him on the question of how we should go about regulating payment systems. Although it is in a different sort of category, I was very resistant to the idea, which was being pursued at one stage, of winding up the Financial Market Law Committee, which you may be familiar with, which Lord Woolf chaired, and which was intended to provide a way of identifying and addressing legal weaknesses in the underpinning of financial markets. Eventually, after a certain amount of time and trouble, that committee was preserved. That wasn’t the original intention.

Q115 Michael Fallon: The first disagreement on payment systems, how was that resolved?

Alastair Clark: The bank took on more of the role in a rather different way from what I had suggested.

Q116 Michael Fallon: What are you going to do on this committee when you disagree with the Governor?

Alastair Clark: First of all, I will express a disagreement in the committee.

Q117 Michael Fallon: Are you going to make the disagreement public? Mr Cohrs has told us he is not going to trouble the public with his disagreements.

Alastair Clark: It is not a binary decision. If it was some trivial matter I think the answer is, "No". If it was something that I thought was material to the committee doing its job then I think the answer is, "Yes".

Q118 Michael Fallon: Members of the Monetary Policy Committee make speeches all the time. You made a speech in Manchester-I have a copy of it-are you going to go on making speeches about the financial stability role?

Alastair Clark: I certainly envisage making speeches or making public comment, or both, on what we think we are at-do we think it is important and how we are doing it.

Q119 Michael Fallon: You see that as an obligation on you, as a member of the committee?

Alastair Clark: Yes.

Michael Fallon: That Mr Cohrs seems unwilling to accept.

Alastair Clark: Michael can speak for himself.

Michael Fallon: He did.

Alastair Clark: I would draw a distinction between talking about how the structure is supposed to work, what the options are in terms of responses-that sort of issue on the one hand-and discussing whether we have a particular concern about XYZ Bank, or whatever it may be, ABC hedge fund, at a particular time. I think the second is much more difficult.

Q120 Michael Fallon: Wouldn’t you accept that one of the criticisms of the bank’s rather limited role-of course it was different-on financial stability, was that it was all big picture? You produced these Financial Stability Reports, the Governor referred to "sermons in church" that nobody went out and paid any attention to.

Alastair Clark: Yes.

Michael Fallon: How are you going to make people pay attention to the Financial Policy Committee’s decisions?

Alastair Clark: Directly, in terms of the decisions. Of course, there will be a record of the discussion and that will be published and no doubt people will react to that. That is one thing. The second thing is-as I mentioned, and as you surely know-the FPC will have, prospectively, certain statutory powers to guide or instruct the PRA to take various actions. That is new. There was no such capability. Under the previous regime the bank could make suggestions to the FSA. It was then up to the FSA whether or not they were pursued, over what time scale, and so on. That is no longer going to be the case.

Q121 Michael Fallon: It was alleged in the early years of the Monetary Policy Committee that there was a very clear distinction between the bank’s members and the externals-the day boys. How are you going to avoid that kind of distinction on the FPC?

Alastair Clark: I think to some extent a distinction is quite healthy, frankly. That is one of the manifestations of independence-that they are perceived to be not part of the executive machinery. The externals are perceived to be looking at things from the outside with a fresh point of view. There will be a difference and I do not think that is unhealthy.

If it gets into, if I may say, this kind of "them and us" tension that arose in the early period of the MPC, that is unfortunate and I think we should seek to avoid it. I do not think there is any great downside in having a perception that there are people coming from a different point of view.

Q122 Michael Fallon: You think there is group think at the bank that needs to be challenged?

Alastair Clark: Whether or not there is group think at the bank, I mean I think it would be very surprising, frankly, in any organisation if there wasn’t some degree of group think. Whether or not there is, however, I think it is incumbent on the external members to lean against them.

Q123 Chair: Were you advocating action to deflate asset price bubbles before 2007?

Alastair Clark: Yes, I think I would have been. Not necessarily-

Chair: Not would have been. Were you?

Alastair Clark: Sorry, was I?

Chair: Were you?

Alastair Clark: No, I was not.

Q124 Chair: Why not?

Alastair Clark: Because I think there was still some doubt about how far the inflation of asset prices could be attributed to excessive credit expansion at that stage. The distinction between-

Q125 Chair: It was difficult to spot whether it was a bubble?

Alastair Clark: I don’t subscribe to the Greenspanian-we can’t spot bubbles we can only pick up the pieces afterwards-kind of approach. I don’t think that is-

Q126 Chair: That seems to imply that you do agree with it.

