Treasury Committee - Minutes of EvidenceHC 459




Treasury Committee

Bank of England June 2013 Financial Stability Report

Tuesday 2 July 2013

Paul Tucker, Andrew Bailey, Dr Donald Kohn and Martin Taylor

Evidence heard in Public Questions 1 - 134



This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.


The transcript is an approved formal record of these proceedings. It will be printed in due course.

Oral Evidence

Taken before the Treasury Committee

on Tuesday 2 July 2013

Members present:

Mr Andrew Tyrie (Chair)

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

Mr George Mudie

Mr Brooks Newmark

Jesse Norman

Teresa Pearce

Mr David Ruffley

John Thurso


Examination of Witnesses

Witnesses: Paul Tucker, Deputy Governor, Financial Stability, Bank of England, Andrew Bailey, Deputy Governor, Prudential Regulation, Bank of England, Dr Donald Kohn, External Member, Financial Policy Committee, and Martin Taylor, External Member, Financial Policy Committee, gave evidence.

Q1 Chair: Good morning. Thank you very much for coming in. We have quite a lot to get through this morning and some very interesting topics to cover. I would like to begin with something that has been in the press quite a bit, which is the allegation that was triggered partly by the outgoing Governor that the banks have been lobbying the Government to get at you in ways that could restrict your independence. What evidence of that do you have? Is Lord King-or is it still Sir Mervyn-right? If so, who were these conversations between? Andrew Bailey?

Andrew Bailey: Well, he made those remarks, I think, in the context of the recent issues around capital and particularly leverage, but it was an illustration of a more general pattern. We are certainly aware that there are conversations that happen between the banks and officials and Ministers. I said last week in the press conference on the Financial Stability Report that what concerns me is that we are trying to build, frankly, a transparent process that has accountability in it, because I am very clear that the failures of past regimes- to be clear, in part but not in whole-have a root in the lack of accountability. We want this process to be transparent, and it is not helpful if there is a large amount of activity that is private to that, which is seeking to influence outcomes.

Now, just to be clear, I will give you my own position on this in the context of the specific example that has come up recently. I have not been approached by any Minister on this question. I was made aware that there were conversations going on with the Treasury. I was made aware by the Treasury. They made it clear to me that they regard the PRA as an independent regulator and they were not seeking to intervene on this question with me, but they did make it clear that those conversations had occurred, yes.

Q2 Chair: What about the allegations that there have been conversations with the Cabinet Secretary?

Andrew Bailey: Well, I have no information to support that, I have to say. There has been no contact that I am aware of with the Cabinet Secretary. I have certainly had no contact with the Cabinet Secretary.

Q3 Chair: If the banks are talking to the Treasury and the Treasury are telling them to get lost, what is the fuss?

Andrew Bailey: Well, I think in substance that would be right. The point is around transparency. It is around being able to see what is going on. It is a better process if this is transparent and we are all accountable for what we are doing.

Q4 Chair: What are you going to do the first time that you take, or you become aware one of your team taking, a call from a senior part of Government trying to influence one of the decisions on which you have statutory independence?

Andrew Bailey: Well, first, it would be a conversation between us and-I would assume-the Treasury, but if I felt this was a substantial problem I would exercise the right if necessary to actually raise it here because you are in a sense our main line of accountability. As you know, we value parliamentary accountability very highly and if I felt this was a problem I would raise it.

Q5 Chair: Well, we will expect you to do that. You have said in the past that we need, and I am quoting, ground rules about how these things are done. Might it be helpful if you set down what those ground rules should be on a piece of paper and send them to us?

Andrew Bailey: I will have a go, yes.

Q6 Chair: Turning to the subject that appears to have been high on the agenda for this alleged lobbying, leverage, it is correct, isn’t it, that the FPC guidance on leverage was to reach 3% by 2018?

Andrew Bailey: Well, the FPC actually had two recommendations on leverage. One was that the PRA should look carefully to ensure that banks were on course to meet their Basel III leverage and capital ratios by the end of the transition period. That is one recommendation, but there was a second recommendation that the PRA should be particularly focused on cases where they felt that there were situations where the position on leverage or capital was particularly concerning in terms of the level and be ready to take action more promptly if that was a cause of concern.

It is important to not just focus on the first one. The first one was important and I will give you a reason why the first one is important. One of the things that for me has lain behind the work that we have done on capital is not just where are we today and some sort of static comparison, but also over recent years whether we have observed that institutions are making the sort of progress that they told us some years ago they would. Are their plans reaching fruition or are they falling behind? The observation I would have is that, for reasons that we can explain and I will come on to in a second, there has been quite a bit of slippage. There are really two causes for that slippage. One is the number of unanticipated conduct-redress costs that have come through. Those, of course, we all know about. They have to be dealt with, but they have caused institutions to fail to achieve their targets for capital retention that were set out in the past. Secondly, up until the last six months to a year where we have seen some correction, interest margins and, therefore, retained earnings were also being squeezed more heavily than they had predicted.

That is all relevant because we were taking a view, and I have said this to a number of institutions, "Look, you are consistently missing your own targets and we have to look at that in the context of where you are aiming to get to". So that is the background to that. But we are also looking at those institutions where we think the starting level, the level today, looks out of line. That was very clearly in the FPC recommendation and it was something that the PRA board took very seriously in the context of leverage.

Q7 Chair: The PRA has not changed its view; the circumstances have changed and you have responded to them?

Andrew Bailey: Well, the one thing I would say is that this work, both the risk-based capital and the leverage work, has been very important because I think in a sense it has been the first thing the PRA has done, but it is also a crystallisation of a view on where we want institutions to be on capital today. As you know, for the first time in the history of this country we have actually come out and been transparent and published what we think the current situations are, where institutions should get to and where the institutions have committed to get to. Now, underlying all of that has been a process that obviously started with the FPC at the system level and then has been handed over to the PRA to deal with at the institution level. We have spent a lot of time with institutions on that to ensure that they have plans that we think are sensible and particularly that those plans meet our other very clear objective that runs through the FPC and the PRA, which is that they do not damage lending to the real economy.

Q8 Chair: Okay. What the banks appear to be briefing the press is that you have changed your demands; that the Bank of England certainly has changed its demands.

Andrew Bailey: Yes.

Q9 Chair: You are saying that is not correct? We will be asking the banks so it would be helpful to have clarity on this point.

Andrew Bailey: Of course, yes. Let me expand on that. Let me give you three points on that that I think are critical

First, just on the point of substance to start with, there is a very clear view from our side that a 3% leverage ratio is a sensible minimum point to have institutions at and those who are not at it to have plans to get there. That, of course, is short of where-discussions that have happened before in this Committee-many people think it should get to, but we are trying here to establish what I call a minimum baseline.

Now, the second point is that on the question of timing it is true that in the context of what we published on the risk-based capital requirements, we have said that we want firms to get there wherever possible and for the large majority of actions to be taken by the end of this year. We have said that some will go into next year but the target has been to get the institutions on risk-based capital to where we want them to be based on the 7% Basel endpoint measure by the end of this year.

There is a logic then to saying, if you are also picking up the leverage question, why would you take a different view to that on timing. There is a presumption starting there, but actually we have said-I want to be very clear on this because this is what we are doing at the moment-to the institutions on leverage, "Will you please give us plans for how you intend to achieve the target we have set, bearing in mind a presumption that we do want this to happen as soon as possible?" As you know from the statement we put out just under two weeks ago, we asked the institutions in question to produce these plans by the end of the month; that was at the weekend. We have them. Staff are now looking at them and we have made clear that we will go through these with the institutions during the course of this month and we will publish the outcome so, again, it is clear to people what we are aiming for.

Q10 Chair: Is the PRA united on all this?

Andrew Bailey: I think the PRA is absolutely united that leverage is important, that the 3% target is important, and there is no dissent that the best way to do this is to see the plans before fixing the date. I would be concerned if we sought to do anything else or-as you will have seen over the weekend-by any suggestion that part of this plan would involve cutting lending to the real economy.

Q11 Chair: Was the outgoing Governor pressing for a shorter timeframe?

Andrew Bailey: There is a range of views on that. I think that he did take the view that as with the RWA-based capital we should hold institutions to a timeframe on this, and we will do that, but he also agreed that we wanted plans. He did not dissent from the view that we wanted plans.

Q12 Chair: There was a full and frank discussion about all these things, not inhibited by a powerful Governor as chair?

Andrew Bailey: The PRA board has just finished its first quarter of existence. It has met eight times in that quarter. It has had another further four conference calls and it has discussed leverage on at least four separate occasions among those meetings.

Q13 Chair: Martin Taylor, did you ever lobby Government when you were chief executive of Barclays?

Martin Taylor: When I was first chief executive of Barclays at the end of 1993 the Bank of England was our supervisor. I would not have dared lobby Government. The Governor would have filleted me. If we had difficulties-

Q14 Chair: So what has changed?

Martin Taylor: Well, I think what changed was that supervision went away from the Bank and the Governor was no longer in that particular game. I suppose that over the succeeding 10 years-

Q15 Chair: The game, by which you mean regulation and bank supervision?

Martin Taylor: No, the relations between the banks and the Bank of England. The Governor was no longer concerned with supervising the banks and I can only suppose that the banks began to go to the west end, if I can put it that way. The habit of lobbying Government, once acquired, is not easy to break. Personally, I would hope that with supervision having returned to the Bank, the Governor would become the first port of call.

Q16 Chair: In your experience, what goes on in America, Dr Kohn?

Dr Kohn: In America there is quite a bit of lobbying at a number of levels but the regulators are quite independent. Certainly, the Federal Reserve is independent but also the Comptroller of the Currency, the FDIC, are all independent of the Treasury and the Administration, SEC and CFTC. The Administration needs to respect that independence and I think they do. It is really up to the regulators and the supervisors to make sure they are not influenced by the lobbying per se. I think it is important to keep the lines of communication between the industry and the regulators open. The dangerous part comes when the industry tries to work around the regulators and to bring pressure to bear on the regulators through third channels. It is up to both the elected politicians and the Cabinet in both countries and the regulators to make sure they respect that independence. It is essential.

Q17 Chair: You have had a remit, Paul Tucker, to get closer to the banks over recent years. Has this gone too far?

Paul Tucker: There is a difference between talking to the banks about what is going on in the market, which the Bank has to do and if it does not continue doing it will fail in its mission, and what is being described this morning. Look, let me say this has been-

Q18 Chair: So what is going on is unacceptable?

Paul Tucker: It is also pointless.

Q19 Chair: Are you agreeing that it is unacceptable?

Paul Tucker: Yes, of course, it is unacceptable, but it is also pointless. This has been a good week. This has been a week in which you have underlined the independence of the FPC and the PRA and the Chancellor of the Exchequer has underlined the independence of those two policy bodies. That is terrifically useful. I think Martin is absolutely right. Habits are difficult to kick. After 15 years plus of a vacuum and a world in which in many respects banks chose their own capital levels, it is quite something for them to get used to a world in which there is an agency of the state, the central bank, that says, "This is how much capital we think the system needs to hold and you, bank X, need to hold, in order to be safe given current circumstances". But that is exactly what Parliament has asked us to do and nothing has happened over the past 10 days or few months that has deflected us from that one iota.

