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To be published as HC 689




Treasury Committee

Appointment of Sir Jon Cunliffe as Deputy Governor of the Bank of England

Monday 14 October 2013

Sir Jon Cunliffe

Evidence heard in Public Questions 1 - 71



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Oral Evidence

Taken before the Treasury Committee

on Monday 14 October 2013

Members present:

Mr Andrew Tyrie (Chair)

Mark Garnier

Andrea Leadsom

Mr Andrew Love

Mr Pat McFadden

Mr Brooks Newmark

Jesse Norman

Mr David Ruffley

John Thurso


Examination of Witness

Witness: Sir Jon Cunliffe, UK’s Permanent Representative to the EU, gave evidence.

Q1 Chair: Thank you very much for coming in this afternoon. Can I begin by asking you whether a banking union can be said to be a banking union without deposit insurance?

Sir Jon Cunliffe: I think my answer will distinguish between theory and practice. In theory, a banking union for a monetary union should involve the sharing of risk. It should involve the sharing of risk on banks, but also it should involve some way of ensuring that the monetary union, if it needed to, could stop bank runs across the monetary union, and clearly deposit insurance is the most powerful weapon we have for stopping concerns about bank runs. You could envisage circumstances where a monetary union would need some form of mutualisation, some form of sharing of risk between the countries to do that.

The reason I distinguish between theory and practice is that I think banking union in the euro area at the moment is recognised as a step-by-step process. I do not think the countries of the euro area have yet reached an agreement about how far they want to go in terms of mutualising risk between themselves and how far they are able to go at the moment. I would say what is called banking union at the moment in the European Union is the first steps towards that: a common supervisor for the largest banks: a resolution mechanism, which is being negotiated at the moment, that may or may not involve some form of risk sharing; and then common rules around capital and resolution, which would apply to the whole European Union-but these are first steps.

Q2 Chair: I want to try to avoid the semantics about the difference between deposit insurance and risk sharing. You are not suggesting, are you, that the risk sharing might involve something that excludes deposit insurance and yet still be called a banking union?

Sir Jon Cunliffe: No, to have a full banking union that would cover the euro area against all eventualities, you would in the final step need to have joint deposit insurance.

Q3 Chair: High-powered answer though you have given me, Sir Jon, the equally high-powered very short answer would have been no, you cannot have a banking union without deposit insurance.

Sir Jon Cunliffe: I think you can take steps towards a banking union, which is what the euro countries are doing.

Q4 Chair: Yes, in the same way that a chicken can take steps to hatch itself from an egg, but you do not have a chicken until it has got out of the egg, do you?

Sir Jon Cunliffe: I would say the steps that are being taken will protect the euro area against a certain level of risk, but they will not protect the euro area against all risks. I do not think it is quite binary, either in the egg or outside; I think there are steps between those two states.

Q5 Chair: Do you think that it is a healthy state of affairs for us not to know whether we have an egg or a chicken?

Sir Jon Cunliffe: I think from a UK point of view it is-

Chair: For the eurozone to be in a position where, I think you will agree, we are at the egg stage, and the question is- You seem to be attempting to blur the distinction between this moment that we cease to have an egg and start to have a chicken.

Sir Jon Cunliffe: If I can give a practical example, first of all, I think it matters a lot to the UK that the banking union is as complete and effective as possible. Secondly, if I give an example, the European Central Bank will carry out the asset quality review, the stress tests of the large eurozone banks, before it brings them into the single supervisor. That immediately raises the question, if some of those banks are found to have insufficient capital, what will the backstop be? Obviously, in the first instance they will try to raise capital in the market, but if they cannot raise capital in the market and their sovereign cannot provide them with the capital, should they have access to mutual funds? I think if a backstop can be found for that exercise, that is beneficial to the UK because it means the stress test will be an accurate one but it will not be a full banking union. We will not be there yet.

Q6 Chair: Okay. We will have to look at the transcript to see whether this binary moment actually made an appearance. Can I take you to something that you said in your evidence? You talked about reform fatigue, vested interests and the erosion of political support. Can you describe what vested interests you had in mind?

Sir Jon Cunliffe: Yes. I was talking about the international reform effort.

Chair: Yes, by all means give the context, I am sorry.