Alastair Clark: No, I don’t. I think it is not as black and white as that. I think the question is not so much whether one can spot some degree of overheating in a particular market. I think the question is more, what are the instruments available to deal with that? I think the resistance has been to the use of the monetary policy instrument-interest rates-as a means of tackling asset price inflation, for reasons that are much better rehearsed by the Governor or Charlie Bean than me. There are some difficulties in trying to use interest rates for that purpose. However, I don’t think that necessarily precludes other measures to try to dampen down, at least, what appear to be excessive levels of asset price inflation.

For example, in the property market, I certainly would contemplate things like loan-to-value ratios as a means of applying short-term constraints on the rises in prices.

Q127 Chair: I have found your answers somewhat confusing. Let us just go through it one by one. Did you spot asset price bubbles prior to 2007, when you were working-

Alastair Clark: When you say asset price bubbles, did we spot that some markets were over-exuberant? Yes.

Q128 Chair: What proposals did you make for dealing with that?

Alastair Clark: We made no specific proposals-I think it is fair to say-except to alert the regulator to the fact that, for example, the commercial property market was looking extremely over-heated and that they might want to address, with those banks who are principally involved in that, the question of whether they thought that was a sensible position to be in.

Q129 Chair: Notwithstanding the first part of your earlier reply, you are sticking to the view that Greenspan is wrong, that you can spot these in advance and you can take action to deal with them?

Alastair Clark: Within limits, yes.

Q130 Mr Ruffley: It is quite modish at the moment to talk about the Government instituting a truth and reconciliation commission, to lay bare exactly what went wrong prior to the financial crisis. Do you think there should be a truth and reconciliation commission of that kind?

Alastair Clark: In a sense, I think there already has been. I don’t put it in quite those terms, but there have been a range of different exercises from the FSA internationally. We have the Independent Banking Commission. We have a number of exercises, which touch on that territory. They have not been consolidated into a single exercise and I think-given where we are-it would probably be rather duplicative to embark on something of that kind now. I think in some ways perhaps it was-

Q131 Mr Ruffley: Can I just interrupt you? Is that because it would be uncomfortable for certain individuals, because what you have described, the pieces of work you have referred to, do indeed exist, but there has been no specific accountability for individual senior players, has there? Don’t you think that would be an interesting commission to have to show the public that people are accountable, if they are senior policymakers, for things they have missed or mistakes they have made? I am trying to get your view of accountability.

Alastair Clark: The general principle is that if people have clearly defined responsibilities they should be accountable for discharging them. If they don’t then they should be held to account for that. I think the question, or the trickier question, is how do you define those responsibilities in a sufficiently clear way, so that you can have legitimate accountability? This was one of the issues, as I mentioned, which precipitated a change in the MOU between the Treasury, the bank and the FSA.

Under the original version, the bank was described as being responsible for financial stability, which was frankly a completely unrealistic description of the role, given the absence of tools to discharge it. So I think, as I say, if one can define the responsibilities clearly and if the individual, or the institution for which they are responsible, has plausible means of discharging the responsibility, then fine. I think in many cases we were not, and possibly still are not, in that position.

Q132 Mr Ruffley: Assuming Parliament does its job well, and legislates for an architecture that has much more clearly defined responsibilities than the discredited tripartite system that you have just referred to, if policy decisions were being made with which you disagreed you would be prepared to resign on principle, would you?

Alastair Clark: Yes.

Mr Ruffley: Or would you say, "Collective responsibility of the committee, I will go with the flow even though I disagree with the majority decision"?

Alastair Clark: If it was what I considered a crucially important issue I would resign.

Q133 Mr Ruffley: Going back to the question of accountability, I understand why the Bank of England-and you have just explained-did not feel that much responsibility for the banking crisis; it was all the FSA’s fault. I paraphrase that. Do you think it is odd that no one was either fired or resigned from senior positions in the FSA or the bank? Could you name an individual, either in the FSA or the bank, who has been fired or resigned as a result of their actions or inactions leading up to the financial crisis?

Alastair Clark: I don’t want to name names, but I think you will be aware of what happened within the FSA. A number of people did depart. It wasn’t designated, in any spectacular sense, as resignation or firing but a number of people did leave.

Q134 Mr Ruffley: Members of the public might be hard pressed to understand who took the blame for being asleep at the wheel.

Alastair Clark: They might, and you could argue-I would not pretend to know what the appropriate level of publicity is-that those who took an interest in the question could readily find out.

Q135 Mr Ruffley: Without naming names, of course, has anyone been moved on at the Bank of England as a result of their actions or inactions or defective policy advice running up to the financial crisis?

Alastair Clark: As far as I know, no, but I left the bank before the crisis.

Q136 Mr Ruffley: Don’t you think that is odd?

Alastair Clark: I come back to the point about the definition of responsibility. It would certainly be odd if there were people who had defined responsibilities that they did not discharge.

Q137 Mr Ruffley: You have helpfully said that the new architecture must more clearly define and better define individual responsibilities.