If I can go back to an earlier question, the debates in the PRA and the FPC are full, frank, discursive, challenging. There has been no question of these decisions being anything other than truly consensual decisions among adults on policy committees.

Q20 Chair: Mr Carney’s efforts to make it even more consensual will struggle since it is already very consensual?

Paul Tucker: On the FPC Parliament says, "Reach decisions by consensus; where you cannot, have a vote". It is our duty.

Q21 Mr Newmark: The FPC announced as part of its capital exercise that firms will be asked to hold a minimum of 3% leverage ratio, which we have been talking about. Some commentators saw this as a circumvention of the Government’s policy not to provide a time-varying leverage ratio to the FPC until 2018 at the earliest. Do you agree with this assessment, Martin?

Martin Taylor: No, I do not. The fact that the Government did not give the FPC powers of direction over leverage ratio does not mean that it is a subject that we cannot discuss and make recommendations on. In fact, we would not be doing our job if we did not make recommendations on it, it seems to me. The new FPC of which I am a member has not made new recommendations on this subject. It has merely reaffirmed those that were made in March. I have to say I am a little bit surprised that the banks themselves seem to have been taken by surprise on the leverage ratio issue because the March FPC was very clear on the question. I know that the PRA has been talking to the banks since April, so the impression you might get by reading the newspapers in the last few days that this was all a terrible shock at the end of June is not something that this Committee should be taken in by.

Q22 Mr Newmark: Paul, whose idea was it to implement the 3% leverage ratio?

Paul Tucker: In respect of individual institutions, the PRA. The FPC did three things. It said, "Here is a framework for how you should assess capital adequacy". That is the point about the adjustments for expected losses, conduct costs. That is the first thing.

Second, it said, "We think that in the current environment all the major institutions need to have a risk asset ratio of 7% by the end of this year". Then it went on to say, "But the PRA needs to look at each individual institution.

We are not the micro body. The PRA now needs to dive more deeply into each of the individual institutions and, among other things, look at their leverage".

That is what the PRA did. In respect of two institutions, it concluded that their leverage was currently and prospectively too high for safety and that there needed to be measures to correct that. That, I would say, is exactly how the system is meant to work. The FPC is meant to take a broad, system-level view, and the PRA is meant to drill down into individual institutions. The answer to your question about who has set these leverage requirements for the couple of institutions concerned: the PRA board.

Q23 Mr Newmark: Do you believe it is right to impose the 3% now, or premature?

Paul Tucker: Yes, I think it is right, speaking both as an FPC member and as a PRA board member and, I have to say, as an MPC member as well.

Q24 Mr Newmark: Andrew, do you think it is right or premature?

Andrew Bailey: Yes, I do think it is right. Just to your original question briefly, I think there is a distinction to be drawn. You very rightly posed the question of the role of the time-varying leverage ratio, but if that were then to be interpreted as the regulator having no authority to set minimum leverage, that would be a great concern to me. I am very much a believer that we should use both the risk-based and the leverage approaches to assessing institutions, and you would be tying one hand behind our back-by the way, the hand that this Committee has clearly said was a problem in the run-up to the crisis. It would be a big problem.

Q25 Mr Newmark: Sorry, do you think that the risk-weighted measures should be taken into consideration or not?

Andrew Bailey: I am a great believer that we use both as a means to assess the safety and soundness of institutions. I am not a one-club person in that sense.

Q26 Mr Newmark: Okay. Do you think that leverage ratios should continue to have a superior predicted performance once regulators targeted it or do you think they would suffer from Goodhart’s law?

Andrew Bailey: No. I think you raise a very good point. It is one of my other concerns about people who say, "If only we used the leverage ratio, everything would be fine". Of course, as you say, if we used only the leverage ratio, people would start to say, "What can I do to get the leverage ratio into the place I want it to be?", which again is why it is important to have more than one way of looking at things. Yes, you raise a good point there. I would not just rely on the leverage ratio.

Paul Tucker: Can I just add that I completely agree. Goodhart’s law would apply. I am confident of that. And that is exactly why the international community-and I can speak for Mark with confidence on this-introduced the leverage ratio as a backstop. But if it is a backstop it will sometimes bite. It is not there for no reason.

Q27 Mr Newmark: But when you look at different asset classes, ultimately isn’t there a certain level of fudging that goes on by banks and central bankers? This is a slight concern of mine. I want to give an example here. I do not want to tread on John Thurso’s stress testing, which he will get to with you, but when you look at banks’ balance sheets today-you look at Greek debt for example-the central banks in Italy, France, Spain and the UK will all look at them in different ways, which leads to an imperfect analysis as to what the balance sheets of the banks really look like when you look effectively below tier 1.

Paul Tucker: The answers may come later from Mr Thurso’s questions.

Q28 Mr Newmark: Yes, but I am trying to pre-empt it because it is something I have been dying to ask.

Andrew Bailey: Well let me have a go, I’ll give you-

Q29 Mr Newmark: Let me tell you what is driving my question. Basel is very limited in what it can do, particularly from a regulatory standpoint. What worries me is that Basel sets a framework and then the central bankers just go and effectively do what they want, which allows situations that are of concern to me. Not that I want to cause any problems for any major banks out there, but effectively the three major French banks are bust and the big banks in Spain are bust. When you look at their balance sheets and you drill down and you look at the valuations that are being taken into account of the impaired assets, there is too much elasticity allowed in analysing those balance sheets.

Andrew Bailey: Let me just offer a thought on this. I think you make a good point and it’s a reflection on the last few years of history. Basel has Pillar 1, Pillar 2 and Pillar 3. Pillar 1 is the compulsory minimum capital requirements that are either modelled or done on a standardised approach but, as you say, can have quite interesting results.

Pillar 2 is then the more discretionary add-ons that the supervisors can use, often to reflect either what should be in Pillar 1 but isn’t in Pillar 1 or what is in Pillar 1 but is not adequately captured. Pillar 3 is different; it’s transparency and disclosure.

What you have seen over recent years is interesting. If you go back to 2008, the major UK banks held almost no Pillar 2 capital. It was a Pillar 1 capital requirement and more or less nothing on top. It was around about £15 billion if I remember rightly. That has changed. So over the last four years, five years, that has moved up. The last time I looked it was around about £125 billion, £150 billion. There has been a lot of putting capital requirements on through the second pillar. That has a strength and a weakness. The strength is that it has happened. On your point, it has also allowed us to address the fact that if the Pillar 1 Basel regime delivers a zero risk weight against Greek debt you might say, "Hang on a minute, that doesn’t look right", and you can deal with the restrictions of the first pillar in the second pillar. But it is not transparent. That is the problem. It is very hard to explain what is going on.

I’ll leave that hanging neatly and jump over to stress testing. One of the great virtues of having a more robust and all encompassing stress testing regime is that it will make these judgments around the second pillar more consistent. You are right that across countries, of course, you get all sorts of differences going on.

Q30 Mr Newmark: Do you think that regime needs to change though and can that only be done through Basel?

Paul Tucker: There are efforts in Basel to address precisely this. There is an acute awareness around the top table in Basel amongst the governors that it is not enough just to issue standards and then they get implemented in different ways around the world. Speaking now as a member of the Financial Stability Board Steering Committee, almost the biggest change that is occurring, whether it is about banks or central counterparties or other things, is we now want to know that there is true compliance with the standards around the world and in broadly equivalent ways. I think that will take years to get into a good place but there is an acute consciousness-

Q31 Mr Newmark: Yes, but if it takes years to get into place-

Chair: Let us make this the last question for this.

Mr Newmark: Chairman, I have got at least one more minute, according to your nine minutes.

If it takes years to get into place, does that not create more systemic risk? Should this timetable not be brought forward in terms of having like for like comparisons?

Paul Tucker: You make a good point and, as I have said publicly before, getting convergence in a world where there are 20 to 25 really important countries around the table is different from a world when there were just three. We both have to accept that in building a safer future it is important to carry all the countries of Asia and Latin America rather than it just being cooked up in Frankfurt, Washington and London.

Q32 Stewart Hosie: Ben Bernanke recently provided forward guidance on the US Fed’s QE programme, indicating that the regular purchases may end during 2014. I think it is safe to say the market reacted very strongly to that. Was the market reaction stronger than you had anticipated?

Paul Tucker: Yes, but not a ‘falling off my chair’ kind of surprise. We talked about this for the first time in the November Financial Stability Report. There has been a fairly aggressive search for yield, particularly in dollar-denominated assets, in credit and in emerging markets, but that there should be such an adjustment, when what the Chairman of the Federal Reserve Board said was that they may start to slow the pace of monetary expansion-so we are in the second or third derivative here-showed that the financial system was getting fairly over-excited. That is part of the background to one of the key recommendations in the latest Financial Stability Report: that we, the FPC, want the microsupervisors, both banks and crucially the FCA with Bank staff, to drill down and see whether there are any excesses building up across the financial system that could threaten stability.

Can I just underline for one second that it is very important for the whole new apparatus, the new architecture, that this is a recommendation that goes to the FCA as well as to the PRA? Something that troubles me greatly is this equation of microsupervision of the soundness of institutions with Andrew and the PRA. Andrew does banks and insurance companies. Everything else is done by Martin at the FCA. It is not the case that everything in microregulation important to the stability of the system is in the PRA. A lot of it is in the FCA. That is exactly why the FPC is able to make recommendations to the FCA, and that is what they think too.

Q33 Stewart Hosie: I think it is useful for you to get on the record quite strongly that the Business Conduct Regulator of the FCA is as important in this regard. It is a useful thing for you to say. I am sure we have all taken that on board. It is also helpful to understand the requirement to drill down and search for stresses and I am sure others will come to that.

I am more concerned about the signalling effect of what was a rather modest announcement that purchases may slow down. Are you concerned that the signalling effect of changes to QE was as strong as it was? Is that a concern to you, that people or banks or institutions may now do things that are slightly irrational on the back of simply a signal?

Paul Tucker: I think it is an alert with a small ‘a’, if I can put it like that. If I compare this with the spring of 2007, there was a fairly modest correction in credit spreads and a number of people said, "This is the correction that we wanted to see", and my own view at the time was, "Hold on. Two funds have already failed." I think that was an amber light with a capital A. I don’t think we’ve got that now but it does mean we need to be on our mettle, not just in this country but our colleagues around the world. So there is a warning shot across our bows on this. I accept the spirit of your question, but I do not want to create the impression that we think that we are on the edge of a cliff.

Q34 Stewart Hosie: I appreciate that. So given it is a small-A alert-not the failure of two funds that will lead to something more significant-what are you going to look at in terms of QE unwinding, particularly in the States or elsewhere, and how it might affect financial stability? What are the signals you will be looking for?