Sir Jon Cunliffe: I think the financial sector has been a very powerful actor in a number of countries. The PCBS report talked about governments being dazzled by the tax income and wealth that the financial sector could create. We are now going through a period where we are trying to institute a programme of international regulatory reform that is consistent, or as consistent as we can make it, across countries. Also, different countries have different structures to their banking systems, so it is clear that in different countries that financial reform programme is, shall we say, less attractive to some players in industry. I am pretty sure they will do what they can to ensure that their local conditions, if you like, are protected and that rules that are inconvenient for them are not applied. I have seen it happen with earlier attempts to have consistency in the international regulatory system and I expect that sort of pressure to happen again.

Q7 Chair: Did you agree with the Banking Commission that the politicians have been dazzled by pressure from banks?

Sir Jon Cunliffe: Well, I think we were all impressed by the apparent wealth creation and performance of the financial sector at that time, to be quite honest. It was contributing a large amount to tax revenues in different countries and it was taken very seriously as an economic sector.

Q8 Chair: So the answer is yes, you did agree?

Sir Jon Cunliffe: Yes. Maybe the best way to put it is I think the sector had a loud voice.

Q9 Chair: Too loud?

Sir Jon Cunliffe: With hindsight, clearly.

Q10 Chair: Do you think the checks are in place to deal with this?

Sir Jon Cunliffe: First of all, I think history is a very powerful check.

Q11 Chair: That tends to wear off, doesn’t it?

Sir Jon Cunliffe: It does tend to wear off, but at the moment the memory of the crisis and the things that went wrong are very, very strongly in people’s minds. I do not think history by itself will deal with it as we go forward. I think institutional arrangements are extremely important, which is why I welcomed the creation of the FPC and why, indeed, I applied for the job as Deputy Governor for Financial Stability. I think legal arrangements are very important, but I also think we need to have an international framework that prevents that happening in the future.

Q12 Chair: You talked about institutional arrangements. The Banking Commission proposed that one of those institutional arrangements should be a statutory duty on the Governor of the Bank of England to notify Parliament if, in his view, lobbying had arrived at an unacceptable level. Do you support that proposal?

Sir Jon Cunliffe: I would have to think, first of all, whether it was necessary. The Governor of the Bank of England has a statutory duty to protect and enhance financial stability in the UK. He is independent. He is publicly accountable and he should be well capable of either withstanding lobbying or saying what he thinks about it.

Q13 Chair: Yes, but it is lobbying of Government, not just lobbying of the Bank, that may be going on and which may be imperilling the work of the PRA and the Bank.

Sir Jon Cunliffe: Government is often lobbied. The question is what does Government do after it has been lobbied? If Government, after it has been lobbied, attempts to put pressure on the Governor of the Bank of England, the reason one picks the sort of person one picks to be Governor of the Bank of England is that they have the independence and the ability to say, "This is not consistent with my statutory duty."

Q14 Chair: That is what we are recommending. We are recommending that he should have a specific statutory duty to report lobbying of that type. You are supporting that?

Sir Jon Cunliffe: I would have to think whether that was necessary. The current arrangements create an independent Governor with a statutory duty to protect and enhance financial stability. If he thinks he is being put under pressure, then there are a number of things he could do, as indeed the previous Governor I think did.

Q15 Jesse Norman: Sir Jon, could you tell the Committee what your expectations are for growth in the eurozone in the next few years?

Sir Jon Cunliffe: I would expect growth in the eurozone to recover a little bit. If we are looking over a three-year horizon, I do not expect, taking the eurozone as a whole, it will be strong.

Q16 Jesse Norman: I was rather hoping you could put some percentages on that: 1% to 2% growth, 1% growth?

Sir Jon Cunliffe: Well, going three years out, it is a bit difficult to forecast. I would not be looking to see growth in the eurozone as a whole much beyond the 1% to 2% range for the next two or three years.

Q17 Jesse Norman: Right, and presumably, therefore, close to zero or even potentially negative once Germany is taken out-in the non-German part of the eurozone?

Sir Jon Cunliffe: Well, that depends on the averages. I can actually see you could have lower German growth than growth elsewhere. I would expect the negative growth in the periphery to flatten out.

Q18 Jesse Norman: Senior members of the Bank of England, Deputy Governors and members of the Monetary Policy Committee, have said to this Committee that there is a balance of payments crisis in the eurozone. Do you share that view?