Alastair Clark: Yes.

Mr Ruffley: Given that, what flaws do you see in the proposed FPC? It is in outline. We haven’t legislated the detail of course, but is there anything you think might be defective in the proposals that are currently in play or is it 100% perfect?

Alastair Clark: I think it is highly unlikely to be 100% perfect.

Q138 Mr Ruffley: If it is not 100% perfect where do you think the deficiencies might lie?

Alastair Clark: Two things occur to me straight off. One is that-I don’t know whether it is a deficiency, but I think it is a consideration-the Financial Policy Committee is dealing with an industry that is almost uniquely internationally linked, uniquely to the extent of the linkages. I think we need to be careful about the expectations of what can be delivered by a national entity with a leverage-principally, but not exclusively-over national institutions and national practitioners, and how far that is equal to the task of delivering financial stability in the round, given the international dimension. I think that is one thing, which is a question at least.

The second thing is, as has been mentioned this morning, that we are going to be spending quite a bit of time over the next six months at least on the question of what instruments are available to do what I have been saying, to translate the analysis into some action. There are quite a number of questions on that. One is that we talk in a broad sense about financial stability, but what does that mean in operational terms? As you may recall, 18 months or so ago the bank put out a paper discussing possible alternative provisions of what operationally might be involved in macro-prudential policy. Should it be concerned with curbing excessive growth of credit? Should it be concerned with curbing excessive growth of debt, or should it be concerned with ensuring that the banking sector, particularly, was resilient in the face of shocks?

All of those overlap to a degree but they are distinct, and I think one of the questions is going to be which? Or, conceivably, are we seeking to pursue all of those objectives and which instruments best address each one? For example, if one was talking about resilience, I think capital would be relevant. If one sought to increase capital requirements, it would be a direct way of trying to address the resilience. However, I think personally I have some question about how effective capital requirements would be, certainly in the short term, as a way of curbing credit growth. If the target was credit growth you may need to look to other things, like loan-to-value ratios or something of that kind.

I think that is the second area: the international dimension and getting clear what the instruments potentially available can deliver.

Q139 Mr Ruffley: That is an extremely helpful and interesting answer, Mr Clark, if I may say. In the light of that, and in the light of the fact that Parliament screwed up in putting in place in the first Labour Government the tripartite structure-legislatively, we did not describe it tightly enough-and in the light of your last answer, what input will vulnerable technicians and your colleagues be making when it comes to the drafting of the legislation? In short, are you in discussions with Treasury Ministers about the legislation, which needs to be just right, for all the reasons you have set down, when this place comes to legislate?

Alastair Clark: Absolutely. In relation to the FPC, the formal process is that the FPC is charged over the next six or nine months with looking at these various possible instruments for implementing macro-prudential policy. It is required to make proposals to the Treasury for the instruments that it thinks would be valuable, or at least worth exploring further, and it is for the Treasury to make orders under the Financial Services Act, or whatever it is going to be called, to give the FPC the powers to activate those instruments.

The FPC will have a role in the analysis of the instruments and in making recommendations to the Treasury Ministers on what those instruments should be, and no doubt there will be some discussion between the Treasury and the FPC about whether we have the same view about the efficacy or not. As a result of that, enshrined in powers will be some description of the instruments that are to be available to the FPC.

Q140 Mr Ruffley: I hope you will speak out, because when the tripartite structure was put in place I don’t recall too much comment from the bank saying, "These split responsibilities will never work". I hope this time, because we only have one final chance to get this right, that you will be speaking out if there are things when it goes through Parliament, or amendments being made or not being made, which you think make the FPC less effective than it should be.

Alastair Clark: I would certainly hope that will be the case.

Q141 Chair: Are there any aspects at all of the regularity structure as set out in the consultation paper with which you disagree?

Alastair Clark: I hesitate to enter into it because it is not the FPC’s business but I must say I do wonder a bit about the way crisis management is set up or characterised. As you know perfectly well, the Treasury is given a role in relation to-quite properly of course-the sanctioning of the use of public money, if it should ever be required in the process of resolution. Beyond that, the bank is essentially in a position to run the show as it thinks fit, with some reference to the Chancellor obviously. What is not defined, and I think frankly needs to be thought about more carefully, and possibly reflected in the MOU-it is envisaged, but maybe it needs to go beyond that-is some closer description of how the decision-making process works once one gets to an incipient crisis.

It is one thing to say that informational flows will work in this way and there will be obligations of that kind, and so on, but I think one of the things that was unsatisfactory in the handling of the crisis that we have just had was that certainly in the initial stages it was not clear who had the casting vote, so to speak, in terms of doing certain things.

Q142 Chair: It sounds as if you are worried that we might be in the same situation again.

Alastair Clark: I think we should try very hard to avoid that, yes, certainly.