Paul Tucker: The degree of correction in asset prices. And just as important-only the PRA and FCA can do this-is whether we have any funds or firms that have become just excessively leveraged or maturity mismatched, liquidity mismatched, in trying to make a ton of money out of the search for yield that has been underway. You might reasonably say there is a dilemma here, but I think it is the new system working.

The monetary policy authorities around the world have been underpinning demand with huge monetary stimulus and I strongly believe that has avoided much worse outturns in the real economy than would otherwise have occurred. The whole point is that the FPC and the PRA are alert to the risks that that can create in the financial system, and that is what was missing in the last cycle.

Q35 Stewart Hosie: Dr Kohn, I can see you nodding there, which is helpful. I am glad there is agreement. However, one economist has said that when the US embarks on policies that are appropriate for domestic circumstances, it can impose policies on the rest of the world that are not necessarily appropriate to them. Does the announcement, not the actuality, of the unwinding of US QE come into that category of doing something that might be very appropriate for the US but not necessarily appropriate elsewhere?

Dr Kohn: I think the rest of the world needs to be aware that the US is in a particular phase of thinking about withdrawing the degree of stimulus-as Chairman Bernanke said, "Taking the foot off the accelerator"; so not putting it on the brake but taking it off the accelerator-and there will be some repercussions around the rest of the world. But it is in everyone’s interest that the US executes this as smoothly as possible. It may not be entirely smooth. It is in everyone’s interest, in the US and elsewhere, to test how resilient the financial systems will be to what we hope is an inevitable situation where economies strengthen and the degree of monetary stimulus is no longer needed. So, yes, what the US does, as the major reserve currency country and a huge financial centre, does have effects on other jurisdictions. Other jurisdictions need to take whatever steps they can take to protect themselves from adverse circumstances to allow the markets to work but to make sure their financial systems and economies are resilient.

Q36 Stewart Hosie: In a sense the early announcement by Ben Bernanke was sensible to alert other countries to plan?

Dr Kohn: I think it allows everyone to plan. The more transparent he can be about the intentions of the Federal Reserve and particularly about their reaction function, how they are going to respond to changing economic circumstances, the more both the private sector and public sector can plan.

Q37 Andrea Leadsom: Dr Kohn, do you think there is a scenario where the pain of unwinding QE is just too great and so it cannot be unwound? Is that something that concerns you in light of the reaction to Ben Bernanke’s statement?

Dr Kohn: No, I do not. I think that there will be reactions in markets. We need to be careful about those here in the UK and elsewhere. We need to make sure systems are resilient but we cannot allow ourselves, whether ourselves is the US or the UK, to be trapped into a monetary policy that is inappropriate for macroeconomic stability because we are concerned about financial stability. So one reason you created the Financial Policy Committee was to enable us to make sure that the monetary authorities could move against their objectives without endangering financial stability. I do not agree that the monetary authorities of the world are somehow trapped into continuing to provide this degree of stimulus when it eventually becomes inappropriate just because of the financial stability concerns.

Q38 Andrea Leadsom: Right. But the retired Governor, last week, was very clear and rather careful, looking again at what he said, to suggest that quantitative easing will remain outstanding for a very long time. So it did seem to me that there seemed to be a conditionality for financial stability purposes rather than necessity, because obviously nobody can completely predict with certainty how long it takes before the global economy recovers. It seemed to me that perhaps he was trying to calm the markets; there was a message there for the markets. Is that a conflict: part one of the question? Part two: should the FPC therefore be instrumental alongside the MPC in determining the means, timing, method and so on of the unwinding of QE?

Dr Kohn: No, I do not believe there is a conflict. I think the Governor was stating essentially what Ben Bernanke, others at the Federal Reserve and governors of other central banks were stating, which is that the global economy is still weak. There is still quite a distance to go until we have all the people employed who should be employed. There are not the sort of inflation risks that would impel some monetary tightening, and it is perfectly reasonable to think that the tightening exercise, the raising of interest rates, is quite some distance off. At the same time, it is up to us on the Financial Policy Committee to make sure, as the rates remain low and people look for yield and take positions that are perhaps induced by the low rates, that they do not take such positions that when rates do come up-and they will come up-the resilience of the financial systems is endangered. So I don’t see conflict at all; I see complementarities.

Q39 Andrea Leadsom: Then the second part of my question was therefore should the FPC be hand in hand with the MPC in determining the timing, the method and so on of the unwinding, for the sake of financial stability?

Dr Kohn: No, I think that decision should be with the MPC, given the objectives it has in its remit from the Chancellor for price stability and, subject to that, growth. I do think we need to understand what is going on in both cases-that has also been part of the Chancellor’s remit to both committees-and we have put extra effort in to that. There is a box in our Financial Stability Report talking about the effects of monetary policy on financial stability. The Inflation Report has had a box and some discussion of the effects of what the FPC might be doing-monetary policy. I think it is absolutely critical that both bodies understand the intentions of the other and understand the side effects of what they may be doing and are able to make adjustments as they carry out their individual remits. No, I don’t think the Financial Policy Committee should dictate to the Monetary Policy Committee how it unwinds its policy stimulus.

Q40 Andrea Leadsom: Do any of you gentlemen disagree with Dr Kohn that the FPC should not be part of that decision? In other words do any of you think it should be a part of the decision about the timing or the method of unwinding QE?

Martin Taylor: I do not disagree with Don at all. I think the remits of the two committees are very clear, but also we have been charged to improve liaison between the two committees and this is something we are working on because the FPC is still quite new. For example, I attended the MPC briefing yesterday and I believe that it is extremely important that we understand what is in the mind of the other committee.

Andrew Bailey: The only thing I would add is I absolutely agree, and I think it is key that in the structure we now have we provide the MPC with all the information and assessment we can of the transmission and the consequences of the plan to do that. I can assure you that one of the good things we have seen in the last three months is a lot more contact and provision of that sort of material to the MPC from both the financial stability side but also from the PRA. That will continue, and it is absolutely crucial because then the MPC can take a more informed judgment.

Paul Tucker: I endorse that as an MPC member. This is a better setup. The decision should rest with the MPC but it should take those decisions in full knowledge of the FPC and the PRA’s assessment of how it would ripple through the financial system. We are so much better equipped to do that now than we were a few years ago.

Andrea Leadsom: Good. That is very reassuring.

Q41 Andrea Leadsom: Can I just change the subject completely now to competition? Specifically I would like to ask each of you, starting with Mr Taylor-

Chair: With brief replies please.

Andrea Leadsom: -whether you think enough has been done to remove barriers to entry at a regulatory level? In other words, we have had a lot of evidence that new banks, would-be banks and small challenger banks have struggled to get through the regulatory hurdles to getting a banking licence. Secondly, the capital requirements for smaller banks have been absolutely detrimental to their success in becoming challenger banks. Then, as I think you all know, I am a big fan of bank account number portability and I would like to get you all on the record as to whether you think that having portable account numbers could change the competitive outlook for banking.

Chair: That was just one quick question and I am sure you can handle it.

Martin Taylor: I stick with the Cabinet responsibility of the ICB conclusion on portability, which you are well aware of.

On competition there is no short answer to this I am afraid but I am just struck by the contrast between the desire of everybody to increase competition in the banking market and the day-to-day struggles we seem to be having to keep the small players alive. I think the rhetoric is in one place but life is difficult, is it not?

Q42 Andrea Leadsom: Yes, but is it not a target of the new regulatory structure to allow, to permit, a bank to fail? Should that not be a key goal in a sense? Horrifying as it is to say it, should it not be possible for a bank to start up and then fail?

Martin Taylor: It should be. I think I have had my 30 seconds.

Andrew Bailey: I think we have made initial progress on the question of barriers to entry for those coming in at the small level. You then have to take a similar look at those who remain small and want to remain small because they are valuable niche players. The third leg of it is one that I think now has to be focused on, and of course this is what the OFT will focus on. We have to be a bit careful about how we use the word "challenger". You use the word "challenger" in your Commission in a particular sense. I think there is a real issue around what does it take, and what is the critical mass of what I would call a "challenger" in your sense of the term, which is not a niche player, but somebody who is on the High Street in "sufficient scale" to provide a real challenge across the board to the big banks. That is a very real question, because the crisis has severely thinned that landscape out. As you know, there have been problems since then as well, much of which is legacy to be frank. But to Martin’s point earlier, that is a very big issue. To solve this challenger issue, we have to go to that one.

On portability, I do think we have to let the seven-day transfer thing happen. If they do not do it, then they will face the consequences. Then we have to work out how you do portability and that is a question that needs to be answered. Many of us have views on it, and I am happy to give those views.

Q43 Andrea Leadsom: Specifically in terms of resolution would you not agree that being able to lift all of the accounts from one bank and put them in another bank, without having to go through money laundering rules and changing bank account numbers and approving and so on, is a solution to resolution from a pure systemic risk point of view?

Andrew Bailey: It would.

Paul Tucker: It would help. I would say two things. First of all, you said something that is music to our ears, which is that it has to be possible for banks to fail in an orderly way and I underline that because there is no group more important than you and your colleagues in the House of Commons on this. The greatest brake on banks being allowed to fail is the concerns that you individually will feel about your constituents and about the businesses in your constituencies when banks fail. If that is where you, as Parliament, end up, then you can expect the regulators to go in a direction that you will not like. So please repeat that often and persuade as many of your colleagues as you can.

On portability, you are right but-this is a personal view-I would caution against advocating grands projets. I do not think this country is any good at them. This is not the same as Railtrack. The point about the Railtrack divvying up is that the tracks were already there. In terms of building completely new infrastructure, the studies would have to be done but they need to weigh the possibility of 10 or 15 years passing and a lot of money being spent without a grand infrastructure being put in place. So I end up where Andrew is. I share absolutely the spirit of what you say. You and we should be on top of the banks in ensuring that they deliver the seven-day transferability thing in the autumn and pick up the debate from there.

Q44 Chair: We are well into overtime. Is there anything you want to add, Dr Kohn? You are allowed yes, no or "I would have done, had I time".

Dr Kohn: I agree with what my colleague said. I do think the resolution thing is extremely important and the reducing barriers to entry. I think it would be dangerous to reduce the capital barrier so far that new entrants had a very high chance of failure, so you are balancing some very difficult things. On resolution, in the US, banks close at 5 pm on Friday and they open under new ownership at 9 am on Monday morning and it seems to work.

Paul Tucker: That is because there are lots and lots of banks so they are starting to-

Q45 Chair: That comes back to whether the PRA is going to take seriously getting new entrants into the market, and that is partly driven by whether you are prepared to accept competition as an objective-a secondary objective to financial stability of course-in statute. Could you just confirm that you are prepared to support that?

Andrew Bailey: We are. Let me take all of that in turn. We are very supportive-

Chair: There was only one question-

Andrew Bailey: There were two parts to that, if you don’t mind me saying so.