Sir Jon Cunliffe: There is a very big balance of payments problem in the eurozone. I think it was of crisis proportions about a year and a half ago. It has come back a bit from that. I think it is a problem of imbalances and the imbalances that were created in the monetary union before the crisis. Current account deficits have gone down in Spain and Portugal; both imports have been compressed and exports have grown in those countries. But within the eurozone itself, I think there is still an issue about surplus in deficit countries in balance of payments terms that needs to be addressed.

Q19 Jesse Norman: Enormous pressure have been placed on the Bundesbank via the EFSF to support the banking systems of the southern tier, has it not?

Sir Jon Cunliffe: Well, the ECB is supporting the banking systems of the southern tier with liquidity and with Mario Draghi’s "do what it takes" statement.

Q20 Jesse Norman: You do not think that there is an implicit subsidy from the banks of the major creditor countries, in particular the Bundesbank?

Sir Jon Cunliffe: This has been pointed out in Germany: there is clearly a mechanism operating, partly through the target payment system, in which credit is extended to the banks in the countries that are weak and that goes across the books of the ECB. The ECB belongs to all of the sovereigns, so if the ECB were to break up, there is a risk there for the creditor countries, Germany, Netherlands, and on the other side. At the moment, the ECB is doing what the private sector banking system will not do, which is direct funds from the countries of the north, if I can put it that way, to countries of the south, so it is happening through the central bank.

Q21 Jesse Norman: Right, but there is a huge lack of resilience, is there not? If there were any kind of external shock it could cause a break-up of some kind?

Sir Jon Cunliffe: The ECB still has a lot of ammunition, if I can put it that way, left if it faced a shock. So far they have not had to start the OMT operations that Draghi talked about. The question is really whether within the eurozone there is a consensus for the central bank to be taking that sort of action.

Q22 Jesse Norman: Or, indeed, the Germans to support it. How can there be a banking union if the Germans are going to continue to be opposed to measures to socialise risk?

Sir Jon Cunliffe: As I said to the Chairman, there can be steps towards a banking union and those steps can be valuable. I do not want to get back into the chicken and the egg, but whether it is a perfect banking union or not, I think we should take the steps we can to insure risk. The debate that is going on in the EU at the moment around the single resolution mechanism, the SRM, is precisely around this question about what extent Germany and other countries might have to contribute to refinancing the banks of other euro countries.

I would say one thing there, having been involved in this for 20-odd years. The extent to which the countries in the euro are exposed to each other already compared to what was envisaged when the euro was launched is pretty material. We now have an ESM, which has loaned money from a central pot to euro governments to do that and I think would be prepared under the current arrangements-if banks in, say, one country had insufficient capital-to lend money to the sovereign of that country to recapitalise the banks, which is exactly what has happened in the Spanish case. Now, that is not complete mutualisation because it is still lending from a mutual pot to a sovereign and it is not taking risk in the same way as if the ESM were directly to recapitalise those banks. But it is a big move towards mutual support compared to the so-called no bail-out clause and where the euro was when it started.

Q23 Jesse Norman: You will be using your position as Deputy Governor to press the ECB for a really robust asset review-

Sir Jon Cunliffe: Yes.

Jesse Norman: -given the fiasco of the previous one around the stress tests

Sir Jon Cunliffe: Yes. I think the ECB will have an incentive to do a very robust asset review because the ECB will be taking on the supervision of these banks. From its point of view, it will not want to turn round in two years’ time and say, "Well, there was a problem but, of course, it was a problem that happened before we started." The incentive on the ECB is to ensure that those banks that come under its supervisory oversight are as robust as possible. I think there is an incentive there that was not there in the previous EBA reviews.

Q24 Jesse Norman: My final question: you do not think that there is any alternative to the current approach, which is to kick the can down the road straight to the institutions and hope for the best?

Sir Jon Cunliffe: I think there are a number of alternative strategies to deal with the euro crisis. The euro countries have recognised-and to me the seminal point in all of this was in July of 2012 when they did so-that more integration is necessary. The issue now is how far, how fast and in what order, and those things have not been dealt with. The best course for the euro countries is to proceed as quickly as they can down that path. The other options that are available, like break-up, to me have a much higher risk factor.

Q25 Mark Garnier: Sir Jon, can I turn to the UK housing market? A lot of commentators have talked about the fact that we are now entering into a housing bubble. Do you agree?