Q143 Chair: If I may say so, what you have just described is a very diplomatic expression of dissent. What we need from our independent FPC members is something that has more directness and less diplomacy.

Alastair Clark: Thank you for the invitation to be less diplomatic. I think, to be clear, with an FPC hat on, I am not quite sure how far the remit extends into this area of crisis management. The FPC is set up primarily as a diagnostic and pre-emptive or preventative piece of machinery.

Q144 Chair: Yes. The problem is that you have been in the bank for 36 years and then you have been intimately involved, a key player in the design of the new system.

Alastair Clark: Yes.

Chair: You can imagine that what we are looking for is evidence of independence, even after you have left the bank, in the design of the new system.

Alastair Clark: I can assure you that the point I have just made to you is one that I have made in internal discussion. Whether-and, if so, how-it might be made in an external debate I don’t know, but I think it is an important point.

Q145 Mark Garnier: In March 2007, you made a speech to the Cass Business School where you talked about trying to define financial stability. You said in broad terms that many people define it as obverse financial instability. You also went on to say that there are no generally accepted metrics for determining whether the financial system has become more or less stable. Have you changed your view in any way in the intervening four years, with the benefit of hindsight?

Alastair Clark: Not fundamentally, no. I think dashboards were referred to earlier on, and I think there is some mileage in that but I think one needs to be, first of all, quite eclectic in terms of the indicators that one looks at. I think we need to look at a number of different things. There is always the danger of becoming the prisoner of the indicators, in the sense that you come to confine your attention to what is on the dashboard and don’t look at what is happening round the periphery, which I think can also be dangerous.

In terms of finding some overall metric, which one could refer to in a similar sort of way as CPI or something in the monetary context, I think we are still a long way, and indeed I am not sure that it is a realistic aspiration to think that we will ever get to that sort of single measure.

Q146 Mark Garnier: Or even a small handful of measures?

Alastair Clark: I think that is an open question, or a more open question. I think there are a number of things, which, either now or in future, one might come to feel were pretty suggestive in terms of the build-up of tensions or stresses. I think leverage ratios are one such, and there are others in terms of market price volatility and so on, which could well have something to contribute. I think we have a little way to go before one can say the best buyer of these six or these 10 or whatever it is.

Q147 Mark Garnier: One of the problems that strikes me is that if you get to the position where you decide that the financial system is unstable, is it not too late?

Alastair Clark: If I may say, I think you make a very fair point. One of the difficulties that emerged in the discussion earlier this morning is that you have this balance between certainty and pre-emption. I think Mr Hosie made the point that if you were certain about X, wouldn’t you do something? Of course the answer is, yes, if one were certain about X, you would be more likely to do something. I think the problem is that the degree of certainty increases the closer you get to the edge of the cliff, and it is a nice judgment how far away from the edge of the cliff you are prepared to take action because-to take an example-in some of the firms that got into difficulties in the crisis the vulnerabilities were evident. At what point did it become legitimate to say to the board and management, "We are going to substitute our judgment for yours"? I think we could make a good case that that was left too late in many cases. It isn’t an entirely straightforward question because you can get into the position of becoming a shadow director for all sorts of things, if you are constantly looking over the shoulder and saying, "Well actually you should be doing this rather than that".

Q148 Mark Garnier: Equally so, if you have clearly defined parameters, and I appreciate how difficult it is, but if you have broadly defined parameters-perhaps a better way of putting it-of what you are looking at then the system will be looking at it as well, and there will be a self-correcting in anticipation of that.

Alastair Clark: Absolutely. You develop some sort of reaction function so the practitioners, the participants in the market, anticipate your likely reaction, which I think is absolutely where one should be seeking to get to.

Q149 Mark Garnier: Also, economically, a very important factor is that our financial services sector is an incredibly important sector to our economy. Of course, we look at financial stability. You are going to be having a direct effect on a very significant tax-take. How are you going to be able to rationalise the conflicts of financial stability again, just making sure this country does very well. This of course was one of the key problems we saw in the lead-up to the crisis, when the City was running ahead of itself with arguable levels of regulation going on.

Alastair Clark: This is absolutely a central question, I think. In the present environment I think that the priority is given very clearly to the financial stability objectives. I don’t think one should lose sight of the fact that-taken beyond a certain point-that could have implications for the attraction of the UK as a place to conduct financial business. It then becomes a tough judgment about whether the benefit, in terms of less potential call on fiscal resources or less damage to the economy that might arise out of a crisis, is worth the sacrifice of, as you say, the activity, the tax revenue and so on, that accrues from having this activity conducted in the UK.