Chair: It had a yes or a no in it as well.

Andrew Bailey: We are supportive of encouraging new entrants. I do think however, and it is the reason I made the point earlier, that we have to have a better understanding of why we have struggled to get real competition in terms of High Street banking.

Chair: Can I have an answer to the question please.

Andrew Bailey: I am coming on to it. My reservation about giving us a statutory objective on competition is that the FCA already has one.

Chair: They do not license banks.

Andrea Leadsom: They do not license the banks.

Andrew Bailey: They do.

Paul Tucker: Yes, they do.

Chair: You were the key player for deciding who gets on to the High Street.

Paul Tucker: Beware of asking the regulators to do too many things in one body. This was the mistake-

Chair: We are asking you to take this on as a secondary objective. Sorry, Mr Tucker, I just want to come back to Mr Bailey.

Paul Tucker: All right.

Q46 Chair: Is the answer a yes or a no to having competition as a secondary objective?

Andrew Bailey: You have not convinced me yet. The reason is first of all that if we have a secondary objective we would have to work out how we would frame it because most secondary objectives are framed as a hierarchy so it would be the usual, subject to that.

Chair: This has been proposed both by the Banking Commission and by the Treasury Select Committee and it is worded exactly in the way you were just suggesting.

Andrew Bailey: The second thing is we have a "have regards" to it and I want to avoid tripping over the FCA. If you have two bodies out there promoting competition we would have to work out how we did that. There is no lack of willingness on my part on this.

Q47 Chair: If I may say so your facial expression is saying something slightly different from the words. It seems clear that you do not think that you are going to be tripping over the FCA. Indeed no one is suggesting that and that is the first we have heard about that. What the risk may be is that the FCA may try to do this but the PRA have much less interest in supporting the licence side of it.

Andrew Bailey: No, no. That I reject. I am not in any sense going to stand in the way. The FCA, by the way, are in the process of setting up a capacity in competition. I am on the board of the FCA and support that. I have no desire to get in the way of what they want to do.

Chair: We want more than an assurance and we are not getting it today but I am going to move on, notwithstanding noises on my right, to Mark Garnier.

Q48 Mark Garnier: I am just going to stick on this last point. I have one last question on this. You said in your reply to Andrea Leadsom that your opinion of grands projets in this country was such that it would take 13 to 15 years and-I am slightly paraphrasing-that we are not very good at this. But can I just ask you what conversations you have had with VocaLink about what they are putting forward in terms of trying to deliver a full account on affordability?

Paul Tucker: Not in detail. I have not personally. We are waiting for the delivery of the seven-day transferability.

Q49 Mark Garnier: If I may, could I suggest that you collectively do have a conversation with VocaLink because they have actually done a huge amount of work on this particular subject. As you know, the Banking Commission has asked for a full investigation for cost benefits.

Paul Tucker: Yes.

Mark Garnier: But also VocaLink are making quite a lot of progress in terms of trying to work out how to do exactly this. I suspect that the £10 billion that we have been quoted by a number of the banks may be nowhere near that and it may be quite a good idea to go and take a look at it because it is something that we could-

Paul Tucker: Those are reasonable points. Collectively we will do it.

Mark Garnier: Yes, it is less than a grand projet, yes.

Andrew Bailey: You are right. I have worked with VocaLink a lot in my past. You are right, they are the natural place to look first.

Q50 Mark Garnier: On household indebtedness-although it has come down a little bit over the last two or three years as a percentage of debt to household income ratio-how worried are you about the fact that people have not reduced their debt in any meaningful way and they have not taken advantage of this very low-interest rate environment to do so?

Paul Tucker: It would have been hard for them to reduce the burden of debt much in the sense that matters, given the weakness of the economy and, therefore, of incomes. There will be many households and firms who had more or less prudent levels of debt if the economy had stayed on the same trajectory, but 10% to 15% below that trajectory the debt burden is higher than anybody expected. Can I just go on to say though that there has been some attention given to numbers in the Financial Stability Report about this? It goes back to something that Don said.

It is very important that the Monetary Policy Committee conducts monetary policy in a way that we begin to withdraw monetary stimulus because the economy is recovering, rather than because we have an inflationary problem without real economic recovery. The circumstances in which households will get crushed are circumstances in which the Monetary Policy Committee fails on its key objective of price stability. The doom scenario is one where down the road some years the monetary policy ends up withdrawing monetary stimulus so as to maintain price stability. I do not remotely foresee that and so what we are trying to bring about are circumstances that the economy recovers with price stability and that the debt burden on households, as a whole, is manageable. But this is a headwind and one of the reasons why we have such loose monetary policy.

Q51 Mark Garnier: You are absolutely right, it is a headwind and to me what is quite alarming is that just a little bit of forward guidance by Ben Bernanke resulted in quite a spike in bond yields over the last two or three weeks. Certainly in the UK you see bond yields spiking by, what, 80 basis points, which may not sound very much in historic standards but it is-

Paul Tucker: It is quite a lot

Mark Garnier: Yes; 165 basis points to whatever it is now. Yes, looking at the numbers on household debt, there is £1.2 trillion of mortgage debt, of which 5% to 8% of its value is currently undergoing forbearance by the banks. In your report you talk about the fact that if interest rates were to go up by 1%-obviously bond yields have nearly gone up by 1% already-and mortgages followed, 9% of households would have to make significant changes to their lifestyles. If they went up by 2%-we are now talking from 0.5% to 2.5%, so still a very, very low interest rate-20% of households would have to change. We are now very-

Paul Tucker: If there was not an accompanying increase in incomes. This point is absolutely vital. This is a very narrow thought experiment where interest rates go up without recovery in the economy, and recovery in the economy means higher incomes for households and higher profits for firms. That will not happen unless the MPC makes mistakes and the MPC will endeavour not to make mistakes.

Q52 Mark Garnier: But you are in the business of risk management. You have to look at where the risks lie.

Paul Tucker: Yes.

Mark Garnier: You are absolutely right, we could have a fantastic opportunity where the economy just goes back to the basis and this is not a problem and we all hope that that is the case. But we could also have a situation of a collapse in sterling, where we would have to do something with interest rates in order to stop importing inflation, at a very, very simplistic level. At that point, if interest rates were to go up by 2%, you would suddenly have at risk, within the banking system and the financial system, £240 billion-worth of mortgage debt-and that is just with interest rates going up by not much more than they already have done on the bond yields.

What is the answer to this? I look at this and I scratch my head a great deal and cannot come up with anything. You obviously do a great deal more. What is the answer? How do we protect, first, households from a spike in interest rates that could come as the result of the wrong stimulus and, secondly, the stability of the economy and indeed the banking system?

Paul Tucker: The first thing I would say is we do not know where these interest rates or bond yields are going to settle as the weeks pass. There has plainly been a lot of amplification of the adjustment in recent weeks. Maybe that will come back; maybe it will not. We will see. The answer to your question is the MPC doing its job well, because the MPC has to generate-

Q53 Mark Garnier: Are they doing it well?

Paul Tucker: So far. I would say this because I am part of it. So far I think we have done a good job of underpinning demand in this country while retaining the credibility of the nominal anchor, the 2% inflation target.

Q54 Mark Garnier: Is the overlap of members between the MPC and the FPC crucial to this?

Paul Tucker: It is certainly very helpful. For example, Andrew and Don were talking about briefing of the committees-and I think Martin did. Tomorrow afternoon is the first part of our Monetary Policy Committee. There is a slot in that for Spencer Dale and me to brief the MPC members who are not involved in this on where we have got to on the banks and so on. Yes, it is. The overlapping membership is very helpful. It allows a degree of specialisation without living in separate parts of the universe.

But the big answer to your question is that we need to generate recovery while maintaining price stability and anchored inflation expectations, and that is our job on the MPC. If we do our job well, the concerns that you rightly point to will not crystallise in a very serious way. Meanwhile, we factor it in to monetary policy because the debt overhang in the household sector is a headwind that has been holding back recovery in demand.

Q55 Mark Garnier: This is genuinely my last question. Do you ever envisage a situation where the FPC might feel it necessary to make recommendations to the general consumer, either just coming out and saying, "Look, you do need to worry about this" or alternatively through banks? Potential buyers sort of saying, "Look, we think this is something that is potentially a worry. Can you do something about it, for example, have more fixed-rate mortgages?"

Paul Tucker: I think more likely is that it will be done via a recommendation to the FCA, which is kind of the consumer body. But if ever we were to do that, in explaining that recommendation we would, of course, be speaking to the general public-via the media, via you-as well. But it will be for them to work out exactly how to take it forward, and in degree they have been doing some of this. Martin Wheatley has sought some prominence in his warnings about interest-only mortgages. Even though that risk lies some distance in the future he plainly wanted households to be thinking about it now and in the near term.

Mark Garnier: Fantastic.

Q56 Mr Love: Can I turn to the mortgage guarantee part of the Help to Buy scheme that was announced in this year’s budget? A number of economists have described it as likely to cause a new housing bubble. Some have even gone further and suggested that it is reckless in the sense that you are using public money to incentivise banks to lend to people that they should not lend to. How concerned are the MPC about the financial stability implications of this particular scheme, Mr Tucker?

Paul Tucker: When they announced this scheme, the Government also announced that three years in they would ask the Financial Policy Committee whether it should continue and the committee will dutifully do that. I am quite pleased. Some of you may recall that the previous Governor and I, well before the crisis, were very clear with you that this country should not have a Fannie or Freddie permanently. They are devices for getting out of one hole only to dig a hole for the future. I think they did help in the 1930s in America, but I am also absolutely certain that they helped bring about the global sub-prime crisis.

I think the Government has been prudent in saying, "Three years in, we ought to ask the Financial Policy Committee to have a look at this". But I should underline-and I know my colleagues agree with this-that we will address the financial stability question, not the other pros and cons of the scheme, which are not for us. This is a Government scheme. It carries some risks over the medium term. We have been given a lever over that but I think that is quite a good thing for the Government to have done.

Q57 Mr Love: I will come to Dr Kohn in a minute about the American experience in this regard and how difficult it has been to get out of these particular schemes in America. But let me just ask Mr Tucker again, do you not think that there is more than a possibility that even within the three-year timescale we may see the emergence of a price bubble?

Paul Tucker: If we saw that coming in ways that could jeopardise the safety and soundness of individual firms or jeopardise the stability of the system, then I believe that my colleagues-because it won’t be me-would do something about it by ensuring that the financial system underpinned itself so that those risks did not crystallise in the worst possible sense. This is why we exist.

Q58 Mr Love: With all the difficulties we have had in the past about whether we have a bubble or do not have a bubble are you confident that the new arrangements will lead to more definitive views about a bubble emerging?