Sir Jon Cunliffe: I am not sure I would agree that we are entering into a housing bubble. I would agree that house prices have risen pretty quickly this year and also that expectations of future house prices have risen, but it is coming from a relatively low base. Compared to some historic measures, housing activity is still not back to levels we saw before the crisis. House prices to income ratios are probably where they were about 10 years ago. The picture emerging is of prices starting to rise, some sense that people are expecting prices to rise, but we are still coming back from a relatively low base and, of course, it is a very patchy picture, because it is very different, there is quite a dispersion across the country. That does not, to me, look as if there is a bubble.

I have to say I do not have access to the much more detailed information that I hope to have access to in a few weeks’ time, but looking from where I am now it does not look that we are in a bubble. There is a sentence in the FPC record that says that at the moment there is not a bubble or, as it is expressed, prices are not rising, it is simply in the expectation that prices will rise.

Is it something that needs to be watched very carefully? Yes. Does the UK have a history of housing booms? Most certainly. Is it something that would need to be dealt with if it posed a risk to financial stability? Yes, but I think it is too early to say whether we are entering into a bubble.

Q26 Mark Garnier: You raise a point that we have not got back to the levels that we saw pre-crisis, but at the levels shortly before the crisis the housing market was pretty hot. Bearing that in mind, I would assume-I may be wrong-you would not necessarily want us to go back to that kind of level. What would you think constitutes a housing bubble? What indicators would you be looking for to make you feel alarmed and that a housing bubble was now inflating?

Sir Jon Cunliffe: First you would want to look for evidence that it was expectations about prices that were driving prices, rather than supply and demand, rather than more people coming back into the market.

Q27 Mark Garnier: How would you define that, just out of interest?

Sir Jon Cunliffe: You look at the balance of supply and demand and what that will tell you. You look at where you are in relation to historic indicators. You also look at the speed of growth in prices because in bubbles prices tend, as I recall, to go up exponentially in that sense. You also have to look at a number of indicators of housing activity.

The other question that I would want to look at is how generalised this is. There are some parts of the country where house prices are still significantly below where they were, others where they have caught up, and London where it has gone ahead. When I was in the Treasury, we looked a lot at the housing market and also to see whether housing market activity that was very hot in one part of the country tended to drive the country as a whole or whether it stayed contained, particularly London and the south-east. In the end, the issue comes down to a structural imbalance between supply and demand, which we have not managed to tackle.

Q28 Mark Garnier: If you thought a housing bubble was developing, would you feel confident to say so publicly?

Sir Jon Cunliffe: Yes.

Q29 Mark Garnier: You would, okay, that is great. If you did see a housing bubble rising, would you seek to use the FPC’s macroprudential tools to deflate it?

Sir Jon Cunliffe: The question is: is a housing bubble developing and does it pose a threat to financial stability? For the FPC, it is important to go back to its remit. The FPC has been given some pretty powerful tools. It has been given a statutory objective. It is not elected, so it needs to make sure that it is using the tools in pursuit of the objective. My guess is that the FPC would be held to account for that. But yes, if I thought a housing bubble was there, or not necessarily a housing bubble, if I thought that things in the housing market were causing a risk to build up in the financial sector, then one would want to use the FPC’s tools to address that.

Q30 Mark Garnier: One of the very interesting decisions by the FPC, or in fact the interim FPC, was that it did not want to be given loan-to-value ratios or loan-to-income tools as they lacked "public acceptability". You said in your written statement that such concerns created, "a hurdle for demonstrating that these are a necessary part of the FPC toolkit." Do you want to expand on what you meant by that?

Sir Jon Cunliffe: Well, there is no huge inwardness there. I am very conscious that central bank officials are not elected. I was involved in giving the Bank of England operational independence on monetary policy and that was quite carefully framed about with accountability and other controls. That same technology, if I can put it that way, has now been given to the Bank for macroprudential, which I think is a good thing, but one has to bear in mind that in the end the Bank is not representing an elected authority. The tools the Bank has at the moment-raising capital generally, the countercyclical capital buffer for the financial sector as a whole, for banks as a whole, or sectoral capital requirements-those tools are about making the banking system more resilient to the risk it is taking on in the housing sector. Giving advice about loan standards, underwriting standards, is getting more into what sort of credit they should be taking on. Having the power to say people in the country should not have available to them loan-to-value mortgages of more than 80% strikes me as going further; it is more intrusive and it bears more directly on households and firms. It may be necessary, and there are some countries where central banks or similar authorities have those powers. I am just saying that before one had them, one might want to have quite a stiff test to see whether that was the only way of dealing with the problem and the FPC does have a number of tools that could address a housing risk to the financial system as it stands.