I think this is something that one has to keep in mind without trying to be too cut and dried about it in advance. Obviously-again, the point has been made-if one overcooked motives to support financial stability to an excessive extent you might wind up with a rather marginal benefit to financial stability at considerable cost to economic activity. How exactly that balance is struck is something I think we can only judge in the circumstances of a particular time and also, of course, what other people are doing, and what other countries are doing.

Q150 Mark Garnier: There are of course social implications as well. When Martin Lewis came before us, last year I think it was, he made a very good point that one of the mechanisms that may be available to you is loan-to-value ratios, which you may well tighten up. Of course, if you tighten up loan-to-value ratios the very first people who are going to be affected are those at the poorer end of the spectrum, and indeed not only will that have a social implication it will also have implications on the ability of work force. Again, how do you rationalise that?

Alastair Clark: Ultimately, you have to decide what the priority of the financial stability objective is and, if only in that particular case, are there other ways of skinning the cat that are less damaging? One is obviously interest rates. How shall I say, guidance in one form or another to the lending institutions may be another instrument one can use. I think absolutely, one needs to be conscious of the collateral impact of some of these instruments in areas that are not strictly to do with financial or perhaps not at all to do with financial stability.

Q151 Mark Garnier: You are going to come under a lot of flack. A lot of people are going to have different opinions on what it is you are doing. How are you going to demonstrate that you have, collectively or individually, taken a wise decision over what it is you do?

Alastair Clark: Again I come back to the point that deeds will tell more than words in this, and perceived success over a period of years will tell more than brave words, ex ante. I think part of the business and part of the responsibility, as we said earlier, for members of the FPC is to try to explain what they are doing, and try to engender confidence, in the sense that people come to accept that the committee and whatever other authorities are involved, but the committee is thinking seriously about the issues; is doing its best to try to understand where the risks are and is conscious of some of these collateral impacts, which I think you can’t ignore. It is by explaining how one is doing it, and then hopefully demonstrating through that that in the end it has been successful in delivering the objective, which is to have a smoothly functioning, acceptably risky, financial machine.

Q152 Mark Garnier: Do you see that job of continual discussion with the public as also allied to the fact that as the pendulum swings back the other way and we get back to a perceived period of financial stability and back to the good times again, the eye of the general public will come off this board? Do you see that you have to continue to maintain that dialogue?

Alastair Clark: Yes, and it swings in both directions. I mean, yes, exactly. I think "taking away the punch bowl" is an expression that has always been an important part of this. Explaining why you are taking away the punch bowl is quite important if you are going to buy into it.

Q153 Mark Garnier: Final question. How would you define success?

Alastair Clark: I think I tried to do it, in the sense that I think it is having a sense that the interested public understand what the intention is, what is being done, and that comes either directly or through commentary in the press, or wherever. Ultimately though it is going to be a question of whether, as Michael said, one can look back after five years and say, "Well, in the circumstances at the time, decisions that were taken seem to have been reasonable ones".

Q154 Andrea Leadsom: The IMF seem to be indicating to Britain that we should stick to our guns in trying to control our own financial stability by taking early steps ourselves. To what extent do you think the FPC needs, to a certain extent, to kowtow to European stability mechanisms, or do you think that the FPC should plough its own furrow?

Alastair Clark: When you say "kowtow to", there are degrees of kowtowing in a European context. There are things that we are, clearly under law, obliged to implement in terms of directives, and so on. Short of some terminal bust-up, I think we are in a position where we will be implementing directives that are approved in Europe. I think we don’t have a huge amount of-

Q155 Andrea Leadsom: Specifically what I mean is that Europe is changing its regulators so that they will have teeth in future, when in the past they were perhaps more advisory. Do you see a scenario where perhaps you have ruled out the imposition of additional capital, for example, but the European regulator decides to impose extra capital? How do you see that working?

Alastair Clark: If they are imposing it through some directives then we don’t have any choice, we have to do it. In areas that I think you perhaps have in mind, there are proposals for so-called counter-cyclical capital buffers, and sundry other bits and pieces like that. I think the risk is more the other way round-that we may want to do more than Europe is intending to do. In those cases, it is very much a judgment for the national authority. If there is discretion to be used, we should use it.

Q156 Andrea Leadsom: What I am trying to get at is, do you favour European-wide action or do you think that the UK, bearing in mind that we are 60% of financial services in Europe, should be going it alone and be taking the lead?

Alastair Clark: I think it should certainly seek to take the lead. Of course, as you will know well, it is a hard row to hoe in Europe because of the reason you give, that the UK is a very substantial portion of financial activity within the EU, and that tends to mean that we have a different perspective on questions in many cases from some of our European colleagues. I think the scope for independent action is going to be limited. What we have to try to do is to make sure that we preserve as much scope as we can in the way that the legally binding arrangements are drawn up, so that we don’t get into the position where, for example-a case in point at present you probably know-there is a debate in train about the flexibility of additional capital requirements that can be imposed, and some countries are very concerned about any significant or very significant flexibility on that front.