Paul Tucker: It is a very good question, of course. We have no choice but to confront that question and my personal view is that too much is made in some commentary about the difficulties of spotting a bubble as though it is some kind of precision art. Frankly, you can normally tell from conversations with the market whether things are out of control. One of the reasons that we have been focused on the search for yield over recent months is intelligence that came to us from Wall Street and hedge-fund land. Do I think we will always get it right? No, of course not. But I do not think it is as difficult as it is sometimes made out to be, as long as one does not try to be overly precise or scientific about it. The FPC is in the business of trying to avoid really terrible things happening, not of landing the economy on a sixpence.

Q59 Mr Love: Dr Kohn, I will not go into whether or not Fannie Mae and Freddie Mac were good for the 1930s and the context of that but the more recent debate about how you get out of subsidising the mortgage market, which has proved incredibly difficult. Are there lessons that we should be aware of as we go into this procedure?

Dr Kohn: I think you have highlighted a very serious one, which is once you get in, how you get out again without disruption. It has been very difficult for the United States. In the US there are many different avenues for Government to subsidise housing and home ownership, both through the tax system and through Fannie and Freddie; through the Federal Housing Administration; there is a Veterans Administration. There are multiple ways of helping people become homeowners and that, to some extent, backfired. There were a lot of reasons for the sub-prime bubble.

I don’t think Fannie and Freddie were the primary reason. Certainly I think the private sector, the regulators, lots of people, were at fault for not seeing the problem coming and not taking action once it came. But there is no question that Fannie and Freddie became heavy burdens on the taxpayer. A major problem there was this was a case of privatising the gains and socialising the losses. That has to be avoided at all costs because private interests will respond to the incentives for gains, particularly if they think they are not at risk for the losses, so that the implicit guarantee, which became an actual guarantee of Fannie and Freddie securities while the shareholders were getting the gains, was a very, very serious policy error and it is hard to get out.

It is encouraging that the Government have put a three-year timeframe on this, that they are in the process of trying to design an escape mechanism-that is the Financial Policy Committee-whether it is exactly the right escape mechanism. I think we are good for looking at the financial stability issue. Someone else, as Paul said, needs to be looking at some of the other issues as an appropriate use of taxpayer money and so on; that is not for us. But we can bring to bear our expertise on whether we think the subsidies implicit in the Help to Buy scheme are driving prices beyond sustainable levels or are incentivising more credit than people will be able to service in the future, that sort of thing. We can bring a view to bear. It is absolutely essential that the thing has a three-year timeframe and a mechanism for ending it.

Q60 Mr Love: I wonder whether there has been a discussion of this in the FPC and the issues surrounding it because, of course, one of the ways you can address it, if there was an emerging bubble, is the use of macro-prudential tools and, in particular, the much vaunted raising of sectoral capital requirements. Is there some concern that you may be in that ball game before the three years is up?

Paul Tucker: The other brake on this going on for long is you as a Committee, and you will need to stay focused on this. It is possible. It is not something that we have discussed as a realistic prospect at present, but our job is to keep track of where bubbles, balloons, threats to stability emerge.

Q61 Mr Love: If I may bat this back to you, this may well turn out to be a very popular policy if it delivers home ownership to a much wider section of the community. Looking to Parliament to end popular schemes may not be the best way to address this problem.

Paul Tucker: You are right. We have said to you before-and, in a way, it is the most important point about the new regime-that eventually we will be taking the punchbowl away and bankers, the public and politicians of all parties will be together. We will be sitting here or my successors will be sitting here explaining the actions in terms of the remit that you gave us in statute and that is what it is our duty to do.

It is absolutely why the debate about independence is so important. This kind of regime, whether it is tightening monetary policy in order to dampen excessive demand growth or taking away the punchbowl in order to make the system more resilient in the face of an asset and credit bubble, is impossible unless the committee charged by Parliament with doing it is fully independent but also transparent and accountable, so you can see what we are doing. I am agreeing with you, Mr Love.

Q62 Mr Love: This scheme will not start until January 2014. The Treasury Select Committee has asked for a whole series of information because there is an information gap in how this will bed down. But is there not an opportunity for the FPC to perhaps raise some of the issues that could be of concern to you on stability grounds in order that that gets fed into the process that is now occurring where they are bringing forward a fully worked out scheme?

Paul Tucker: We must not stand in the way of Government policy but we must do our job. As you say, if there was a need to increase sectoral capital requirements or whatever, then that is something that we could do. But I note your concern and will take it back.

Chair: Government policy is that you should be independent and I think we heard what you have been saying.

Paul Tucker: We are keen on that.

Q63 Teresa Pearce: The FPC has been given the ability to terminate this scheme or end this scheme. Do you think that is the correct body and do you feel, as it would be quite a political decision, that it is within your remit?

Paul Tucker: I think, as Don said, the plan is that we be asked three years into the scheme to give a view on whether there were risks to financial stability from continuing the scheme beyond its original three years. We would have to address that question in terms of our statutory remit. It has got absolutely nothing to do with us whether this is a good use of taxpayers’ money or anything else. We would ask the question that falls within our statutory objectives and functions given to us by Parliament. I think that is a reasonable question for Government or anybody else to put to us about this or any other scheme.

Q64 Teresa Pearce: You are saying that in three years’ time you will make a decision. But given that you said earlier that stability is your key remit, if this policy caused a housing bubble and affected financial stability, would you not voice a view before then?

Paul Tucker: I am sorry if this was not clear. If we thought that a bubble was emerging in the housing market or anywhere else that was a threat to stability-from the Help to Buy scheme or from any other source for that matter-yes, we would air it and we would have tools to do something about it through, for example, raising the amount of capital that banks have to hold against mortgage exposures. We would not sit back.

Q65 Teresa Pearce: But you could not end this earlier.

Paul Tucker: Sorry?

Teresa Pearce: But you could not end it before three years.

Paul Tucker: As I understand it, the Government and Parliament are establishing the scheme for three years. We would not have the power to do that.

Teresa Pearce: You would not have the power.

Dr Kohn: We can make a recommendation to the Treasury, however.

Q66 Teresa Pearce: You could make a recommendation, right, okay.

Paul Tucker: Right.

Q67 Teresa Pearce: The mortgage guarantee scheme makes the Government an active player in the mortgage market. Do you think that is wise?

Paul Tucker: As we have made clear, I hope, I do not think it is wise in the medium to long term at all. This country has had a successful housing market without a Government subsidy. In the United States-and I think Mervyn and I must, first of all, have raised this point with the Committee in, I am guessing, 2005 or 2006-I do believe that Fannie helped get the United States out of the 1930s but I am absolutely sure that that structure helped brew the bubble that blew up the world in 2007-08. This is not a market that needs a permanent subsidy.

Q68 Teresa Pearce: What do you think this policy is trying to achieve?

Paul Tucker: This goes back to an earlier point. Big picture: we had a commercial banking crisis in this country. For all the discussion and important reforms of investment banks, this country had a commercial banking property boom and bust, not on the scale of Ireland but a really bad boom and bust that has taken a lot of capacity out of the commercial banking system. In those circumstances, none of the markets-the mortgage market nor, more importantly, the small firm-lending market-is working as well as anybody would like. It is not for me to speak for a Government policy but I think this is part of the Government’s efforts to lubricate that market and get it going again.

Q69 Teresa Pearce: What do you think success would look like?

Paul Tucker: I think that is a question that you will have to put to the Government. Success for us is getting economic recovery, maintaining inflation in line with the 2% target and achieving a resilient financial system.

Q70 Teresa Pearce: Do you share this Committee’s concerns about the lack of clarity that there is about this scheme? Our Budget report had page after page of questions on this scheme. For instance, the Chancellor announced it in the Budget and then he came to this Committee and we asked about second homes. He was very unclear and, in fact, at one point said that, "Yes, there would be people who needed two mortgages because of a marriage break-up or moving jobs". Yet, on 30 May the website made it quite clear that would be for one home only and not second homes and the Prime Minister repeated that in PMQs on 12 June. Will you be raising with the Chancellor some of the concerns we have raised about this scheme, given your involvement in it?

Paul Tucker: We have a different role.

Teresa Pearce: But your role is stability and a housing bubble will be massively-

Paul Tucker: Eventually the scheme will be fully specified. As we have said, we will track the effect of not only this scheme in particular but everything, including very loose monetary policy on the housing market and on credit conditions. But it is not our role to be in the business of scrutinising individual Government policies as they are designed and evolved.

Q71 Teresa Pearce: But is it not your role to be concerned where it may affect household budgets, financial stability and the housing market?

Paul Tucker: It is our role to be concerned or to be focused on the housing market, credit conditions and small firms in ways that could threaten stability. Once we start drifting away from our remit you would rightly put us back in our box.

Teresa Pearce: Okay, thank you.

Q72 Chair: We know, do we not, Andrew Bailey, that most cycles in the UK have been associated with property booms and busts? When you come to comment on Help to Buy, can you give us a commitment that, as a group, you are going to be commenting on whether subsidies to major asset markets like this store up trouble in the long run?

Andrew Bailey: Yes. I think you are right and your historical observation is correct. My perception of the public policy difficulty that is being addressed here is how-going back to Paul’s point about the problems the banking system has had-you get a greater supply of higher-LTV mortgage lending to support higher home ownership. Yes, there has been a marked change in lending standards and the balance between home ownership and the private rental market. You are right: British history, of course, has seen this in the past and I think that the big question is, can this be done sustainably without setting off a bubble in house prices? We will be absolutely focused on that, yes.

Q73 Chair: I am just keen that you should ask yourselves and then answer that privately.

Andrew Bailey: Yes, absolutely, absolutely.

Chair: I have it in a more broadly-framed way than the way that Mr Tucker suggested it might be addressed.

Andrew Bailey: Absolutely.

Chair: I will give Paul a chance to come back.

Paul Tucker: Your point is, would we feel comfortable with subsidisation of types of finance?

Chair: Of which the housing is the primary one.

Paul Tucker: Not if they create distortions that can threaten stability.

Chair: Might create.

Paul Tucker: You are right to say, of course, that this country has had endless property booms and busts. Most of them have been associated with an inflation boom and bust. The monetary regime we have had since the middle of the 1990s provides a strong safeguard against that but what everybody has learned is it is not a sufficient safeguard. One can have credit boom and bust without inflationary boom and bust: hence the FPC. It is the core role of the FPC to prevent that and I have no doubt that it will.

Q74 Mr Ruffley: Mr Bailey, I would like to ask about capital ratios, the 20 June press release setting out your conclusions of the latest capital shortfall exercise indicated that you expect the additional £13.4 billion of further measures to be effected by the end of 2013.

Andrew Bailey: For the most part.

Q75 Mr Ruffley: For the most part. Could you just say why you have decided to allow the first half of 2014 to be limited flexibility? What order of magnitude are you talking about to let it slide to the middle of 2014?