Q31 Mark Garnier: This is quite an important philosophical point, because, of course, the FPC was created in order to take those decisions that politicians would be too timid to take. One thing that politicians can be quite rightly accused of is pandering to the desires of an electorate, certainly once every five years or four years depending on the electoral cycle. Given that, and given the fact that the FPC is absolutely there to take those difficult decisions and absolutely put in place to be above politics and, therefore, if you like, above public acceptability, is what you just said about public acceptability of things like LTV ratios not completely rejecting the whole concept of the FPC?

Sir Jon Cunliffe: I was in danger of saying it is not binary. The FPC has powerful tools that it absolutely needs and must have, particularly around capital in the system, sectoral capital. It has tools of recommendation, which I think will be quite powerful, particularly complier-explained recommendations to the regulators. It may turn out that those are not sufficient and in order to deal with the risk to financial stability and to take the sorts of decisions that you describe it needs more tools. Then it would have to ask Government and Parliament to give it those tools. I am just saying that as those tools start to bear more and more directly on individuals and firms in the economy, one has to maybe set a little bit of a higher test on whether those tools are necessary? Could it be done in other ways?

Q32 Mark Garnier: Just one last question, referring back to your incredibly important point about the regionality of any house price movements. Clearly, in some parts people might think there is a bubble, in other parts there is the opposite-we have seen prices coming down. Do you think there is any role of the FPC to try to intervene on a regional basis or do you think that is just too difficult?

Sir Jon Cunliffe: I think it goes back to the question of whether this movement in house prices is causing a threat to financial stability as a whole. If it is, then the FPC would need to find a way of addressing it.

Q33 Chair: When you were saying a little while ago that house prices have risen compared to a low base, you then said compared to 10 years ago, I think.

Sir Jon Cunliffe: I was talking about the house price to earnings ratio, which I think is now back to about 2003-2004.

Q34 Chair: I see. I thought you were talking about house prices.

Sir Jon Cunliffe: No.

Q35 Chair: Okay. You think that that is a good measure?

Sir Jon Cunliffe: It is very difficult and I recall discussions-

Q36 Chair: Sorry, while you are reflecting on how to answer that question, there are two schools. Basically, there is one that says yes, it is a very good long-term measure, and there is another that says it is a sort of measure but you would expect the ratio to rise slowly and for people to use an increasing proportion of their income as savings in their home.

Sir Jon Cunliffe: I am in the second camp, yes. Mr Chairman, I was getting to the second.

Chair: Okay.

Q37 Mr Love: Can I stay on the housing market and turn to the help-to-buy scheme and, in particular, the mortgage guarantee part of that scheme, which comes in in January? Do you believe that that may pose a risk to financial stability?

Sir Jon Cunliffe: I think one has to separate out direct and indirect effects. To the extent that it allows banks to lend at higher loan-to-value ratios and not take the risk because the Government is insuring them against that risk, I think it does not pose a risk to the banking system. The banks are being able to lend more and the Government is insuring them against that increment of lending.

In terms of whether it leads to households becoming over-exposed because they can now borrow higher amounts, there is a possibility that it could do that and that would create more of a risk, but that is one of the reasons it is necessary to keep a very firm eye on the lending standards that lenders use, the underwriting standards.

The more indirect answer is if it contributed to house prices going up at an unsustainable rate and that contributed to a threat to financial stability, that is something one would have to look at.

Q38 Mr Love: The chief executive officer of Lloyds Bank is the latest to express his severe misgivings about this particular scheme. Why is it there has been so much negative comment even before it has been introduced?

Sir Jon Cunliffe: I only read his comments in the FT this morning.

Mr Love: So did I.

Sir Jon Cunliffe: So that is the only guide I have, I am afraid. I think what he was saying was that in the end the reason why not everybody who wants a house can afford to get a house in the UK is pretty much to do with structural problems that we have in the UK. Maybe this is the answer also to why the house price to earnings ratio drifts up over time: because we do not have the supply that balances the demand. It is for government to decide how to tackle that very thorny issue about balancing the interests of different groups in society. I read his comments to say-I thought he had actually said but this is just on the FT report-that this scheme deals with an aversion of banks and building societies to provide higher loan-to-value ratios but that it will not solve the problem because the underlying problem is a structural one and it could lead to increases in house prices, which need to be watched. All of those things seem to me to be sensible.