The UK is arguing, partly so as to leave freedom for national manoeuvre in the context of the FPC, to leave a good deal of discretion to the national authorities, so that they could impose considerably greater capital requirements if they thought it necessary.

Q157 Andrea Leadsom: Do you think that the representation on the three key regulatory boards for Europe is adequate? Is the FPC itself going to be suitably represented by our single seat on each of those boards?

Alastair Clark: No. As core FPC, no it will not. The FPC has no defined direct international representational role. In that context, its role will be to influence the thinking and the positions taken by those who do sit on the various boards-ESMA and so on.

Q158 Andrea Leadsom: So there will be no lines of accountability or responsibility?

Alastair Clark: There is no direct link, in the sense that there won’t be somebody who flies under an FPC flag on any of those committees.

Q159 Andrea Leadsom: Do you think that that is a fundamental flaw?

Alastair Clark: It is important that the UK clearly has an effective voice in those discussions. I don’t think it is within the model of the FPC to imagine that it, as a committee, should be the sharp end, so to speak, in such discussions. I think its role is to help shape UK policy, which then one hopes will be represented in those groups by whoever is the representative.

Q160 Andrea Leadsom: If I can press you again, Mr Cohrs said earlier that the big shock about the financial crisis was the extent to which all financial institutions are interrelated and it still seems to me, even with potential ring-fencing, that Mrs Jones is not going to have confidence that Barclays isn’t going to go bust. She is not going to trust in the ring-fence. Therefore, that interrelation does have the potential to create another crisis. Surely that therefore implies that there should be much broader international co-operation, and it seems to me that the one body that is looking at stability surely ought to have its own links to the European bodies.

Alastair Clark: Of course, in a procedural sense it does because Mervyn King is the Deputy Chairman of the SRB, the Systemic Risk Board at the European level. Of course that will not always be the case but there is the opportunity for, probably, somebody from the bank to be present on the SRB independently of having the Deputy Chairman. That person from the bank-in the current circumstances it would be Paul Tucker-will certainly be a member of the FPC. In that sense, even if it is not described in those terms, there is a direct capacity to input.

Of course, the SRB itself has only limited discretion. In fact I don’t think it has any outright powers to insist on things. It is in a different category from ESMA and the banking regulators where they do have statutory powers, but they are concerned with describing the financial regulatory system, not with crisis management or anything of that kind.

Q161 Andrea Leadsom: You wouldn’t think that we are at risk of setting up just another different tripartite system with a European regulator, the CPA-Consumer Protection Authority-and the bank, as the three legs, each of which is not properly accountable?

Alastair Clark: Are you talking in a UK context?

Andrea Leadsom: In a future financial crisis, is there a risk that we again end up with buck passing as we did in the last financial crisis, except that this time it has a European dimension?

Alastair Clark: If we take it at the national level first, the reason for my comment about the crisis management is that I think we need to be as clear as we possibly can about what the decision-making process is in handling things domestically. If you extend it to the international dimension then there is a question, and I think frankly we are some way away from having any kind of formally integrated decision-making process about handling cross-border financial crises. There are various understandings being developed, and so on, but this gets into difficult areas of national sovereignty. It also gets, frankly, into the question of who writes the cheque if something goes wrong. There is no central European fiscal authority; there is a Central Bank, which covers part of the territory. There are regulatory arrangements, which cover a broader part of the territory, but there is no central European fiscal authority that could play the same role as a national finance ministry in providing fiscal resources.

Q162 Andrea Leadsom: To what extent will learning or devising a way to deal with a specific international crisis be part of the remit?

Alastair Clark: I think it is an area in which the FPC certainly needs to take an interest because, as you say, it is part of the context. To repeat the point, as its remit has been drawn up, the FPC is not cast in terms of a crisis management role. It is in terms of a preventive role.

Q163 Andrea Leadsom: One last question to finally understand this crisis management role. Whose responsibility is crisis management? Where does the buck stop in terms of crisis management in your view at the moment?

Alastair Clark: In the UK?

Q164 Andrea Leadsom: Under the new regulatory environment, who exactly will manage the crisis?

Alastair Clark: It is very clear. The way it is drawn up is that the Bank of England is responsible for the management of a crisis, except insofar as it potentially involves the use of fiscal resources, in which case the Treasury has to be consulted and give its approval.

Q165 Andrea Leadsom: So the FPC would be identifying, spotting and preventing the problem, but if it came to a crisis it would revert to the Governor of the Bank of England and the FPC would have no role in that?

Alastair Clark: As presently defined, that is right.

Q166 Andrea Leadsom: Do you agree with that?