Andrew Bailey: The reason for that obviously is that the task of PRA is to take the firm by firm view and look at the measures that each firm could take and the flexibility that each firm has, and we did that. We pushed firms very hard, I can assure you, to get those measures done by the end of this year. Where there were a few cases of firms are undertaking broader structured restructurings, it was sensible for us, where possible, to accommodate them because we want them to happen from the point of view of our objectives of safety and soundness. That is it, really. I can tell you that we pushed hard and did not let people off the hook where we could see that they could achieve it during the course of this year.

Q76 Mr Ruffley: You applied a 7% core Tier 1 ratio in this latest exercise. Is it the case that the interim FPC wanted it to be 10%?

Andrew Bailey: No, not during this exercise. 7% was the conclusion reached by the interim FPC. We were unanimous on that, weren’t we?

Paul Tucker: Yes, we were.

Andrew Bailey: Yes.

Q77 Mr Ruffley: What do you say to some reports, Wall Street Journal being one of them in May this year, that in some sense the FPC lost the battle? The FPC wanted additional capital to be raised through the issuance of new equity and, that not being the case, you lost the battle. What do you make of that allegation?

Andrew Bailey: I do not start from a theological position, as to how this change in capital position should be achieved.

Mr Ruffley: But Sir Mervyn King did, did he not? Perhaps Mr Tucker could help.

Paul Tucker: No, no. You carry on.

Andrew Bailey: As you know, because this is very clearly on the record, the Government made it clear that it was not going to subscribe new equity to the two banks that are in varying degrees of state ownership. So we set about working with those institutions to work out how you did it within that overall constraint. We accepted that, absolutely. We said, "Okay. If that is what your constraint is we will work with that constraint". But I am very clear: if, as is happening, institutions are shedding activities-always accepting the constraint of not reducing lending to the real economy-if they are selling business, if they are selling non-core assets, which relieves their capital position, that is all sensible. I do not have any difficulty with that at all.

Q78 Mr Ruffley: Anything you would like to add?

Paul Tucker: No, I completely agree. My observation is that the FPC stiffened the sinews of the micro-supervisors, provided a framework for the micro-supervisors to work within. As Mervyn said to you last week, that has been easier since 1 April when the micro-supervisors became part of the broader Bank of England.

Q79 Mr Ruffley: Lots of people would see as counterintuitive the statement by Sir Mervyn-and I believe the FPC agrees with this-that it is insufficient capital that restricts lending, rather than the reverse. Since last August when FLS began, what has happened to net lending of the big eight banks that were the subject of your last capital shortfall review? Is it flat? What can you tell us about net lending since then?

Andrew Bailey: Let me just give you a bit of history on this, if you do not mind, because it is important.

When we were looking at the design of the Funding for Lending scheme, which is just over a year ago now, there were really two things for me that were strong motivators for why we should do it. One was the fairly febrile state of the euro area. I will say that and then put that to one side, but that was a factor a year ago, clearly.

The second one was that we get from the major banks about once a year their own projections for lending for the year ahead-and often a more uncertain projection for the year thereafter, but let us look at the year ahead. What we got, just over a year ago, was a set of projections which were quite substantially negative. For me that was a very substantial piece of evidence that suggested that we had to do something.

It was a discussion that we were having a year ago, but the reason I say this is because of course what this meant was that in the first year of the FLS-and I make this point carefully-this scheme may achieve something by making lending less negative than we were looking at. As Paul was saying, it has been broadly flat, and of course there have been distributions within different types of lending. I accept that is not a great outcome in terms of lending, but you have to understand the context we were in.

Q80 Mr Ruffley: No, I understand that. It is a given that it has been flat. Can you tell us what your future projections tell you, because you did that exercise last summer? What does it tell you? With all this amassing of more capital through disposals, you are inviting us to believe that this capital ratio and this additional capital ratio will be hit, not by shrinking the loan book.

Andrew Bailey: No.

Mr Ruffley: You are inviting us to believe that the ratio will not be hit by constraining lending. I therefore ask you: what is your projection for the next 12 months?

Andrew Bailey: I will break it down a little bit. The projection now looks more positive than we had before. I would say there are a number of features to that. First, what we have seen very markedly is a reduction in funding costs. I would say that has been the major achievement to date of the Funding for Lending scheme. It is not alone, obviously: it sits alongside what has been going on in other parts of the world. But I think that is a major achievement. We have seen a very sharp change in funding costs. That is important because what we had seen was a very substantial and unusual-but not necessarily unexpected in the conditions-wedge between the effective cost of bank funding and the official rate. We have seen that change, and that is a very helpful precondition to start stronger lending. The projections that the banks are now giving us do show stronger lending across both the mortgage sector and the small and medium-sized firm sector in their projections looking ahead.

It is true of course that there are still institutions-and this is why the overall picture has to be looked at-who are running off so-called non-core assets. We want that to happen because it again is tackling the legacy problem. The key question is whether these projections are going to come to fruition. I have asked the banks-and we have to watch very carefully- "Are your projections, particularly for lending into the small- and medium-size firm sector going to come to fruition? How are you going to do it?"

Q81 Mr Ruffley: What answer do they give?

Andrew Bailey: The answer they give is that they are increasing their capacity to make lending, and that is good, but the jury is very much out on this. We have to see the evidence on it.

Q82 Mr Ruffley: Yes. You see, there is concern in Parliament and in the wider economy that some of the banks will say-put aside, granted, the cost of lending has gone down-that it is going to be very difficult to get the actual quantum of net lending up to higher levels than in the last 12 months, because of this extra additional capital raising that you announced on 20 June. What do you say to that?

Paul Tucker: Well, we just disagree with it really. I mean, we are now in a period where, thank goodness, there appears to be something of an economic recovery which we think can be sustained. But the road is going to be bumpy. It may be very bumpy at times. The really dreadful risks in the international environment have not completely gone away. The thing that would threaten recovery more than anything else, probably, would be to find the banking sector injured even further by fall-out from the euro area or elsewhere in the world.

The other thing I would say is that we are not the only people in the world who think that the capitalisation of the banks needs to improve. It is not a huge secret that our banks need to build up their capital adequacy.

We are not making some brave trade-off of the short term versus the medium term. We believe that as they improve their capital adequacy their access to funding will improve, and that that will help the recovery of the economy. Indeed, that was the view of the MPC when it looked at the implications of the FPC’s actions in its May inflation report.

Q83 Mr Ruffley: I do not think anyone would suggest we should backpedal on securing better capital adequacy.

Chair: You had better make this the last question.

Mr Ruffley: This is my final question. Is it not the case though, that the test as to whether or not you are right, Mr Tucker and Mr Bailey, is whether or not the lending numbers for which you have projections, or you have seen projections, goes up in the next 12 months. And I just would like-

Paul Tucker: Well, depending what happens to demand in the economy. We can do things that remove impediments to credit supply, whether it is the capitalisation of the banks, the Funding for Lending scheme, or the actions that we are taking on liquidity. We can improve credit supply. We cannot conjure demand if it is not there. That will depend upon confidence among businesses and households that the economy is recovering. I just do not want to accept it as the absolute test, but in the spirit of it, yes, we accept that.

Andrew Bailey: Can I also make two brief points? There are other factors at work here. I am not trying to shift blame, but pointing to things that I do not think get enough attention.

First of all, the banks have to look very carefully at their capacity to make lending. Here I am talking about the small and medium-size companies sector, because there has been a big change in what might be called the "industrialisation in mortgage lending" in this country. There has not been the same change in terms of having the information that they need to make loans, and the capacity to do it.

Secondly, and there is a little bit about this in the Financial Stability Report, there is a very interesting question about the differential between the position of companies in this country-particularly small and medium-sized firms-who are either in the commercial property sector or dependent on commercial property as a form of security for borrowing and those who are not. I raise this point because we discussed the mortgage market earlier at some length, and there is a good reason for doing that. My own view is that there is not enough attention given to the very different state of the commercial property sector in this country. The fact is that there is a substantial tail of commercial property in this country which is not in good state as an asset class. Not enough attention is given to this issue.

Q84 Chair: Before moving on, I think it just might be helpful to get a view from the independents. If there is anything you would like to add on this question from what you have just heard from Mr Bailey?

Dr Kohn: No, I think a bank that has barely enough capital or is very close, is not going to be an aggressive lender, and is at risk for higher funding costs. The more capital it has, even though it may be a little more expensive to raise that capital, the more it will be a much more vigorous lender in the market, and relieve some of those supply issues.

Q85 Chair: So the shareholders will get a bit less than they would otherwise get while that is raised or do we need bonuses to be clipped a bit?

Dr Kohn: But the UK economy would be better off.

Chair: Yes. But you agree with the points I have just made?

Andrew Bailey: Yes.

Paul Tucker: Yes.

Martin Taylor: I agree with Paul that the best thing the Bank of England can do is to remove impediments to credit supply. We cannot do much about credit demand. New lending to solvent businesses in the early stages of a recovery, which is where we may be at the moment, is some of the best business a bank can do. If there is that demand out there now, one would expect to find them falling over themselves about it. All of this politicisation on credit demand, it all goes back to the capital issues and the leverage issues. I think that is what is happening here: the reason we are hearing the banks squawking so loudly at the moment is that the PRA under Andrew Bailey is being effective. The Wall Street Journal was completely wrong in its article in May, it got the story absolutely back to front, as is becoming evident with what you are seeing playing out in the press now. The PRA is doing its job; about time too you might say.

Q86 Mr Love: Sorry to go back to our favourite topic of conversation, but it is to really illustrate it through the Help to Buy scheme. I am trying to get a view of what is the legitimate part of an independent regulator’s responsibility. Can you raise any concerns you may have about the financial stability impact of any scheme? Can you recommend ending the scheme before the three-year time limit if a bubble emerges that you have to take action on? How do you see your role vis à vis the Government of the day?

Paul Tucker: Yes we could.

Mr Love: You can do both?

Paul Tucker: The Act gives us the right to make recommendations to the Treasury; indeed we can make recommendations to absolutely anybody, and I don’t doubt that we would be prepared to do that in the interests of stability. I did not wish to mislead you on that earlier. But equally we have no role in whether this is a good use of taxpayers’ money or any of the allocative decisions: we must just do the job you have given to us.

Mr Love: I understand.

Q87 John Thurso: I had it in mind to ask about stress tests.

Paul Tucker: Please do.

John Thurso: How important is stress testing to what you are doing? And then you can give the answer you would have given Brooks.

Paul Tucker: In many respects, over the medium term this may be the most important thing we are doing to date. In the many hearings in front of this Committee, the MPC and its mandate, the inflation forecast is the centrepiece and you press it and probe it and sometimes it has been materially wrong, but it provides a quantified framework for assessing how we are using our powers.