Q39 Mr Love: You have touched on two occasions-in the answer you have just given and on a second occasion to Mark Garnier-on the importance of supply and demand. Isn’t the major concern about this help-to-buy policy that it does nothing directly to deal with the supply issues, but only addresses the demand, and it will therefore further skew that supply and demand equation and may well lead to a bubble?

Sir Jon Cunliffe: I guess you could argue if there was more demand partly as a result of the scheme, that will stimulate more supply.

Q40 Mr Love: You mentioned about lending standards and the fact that the Government is guaranteeing, which potentially could lead to sloppy lending, if I can put it that way. Are the guarantees that are written into this scheme sufficient, do you think, to preclude this being a major concern for the Financial Policy Committee?

Sir Jon Cunliffe: I think the Financial Policy Committee needs to keep an eye, through the microprudential regulators, on lending standards and underwriting standards. I think also it is not just a question of exposure of banks, but it is also a question of households becoming over-exposed and whether that could pose a risk to financial stability. Clearly, that is something you have to watch.

What I have heard-and, as I say, I have not seen any of the data on this-from the lenders is that they will try to make sure that people who take these higher loan-to-value ratios are people who have the income to support the loan but do not have the capital to provide the deposit. That is how I understand the scheme works, but I think that is something that has to be very carefully watched.

Q41 Mr Love: The Chancellor, in responding to the concerns that have been raised, indicated that the FPC would have a role in reviewing as of next September, which is, of course, almost a year away. Is that an appropriate timescale? Is your understanding that the FPC can intervene at any time if it believes that prices are getting out of control?

Sir Jon Cunliffe: My understanding of the FPC’s remit is that if the FPC thinks there is a risk to financial stability it can use its tools, wherever that risk comes from. The issue that we were discussing on lending standards is something that I think the FPC has already said it would want to keep a close eye on. As I understand it, what the Chancellor has said is that, on the scheme itself and the rules of the scheme, the FPC can make recommendations every year on whether the cost of the insurance, the charge-the premium if you like-should be changed but also whether the limits-there is a £600,000 ceiling on the scheme at the moment-should be changed. I think what the Chancellor has done is given the FPC the chance to make recommendations about changing the features of the scheme, but the FPC’s overall responsibility for financial stability remains and that is ongoing. I do not think that is annual.

Q42 Mr Love: The other big concern that has been expressed and reflected in the question from Mark Garnier was the very big regional variations in house price inflation at the present time. Whereas much of the country could not be considered to exhibit anything that would approach a bubble, there is major concern in London and I suspect a slightly lesser concern in the south-east. Do you think that the FPC should be able to comment on perhaps adapting the help-to-buy scheme to support those regions in need of such a scheme and perhaps be a little more critical where house price inflation seems to have a will of its own?

Sir Jon Cunliffe: I certainly think the FPC, either acting with its standard monitoring and tools or in recommending to the Chancellor on the rules of the scheme, should be able to say, "We think there is a risk to financial stability from what is happening in the housing market generally," or, if necessary, "from what is happening in the housing market regionally." The key to me is that link to a risk to financial stability.

Your point there was also whether the FPC should say the scheme should concentrate on where it is needed, not where it is not needed, and I do not think that is a recommendation for the Bank of England or the FPC to make on where. This scheme is designed to address a certain social need: the inability of people to buy houses. That is rightly and properly a political decision that resources are used to do that. I do not think we should comment on that.

Q43 Mr Love: It is really the consequences of the policy I was trying to get you to comment on, where clearly the impact may well be very different in different parts of the country. Whereas I do not think there is any real worries about most parts of the country, there seems to be a very genuine worry expressed in all of the comment that there has been about this about the impact perhaps in London particularly.

Sir Jon Cunliffe: And the south-east, I think.

Mr Love: To a lesser extent.

Sir Jon Cunliffe: If that looks as if it is posing a risk to financial stability, the FPC should comment on it and address it.

Q44 Mr Newmark: The Treasury’s own report into the financial crisis management response noted that financial stability was not a significant area of Treasury business. I am quoting here, "After 2003, when the Bank began to reduce its own staffing on financial stability, the Treasury chose not to increase its capability." You were Second Permanent Secretary at the time the Treasury chose not to increase its resources. What discussions were had about that and how were you involved?