Alastair Clark: I think it would be a bit gratuitous to throw away the information and the analysis that the FPC had done, no doubt in the run-up to the crisis, on handling it. Some way of making use of that has to be found, but in terms of the management of the crisis I think it probably is right. I think what is required in a crisis management context may be a little bit different from what is required for the preventive work in advance.

Q167 Mr Mudie: Mr Clark, I think you have an obvious difficulty inasmuch as the last person wasn’t in the Bank of England, wasn’t in the Treasury, and so we cannot finger him, but you can be fingered. You have history, don’t you, which you have to accept? You were there when it all happened.

Alastair Clark: Yes.

Q168 Mr Mudie: As we are looking at putting you on a committee that has to spot and avoid, and take action to avoid the next crisis, it is interesting not to speculate but to look at what happened when you were working and helping to spot the last crisis. Did you spot, or when did you and the bank spot, this sub-prime problem in America?

Alastair Clark: I can’t remember the dates, but I would say it was certainly identified as a potential issue, but on a scale that wasn’t at that stage known, probably in 2006.

Chair: It was in the press by then.

Alastair Clark: Yes. I think what wasn’t realised was quite how gross the mis-selling-if I can call it that-had been.

Q169 Mr Mudie: It wasn’t realised by us, but was it realised by the professionals?

Alastair Clark: No, I don’t think it was entirely.

Q170 Mr Mudie: Why?

Alastair Clark: The process of providing mortgages in the States, which is where quite a lot of the mischief arose, was ostensibly conducted under rules set by the Fed but policed by the State Banking Commissions. The fact was that-at least by implication-people probably thought that that is how it did indeed work. It transpired in the event that the degree of oversight exercised by the State Banking Commissions was negligible, and the Fed, for whatever reason, either did not recognise that or didn’t feel able to substitute for it.

Q171 Mr Mudie: Were you aware then of the securitisation of the mortgages-

Alastair Clark: Certainly.

Mr Mudie: -that was in the British institutions?

Alastair Clark: Yes, I think of course there was recognition that a number of the vehicles that were created, including by Northern Rock, to provide finance for their mortgage lending did include assets, which-

Mr Mudie: It wasn’t even Northern Rock. It was mainstream banks securitising.

Alastair Clark: Well, subsequently mainstream banks.

Mr Mudie: Northern Rock is-

Alastair Clark: More mainstream banks than Northern Rock, you are quite right.

Q172 Mr Mudie: Did you spot the securitisation that was going on?

Alastair Clark: I don’t think people realised-

Mr Mudie: No, not "I don’t think people realised". Did you or the bank realise or were you aware of the securitisation of these sub-prime mortgages and were you aware of the extent of it?

Alastair Clark: We were certainly aware of the securitisation of sub-prime mortgages. We were certainly aware of the fact that they were being securitised.

Q173 Mr Mudie: And the extent?

Alastair Clark: What we were not aware of-maybe we should have been-was the extent to which, frankly, rubbish was being included in the pools of assets that were being securitised.

Q174 Mr Mudie: In 2006 when the sub-prime hit the press and the extent of it was public knowledge, did you not make the connection, "Hell, we had better see what is happening-these have been securitised and our banks are handling them"?

Alastair Clark: I think not sufficiently tightly, is the answer. We did not make that connection. I would say again-although I don’t think it is either terribly productive or terribly fair to point the finger at the regulator-

Q175 Mr Mudie: The FSA, you mean? You were still doing financial stability though, weren’t you?

Alastair Clark: Yes, absolutely, so I don’t try-

Q176 Mr Mudie: Did you ask the FSA about it?

Alastair Clark: I don’t seek to excuse it on the basis that institutionally it might have sat-

Q177 Mr Mudie: So don’t say it. You were responsible for financial stability. Here was sub-prime going down all over the States, you knew it was securitised, and you didn’t follow it through in terms of financial stability with the British institutions.

Alastair Clark: We didn’t pursue it as-

Mr Mudie: Should you have?

Alastair Clark: -as actively as we should have done.

Mr Mudie: You should have done, yes.

Alastair Clark: There are two things. One is that I think there was probably too much faith in the environment in which these things were created and not a sufficient recognition that indeed quite a lot of it was rubbish; but secondly, I think the structure of the vehicles that were used for securitisation was probably not examined sufficiently closely. The master trust structure, which was used in many of those securitisations, is complicated and it is quite hard to unravel what is going on.

Q178 Mr Mudie: Should it be?

Alastair Clark: Sorry?

Mr Mudie: Should it be more transparent? Should it have been analysed and worried about?

Alastair Clark: I think it should probably have been analysed further. Should it be more transparent? Yes. Indeed, as you all know from some of your other inquiries, there has been quite a significant effort to resurrect the securitisation market but on the basis of more transparent simpler structures, and that has only been partially successful so far.