In broad analogy, for the FPC we are charged with keeping the financial system resilient without damaging growth and prosperity. We need to find a way of explaining to you and the public what it is that we are doing, and stress testing has the potential to be a very important part of that. All of us have been hugely impressed by what the Federal Reserve has managed to achieve over recent years, really building on what they did in the spring of 2009. To elaborate just for a second and then Andrew, I'm sure, should say something, this would be not only for the FPC but for the PRA board as well, and it needs to be prepared carefully, which is why we articulated some high-level principles for designing a stress testing framework in this financial stability report; it is why we are planning that there should be a discussion paper in the autumn of this year; and it is why we do not imagine that there is just one simple scenario that you can apply each year and it will reveal the riddle of the universe in some way. It has to be a combination of a single scenario for the market as a whole, with a degree of severity chosen by the FPC and then the PRA board tweaking that or applying in parallel particular stresses for individual institutions.

If I can go back to Mr Newmark’s question, we are not going to rely on just the risk asset ratio or on the leverage ratio or on stress testing. Ultimately, it is impossible to write down some all-knowing rulebook for the financial strength of banks; you have to probe them and prod them and make an assessment. This has the potential for us in delivering our mandate and for you in seeing what is going on, holding us to account, to be really very important.

Q88 John Thurso: Your comment at the beginning that in the same way that with the MPC we are looking at the inflation number, this is the central thing-it has that degree of importance. Have you given thought to how that might be expressed in a report, with the kind of visual clarity that one has in the MPC report where there is a fan chart? Going right back to the very first hearings we held before FPC was created and some of the very first witnesses to come before us, what came out was that a simple set of dials, easily read, easily understood, that told you where the thing was going was of the utmost importance. Are you saying that this really is probably the central dial?

Paul Tucker: I hope it will be. The straight answer to your question is that we are beginning to. What is in my mind is that one would identify and apply a scenario each year. You and the community would be able to judge for yourselves how severe that scenario was and, in my mind, we would reveal how well the system did when confronted with that scenario. You would then be able to say, "We want the financial system to be able to withstand something much more severe than this" or alternatively, "This is a ridiculously severe stress test".

Q89 John Thurso: You are doing an annual exercise, so the market knows it is coming, it is no sign of strength or weakness.

Paul Tucker: Yes, simultaneously across all the firms, certainly all the meaningful firms, and-there is no decision on this-but my personal view is that we would publish the results in some form.

Q90 John Thurso: Presumably you would publish the community result rather than an individual firm’s result?

Paul Tucker: I think that remains to be debated. If you look at the United States, they have published individual results as well. This leads on to something that is tremendously important. In embarking on this, we need to be absolutely clear what happens to an individual firm if it is revealed to be feeble in the face of this stress test. This brings us back inevitably to the debates about resolution.

John Thurso: Because there is a tension?

Paul Tucker: There is.

John Thurso: Perhaps this is the moment to pass over to Andrew, because there is the tension between your individual regulation and your committee’s overall view.

Paul Tucker: We would see it as a complementarity.

Andrew Bailey: The key point that Paul has just made is that before you go into it you have to be very clear what you do when you have a firm that falls short. I am afraid the salutary lesson on this is the European banking authority. There I would say that two things have happened as a consequence of not being able to answer the question, "What do you do?", when firms fail in that land. One is either firms fail and nothing happens or secondly nobody fails because you design the test to ensure that nobody fails, or the test is put into practice so that nobody fails, but of course the test is worse than meaningless at that point; it is actually positively misleading.

John Thurso: And you would see that it was meaningless.

Andrew Bailey: Both of those things have happened.

Q91 John Thurso: Can I spread this to the two independent members? Perhaps we could start with you, Martin. How important do you see this as and what should be done to make it into the dial we have been talking about?

Martin Taylor: I think the devil will be in the detail really. I am not yet familiar with the design of the stress test in a particular sense, but I think it is potentially an enormously important tool for the Committee. We need somehow to get transparency and predictability into the whole stress testing part of our machinery so that the market knows what is coming, the institutions know what is coming and, in a sense, people begin to rectify their own failings without having to be told, because they know that if they don’t the stress test will reveal them. That would seem to me to be a very good place for us to get to, call it zen supervision.

Q92 John Thurso: To what extent is systemic stress the sum total of individual institution stress, and to what extent is there a difference between individuals? Can there be systemic stress when all of the individual institutions pass a stress test and how do we deal with that?

Martin Taylor: I am not the person to answer this. This is all the networking stuff.

John Thurso: Should I give you a breather and ask Donald Kohn?

Martin Taylor: Sorry, Don.

Dr Kohn: Yes, you could have a situation in which individual institutions looked at individually look like they are robust to a particular set of stresses on the system, but because there are interdependencies and interactions among them, the system itself may not be robust. As we have laid out in the box in the financial stability report, one of the goals-which I think is probably a little bit of a more distant goal, but is certainly there, one of the design principles-is to set this up so that you can look at the systemic implications as well as the bank by bank implications. So you are absolutely right in that regard.

I am a very strong supporter of proceeding down this path, and to pick up on Martin’s last point, if the banks know that transparency is important, if banks know it is coming, then they will take actions to prevent some adverse publicity ahead of time. They will prepare themselves for this. It is a very important discipline on the system-the capital is there to protect against unanticipated losses. This is a way of testing whether the capital would be adequate to protect against severe unanticipated losses.

It was not the centre of the distribution, it was not the expected path of property prices and losses that hit the system five years ago, it was the tail, it was the "what if one of these things happens that you are not expecting" and then "what are the ramifications and the dominos that fall that you haven’t anticipated" that really brought the system down. So the system must be robust to these very severe stresses as well as positioned to be lending in good times.

Q93 John Thurso: It seems to me that one of the problems that we all face in this-and I use "we" rather than "you" because I think this is a bit of a joint venture-is that you could go to the extreme, the "what is the risk of an asteroid hitting the earth?" type of risk assessment, which everybody will fail always and therefore it becomes irrelevant. Equally the danger in the opposite direction is to come up with the classic corporate risk assessment before things get serious, where everything is a risk but has a low probability so you then cannot worry about anything and everybody passes. How do we get to the point where we have a stress test that you can apply going forward, given none of us knows what the future is, that actually has a realistic possibility of being a test that people pay attention to but does not frighten the lives out of the horses.

Dr Kohn: One way is to look at history and to look at severe events in the past and use them as a metric for what you test the system against and maybe plus a little. But you are right, you cannot be so divorced from reality and make a system that is going to be completely stable to any possible outcome, including asteroids or whatever. That would be the system that probably would not be a very vigorous lender; it would not be an innovator. You can look at history and come up with extreme events and see how they line up, and then test the system against them.

Paul Tucker: I think you will play a very important role in this as well. Once the scenario is chosen, it gets applied and drilled down through the system-that is done by the technocrats. An important role for this Committee, drawing on outside commentary, will be to say, "This is an absolutely ridiculously severe scenario" or alternatively, "This is ridiculously gentle". We will have to be on our mettle in being prepared to defend why we chose the scenario we did according to the circumstances. Where it is different from monetary policy is this comes closer to choosing the target. There is not an equivalent of 2% on the CPI measure of inflation. The great debate is how resilient you want the system to be.

Stress testing is a way of doing two things: having a debate with you and the broader public about just what degree of stress do you think the system should be able to absorb, and then separately and in parallel finding out what degrees of stress the system can actually absorb. I think that will be a much more fruitful debate than what is it that we have in our heads that you do not know.

Andrew Bailey: We have to remember that we are looking at the tail of the distribution here-it is not the central case-because otherwise you get into the failure of imagination problem which is your corporate stress test. I well remember in late 2008 when the FSA started stress tests, and they used what they used to call an early 1980s U-shaped recession scenario, and it had a 40% fall in the UK house prices. A chief risk officer of a major bank came to me and said, "But you do not expect UK house prices to fall by 40%". I thought, "That is not the point". This is not the point of a stress test; it is a probability distribution. That is Don’s point.

John Thurso: You have given us the questions we need to ask you going forward. I think I will probably leave it at that.

Q94 Jesse Norman: Martin Taylor, if you were the chairman of a bank running a sale process with two bidders, and one of the bidders comes to you and gives you a document that looks like a rather authoritative and extremely damaging analysis of the prospects on the other side, would you take that seriously, and what would your actions be?

Martin Taylor: I would talk to my financial advisors, I think.

Q95 Jesse Norman: Would you share it with the board?

Martin Taylor: It would depend what stage the thing had reached, wouldn’t it? I cannot imagine what you have in mind.

Q96 Jesse Norman: No, I am sure you cannot, but it would not slip your mind that you had received this rather important document?

Martin Taylor: Probably not.

Q97 Jesse Norman: Thank you for that.

Mr Bailey, moving on to a potentially related issued, did the PRA advise the Co-operative Bank to discontinue its bid for the Verde branches because of the capital shortfall that you discovered?

Andrew Bailey: We never approved the Co-op bid for the Verde branches. We never approved the bid, let me be clear on that.

Q98 Jesse Norman: You never approved the bid?

Andrew Bailey: No. Can I just give you a little bit of history, and that might help? Going back to the outset of that whole process, which was about two years ago, when it was first an idea, I said to the board of the Co-op Bank that in my view-and I have to say it was a view without having done the stress test that was subsequently done-they needed to raise capital.

Q99 Jesse Norman: This is two years ago?

Andrew Bailey: Yes.

Q100 Jesse Norman: You said to the Co-op, pre-stress test, they needed to raise capital?

Andrew Bailey: Yes. Towards the end of 2011 we then made it clear to them that-and I will use these words carefully-it was not clear to us that the Co-op Banking Group had the ability to transform itself successfully and sustainably into an organisation on the scale that would result from acquiring the Verde assets. Then we set out five things, the five areas that they would have to deal with: capital, liquidity-risk management, integration, governance and management. That is obviously a pretty full set, as you might say.

Q101 Jesse Norman: Roughly everything.

Andrew Bailey: Roughly everything. I made it clear to them at that point-the tail end of 2011-that they had to make that clear to Lloyds.

Q102 Jesse Norman: This was 2011. This is a year before the bid gets put?

Andrew Bailey: Yes. Obviously I do not have a gateway to go to another bank and says, "Let me tell you something about another bank", but what I did do was to say to Co-op, "It is your duty to inform Lloyds of this".

Q103 Jesse Norman: You would regard your instructions as being pretty authoritative?

Andrew Bailey: Yes, and they did. I believe they did. I have no reason to doubt that they did. I have evidence to suggest that they did, by the way, so I do not doubt that.

Let me just move on to 2012 very briefly. Verde would have brought to Co-op three things: capital, because Lloyds was putting capital in; management; and IT systems, all three of which would have been of benefit to Co-op. We then in 2012 did the stress testing and did the capital analysis, based on what we then knew about Verde.

Q104 Jesse Norman: Just to be clear, you regarded the management that would have come with the branches as superior to the Co-op’s management and therefore as being net improvement?

Andrew Bailey: Yes.

Q105 Jesse Norman: You thought the same about the capital and you thought that the IT issues that inevitably involved them reintegrating would nevertheless be net beneficial to the Co-op Bank?

Andrew Bailey: Yes, because Lloyds were providing the Verde entity with an IT infrastructure. The evidence for that, by the way, is that Lloyds are now moving to an IPO, which will of course therefore be able to use that IT infrastructure and that management, so you can see that. That was always the view and I always said that there had to be a plan B.

In 2012 the capital exercise and the stress testing were done. That revealed-and in a sense went somewhat beyond the thrust of the point that I made back in 2011 that I mentioned earlier to you-that they needed capital, although it backed it up. At that point they needed more capital. Now of course they were getting capital from Lloyds under Verde and they had already signalled to us that they were going to sell the insurance businesses, which they are doing. Our assessment again was not-this was again a point that was made to the management of Co-op-that they needed to raise capital. I said to them they needed to bring capital in.

Q106 Jesse Norman: When you looked at the original capital shortfall that you were concerned about, what kind of valuation did you place on the Britannia assets that they had?

Andrew Bailey: The main issue was around the Britannia assets.

Q107 Jesse Norman: Could that have been addressed by the increasing capital that would have come with a successful Verde entity?

Andrew Bailey: Not entirely. It would be quite wrong to go and away and conclude that if only Verde had happened, everything would have been fine. Verde would have brought some capital in, but in our judgment not enough.

Q108 Jesse Norman: So the underlying capital problem would have remained? You identified this in hard terms as part of the stress testing. When exactly was that?

Andrew Bailey: The second half of 2012.

Q109 Jesse Norman: By the time the Verde transaction is well underway, it is perfectly clear that the PRA and behind it the-

Andrew Bailey: It was the FSA at that point.

Q110 Jesse Norman: The FSA but in due course the PRA, the person who is running the PRA, has a specific and now validated concern.

Andrew Bailey: Yes.

Q111 Jesse Norman: So when Lloyds received, as it did, on 27 January 2012, these concerns expressed by NBNK and their financial advisors, many if not all of which have turned out to be true, those concerns almost precisely track the concerns that you had already expressed officially to them through the FSA?

Andrew Bailey: I think that is correct, but I have not seen the detail of what Lloyds received. Let me also say I should be very clear that while we undertook no detailed work on the NBNK proposal-I did meet NBNK a number of times because they were obviously a potential bidder-we did make clear to Lloyds that were they to go ahead with NBNK there would have to be a similar process to identify the strengths and weaknesses of the NBNK proposition.

Q112 Jesse Norman: But it was regarded within the FSA, and more widely perhaps within the bank, that the Verde transaction, if consummated, would be a net improvement and part of the reconstitution process for the Co-op Bank?

Andrew Bailey: Yes. I think that is a fair point. That is a fair assessment of our position. My own position was, subject to this very big issue around capital, that Verde brought things to Co-op that would be of benefit, yes.

Q113 Jesse Norman: Did you at any point in 2012 or thereafter suggest that the Co-op should not proceed with the Verde transaction?

Andrew Bailey: We said all along that Co-op were not in a position at that time to proceed. The reason I wanted that to be made very clear to Lloyds was that I did not want a situation where the thing failed to happen and Lloyds turned around and said, "If only you had told us". So although it was slightly unusual in our practice to do this, I was very insistent that Lloyds were told, for that very reason, that there was reasonable probability that this was not going to happen.

Q114 Jesse Norman: There was, in fact, no genuine doubt as to where you stood on either side of Lloyds or the Co-op as regards this transaction?

Andrew Bailey: I do not think so, but you should ask the various parties involved in this thing.

Q115 Jesse Norman: Believe me, we will.

Andrew Bailey: You will; I hope so.

Q116 Jesse Norman: That is extremely helpful.

Did you have any conversations with Lloyds after the transaction was pulled, about the reasons why it had behaved as it had done?

Andrew Bailey: Sorry, the reasons why it had-

Q117 Jesse Norman: Why it had behaved as it had done; why it had continued to favour the Co-op, despite these extremely damaging potential revelations and the advice from supervisors, as far as it did.

Andrew Bailey: We were aware, and I think this came out in the evidence that you took from Lloyds two or three weeks ago, that they were also sceptical about NBNK. We were aware of that. We were not, as I say, in any sense as closely involved in that, but we were aware of that. The other thing I would say, just reinforcing a point I made a few minutes ago, was that the other thing that I had said to Lloyds really throughout the process was, "Given the bids you have-"

Q118 Jesse Norman: You were tracking it quite closely, I take it.

Andrew Bailey: Oh, yes.

"Given the bids you have, you have to have plan B in place", plan B not being NBNK but plan B being an IPO, which is what they have designed. The point that António Horta-Osório made to me several times was that they were very aware of this point and agreed on it, and that in a sense they were doing the work to create the Verde entity with optionality in it, if you like. So it could go one way, which would be to an acquirer, or it could go another way, which would be to the IPO.

Q119 Jesse Norman: That is interesting.

Mr Tucker, why has the Co-operative Group not been asked to make good the losses as the equity shareholder in the Co-operative Bank?

Paul Tucker: I think that is more a question for Andrew as the micro-supervisor.

Andrew Bailey: We have identified the capital shortfall and we have put it to the Co-op that they have to solve this problem, because there is no evidence to suggest that they do not have the resources at their disposal, and I would define that broadly, to do so. They have come up with the approach. The Co-op Group is putting resources into this.

Q120 Jesse Norman: But it is not absorbing all of this-

Andrew Bailey: No, it is not.

Q121 Jesse Norman: The effect of it is that bondholders will, many of them, be wiped out.

Andrew Bailey: It is a conversion, actually, into equity. Again, you need to ask them this question, really, but it is a combination of resources from the Co-op Group and bondholder conversion, which creates core Tier 1. The key point for us is that they are short on core Tier 1. They have other tranches of capital, instruments, which sit below that, so they have lower Tier 1 capital and they have subordinated debt.

Paul Tucker: What I would add, from a resolution perspective is, where a non-financial group owns a bank and the bank fails, the resolution toolkit will include being able to wipe out the equity and then write down the debt of the bank and convert part of the debt of the bank into equity so that the debt holders become the new owners.

Q122 Jesse Norman: In other words, the situation is that the PRA could, if it wished, require the Co-op Group to make good-if it did not accept the reconstruction plan that has been offered, it could require it to come in for the full value of the equity option.

Paul Tucker: No. I am speaking abstractly or in general, not about this particular situation. If the owners will not or cannot make a bank whole, then the resolution toolkit essentially involves putting the losses in order of the creditor hierarchy-equity, sub-debt, senior unsecured bonded debt-and they become the new owners.

Q123 Jesse Norman: Do you think it is unethical for an institution to walk away from its ownership position?

Andrew Bailey: They are not walking away from it; they are diluting their ownership position quite substantially.

Q124 Chair: But I do not think the bondholders take a bigger hit and it is consonant with the credit hierarchy point that Paul Tucker-

Paul Tucker: But the traditional view of the Bank is that owning a bank is a serious thing to do, and as an owner of a bank you should expect to stand behind the bank. Where that is not possible, then resolution beckons as the solution. If you can mimic that through an exchange offer, then that is a better solution still.

Q125 Chair: But do the bondholders not have a right to be a bit aggrieved, bearing in mind that the owners have not taken the first hit that they might otherwise reasonably have expected to do?

Andrew Bailey: I think this is a discussion you must have with the management of Co-op.

Q126 Chair: Yes, but I am asking your view.

Andrew Bailey: What they have done is, frankly, something that you do see in the non-financial corporate world, which is they have proposed a restructuring. It involves the owner putting in money and the bondholders being converted, and I really do think you have to talk to them about the structure of it.

Q127 Jesse Norman: But one might expect the Co-op, of all institutions, not to obey the Wall Street rule and just walk away from an investment. You would expect them to bear the full responsibility of their ownership.

Andrew Bailey: They obviously have choices to make, and I do think you have to discuss those choices with the management of the Co-op.

Q128 Chair: I just have one final question I would like to ask you, Mr Bailey, which may seem a procedural point, but I think it is important that this Committee at the start keep an eye on these things. In one of your boxes, box 5, it is noted that the FPC record from the November 2012 meeting was not provided to the public at the time, but it has now been made public. I would like to know how you went about taking the decision first to withhold it and then to make it public, and whether you have a list of grounds on the basis of which you make these judgments.

Paul Tucker: Shall I take that? The decision was taken by the FPC back in November last year not to publish it. Whether to un-redact, if you like, was reviewed at subsequent meetings. At the latest meeting, the view was reached that it was safe to do so. The reasons, I believe, were set out in the record of our meeting published yesterday morning.

Q129 Chair: I have it in front of me, but I just wanted to establish what the ground rules for these redactions are. It is not that I am challenging the decisions taken, but I think we should know what they are, for transparency.

Paul Tucker: Perhaps something else to say is that we chose to adopt the processes that apply to the statutory FPC, even though this was a record of the pre-statutory FPC. The test is one of whether it is in the public interest. Our conclusion back in November was that had we published this, it would have been misleading. What we were doing in November was having a sighting shot as to what the aggregate scale of the adjustment to the capital of the UK banking system might be in order to make a judgment as to whether or not to ask the micro-supervisors to drill down further.

The steps were: in November, set a framework, have a sighting shot of what the numbers might be, not say, "Here are the numbers" but instead say, "We have enough to say to the micro-supervisors, ‘Drill down further’". In March they came back to us with the numbers, but we did not then have clear policies of what would be done.

Q130 Chair: You were applying a broad public-interest test to this.

Paul Tucker: Yes, on safety.

Q131 Chair: You were not applying the test of whether there was a risk to systemic stability?

Paul Tucker: Including that, but more broadly not misleading people.

Q132 Chair: Not limited to that but more broadly. This public-interest test is quite broad, is it not?

Paul Tucker: Yes, and so we need to give reasons when we do this, and that is what we will do. That is why we put it into a box, because we did not want to un-redact this in some quiet way that no one noticed. We greatly welcome the question. We want you to be able to see when we have excluded something and when we have then released it.

Q133 Chair: I just want to be clear what the criteria are, and we may come back further to working out what you mean by public interest. Maybe we do not need to prolong it now, but I think it is something that does need to be gone into.

Andy Haldane, in a separate episode in recent evidence, said that, "Lowering regulatory requirements to support the wider economy was discussed in the FPC meeting but not recorded in the formal minutes". He said, and I am quoting again, that he believed that this was a "mistake". Are you aware of any other instances of the record not fully reflecting the discussion?

Paul Tucker: Absolutely not.

Q134 Chair: And you agree with Andy Haldane that in this case it was a mistake?

Paul Tucker: I do not think I do, really, actually.

Dr Donald Kohn: I do not recall the particular incident that he is referring to. We made quite a bit of effort to make sure the record reflects all the views that were expressed at the meeting.

Chair: We are keeping an eye on these things in this Committee, as you have probably noticed from those questions, and will continue to do so.

It has been quite a long session, this morning; over two hours. I am very grateful to all four of you for coming along. It has been extremely interesting; lots of information for the public record. Thank you very much indeed.

Prepared 16th August 2013