Q179 Mr Mudie: You see this is what worries me. When I read your two papers dealing with securitisation and shadow banking, you make the point, "A proportion of all our financial intermediation subject to prudential regulation has probably declined quite a lot over the past 30 years". You go on, "How much of a worry should this be? I don’t know. But wherever we end up it should surely-"

"I don’t know"? "Wherever we end up"? There is the first one. You are deep into financial stability with the bank. Something is happening in the States, it has a link to us. It is what started the whole crisis off. You did not pick that up. Two years later you are making another speech and you say, "Well, yes, there is less prudential regulation. It has declined over the last 30 years, should we worry about it? I don’t know".

Genuinely, Mr Clark, do you think I should have confidence that you have the dynamism, the interest, to be on that policy committee spotting-not all the run of the mill things that were put in the Financial Stability Report in 2006? Because the next crisis is not going to be the same as this crisis, is it? We are looking for people who don’t do the ordinary job of somebody in a bank who looks at all the usual measures; we are looking for somebody who is out to spot trends-what is happening and what we should worry about.

Alastair Clark: I think that is exactly the spec.

Q180 Mr Mudie: Do you think you fit that bill?

Alastair Clark: I think, I-

Mr Mudie: Go on then, tell me why though in view of those two things I have raised.

Alastair Clark: You quote those two but let me take another example, if I may. There has been a lot of talk this morning about networks and the implications of networks, which I think goes wider than has perhaps been recognised. One implication is in terms of the mechanics of contagion. If you have very interconnected systems a shock over here gets transmitted to the rest, but another dimension, which I think hasn’t had quite so much attention but I think is also important, is the impact on transparency. If you have a banking system where, let’s say, 20% of the assets of a bank are held as claims on other banks, and so on and so on and so on, it is quite difficult for anyone who is trying to form a view about the credit standing of the first bank to have a good picture, because so much of it is conditional on these further statements.

I rehearse all that because I initiated in the bank, six or seven years ago, a programme of work on interconnections and the implications of that for financial stability. I think that has proved to be quite an important direction of travel for looking at financial questions. I could probably quote other examples but I don’t subscribe to the-

Q181 Mr Mudie: Okay, you do not think two is enough. Let me just take your other speech there. You have accepted with Stewart Hosie that-you mention it in this speech- you were aware of problems, overheating in the housing market, for example, and you say, "Look at our 2006 Financial Stability Report. It will show that we are more aware". Then you make this speech a year later.

Alastair Clark: Which speech are we talking about?

Mr Mudie: It is a speech to the Cass Business School on analytical models of financial stability.

Alastair Clark: Yes.

Mr Mudie: Mervyn, may I say, would have approved of this speech because it is solid stuff. You are not writing Mervyn’s speeches, are you?

Alastair Clark: Sorry?

Mr Mudie: Never mind.

Alastair Clark: No, I do not write Mervyn’s speeches.

Mr Mudie: The serious point I am trying to make is a year later, a few months before the crisis blows in this country, you make this speech and it is against a background where you have months before, almost a year before, said how serious it is all getting, and this is on, as I say, analytical models of financial stability. You end up-conclusions: "Looking further ahead a framework does now seem to be emerging in which a more systemic discussion of financial risks can take place". So we have this severe overheating. We have all these problems. We have the Americas falling about, but this laid-back, "A framework now does seem to be emerging". Then to top it all, you finish it off with, "But don’t hold your breath". Bloody hell, even if I thought you were the most dynamic person going, I would say what on earth was this all about?

Alastair Clark: I think, to be fair, it wasn’t a speech about the conjunctional risk of the financial system. It was a speech prompted by a question about what the bank was doing to improve the modelling of financial stability, and the answer is what you just read out.

Mr Mudie: No, no, Mr Clark, just stay there though. This is not an academic exercise.

Alastair Clark: No, of course it is not.

Q182 Mr Mudie: We are within months of the biggest crisis we have had for a considerable time, and you are making this laid-back speech on systemic risk and analysing systemic risk. You are talking about the banks’ models and you are saying, "Well, a model seems to be merging but don’t hold your breath". I would be seriously worried if I had made in that speech and had-

Chair: A quick question and a crisp reply, please.

Alastair Clark: What you described is a speech on a different subject. That wasn’t the subject of the speech. The speech was about a piece of work or a direction of work that the bank was undertaking, which incidentally I think is still being undertaken with some energy and has moved forward, but I think the punch line that you quoted is still relevant.

Chair: I wish I had asked for crisp replies earlier. That was excellent. Thank you very much, Mr Clark. Thank you for coming to see us today. I am bringing this session to an end now and we are going into private session. Thank you very much.

Prepared 15th June 2011