Sir Jon Cunliffe: Well, I should say I was Second Permanent Secretary; I was also specifically responsible for financial regulation for two years at the beginning of that decade and then for eight or nine months just before the crisis. I chaired the tripartite, so I was quite involved in all of that. I would say a number of things.

Q45 Mr Newmark: In answering that then, it would be helpful to know what lessons learned from the crisis while at Treasury, because that is my next question.

Sir Jon Cunliffe: Yes, okay. Quite a few, I hope. The first point is we were aware-I am trying to get the years clear-in 2003, 2004, 2005, that we were in those times understaffed on financial stability and financial regulation. That was when James Sassoon was the managing director. We did gear up a little bit, but the report the Treasury did afterwards into the crisis suggested that we had materially underestimated the need for staff. There were some attempts to increase staff over that period, but they were not enough.

Q46 Mr Newmark: Were you yourself championing that? Did you see a need for that?

Sir Jon Cunliffe: I saw the need for more staff because I had run that area, but it would be wrong of me to say I saw the need for the amount of resources that were needed.

Q47 Mr Newmark: Why do you think everybody was cutting back at the time?

Sir Jon Cunliffe: The Treasury has a tendency anyway-and that is in the report that Sharon White did-when it is enforcing discipline on other departments to show that it can take its own medicine. There is always a tendency in the Treasury, with pretty small numbers actually, to cut back. I think generally that is a mistake because it is quite a small department and if you start to cut small numbers you lose expertise.

There is a broader issue here. I think we left a gap, bluntly, called financial stability. We were not conscious of the fact that we left that gap. When we set up the arrangements after the 1998 Act for the Bank of England, I am not sure the Bank at that time had the sort of financial stability mechanisms that it has developed since the crisis. We brought together the bank, which still retained a financial stability objective, though not precisely specified, the FSA, which was essentially microprudential, and the Treasury in the tripartite committee, but it was not a committee in the way that the FPC is a committee with a developed function, resources and tools. It was a group of three players in that space.

Q48 Chair: It scarcely met?

Sir Jon Cunliffe: The official committee met every month. The principals’ committee did not meet very often. I have to say I do not think we saw the resources necessary to monitor/identify risk. We did not see the tools necessary.

Q49 Mr Newmark: It looked like everything obviously fell between various stools because nobody either put up the resource or was taking direct responsibility for what happened. Going back to my question then, what lessons are learned and is the system we have now in place robust enough to deal with any crisis that may suddenly come?

Sir Jon Cunliffe: The lessons I take from it are the following: firstly, you need to specify responsibilities very clearly and you need to ensure that in specifying responsibilities you avoid underlaps. I think in 1998 we did that for monetary policy very successfully, but we did not do it for financial stability successfully enough. Secondly, you have to ensure the organisational arrangements allow for information to move across the boundary. When you have three separate bodies, that is much more difficult than where you have everything under one roof. On those two issues, specification of responsibility and transmission of information, the new arrangements are much, much stronger. Thirdly, you have to put the resources in, which I think is the initial point. I will take a view when I am in the Bank. It is difficult to look from the outside. The resources on financial stability clearly have gone up enormously both in capability and capacity, but I would like to take a view once I have been inside rather than from the outside.

The other lesson I take from it, which underlies this whole period, is the past is not always a very good guide to the future, but you have a tendency as a policymaker to base your expectations of the future on the past. We had not had a systemic crisis for a considerable time.

Q50 Mr Newmark: But there seemed to be a psychology, at least from the Chancellor at the time, that he had defeated economic cycles-that there were going to be no more great economic cycles. It was as though there was some sort of Stockholm syndrome, it would seem, within the Treasury in which you all bought into this idea that Gordon Brown had tamed the economic cycle forever and that we would never see a crisis ever again, which is why I think people did not spot the crisis coming.

Sir Jon Cunliffe: I would broaden it just a bit. This failure to predict the financial crisis coming was something you saw across the world from very different sorts of regulators and very different sorts of systems. I can only think of one body that consistently warned about this, which was the Bank of International Settlements. This tendency to think that because we had not had an event like that for a long time and it was in the so-called tail of distribution we would not have one was pretty widespread.

Q51 Mr Newmark: From where you were sitting, you were in a position as Second Permanent Secretary for the economic forecast, where you were responsible. Did you get any sense a crisis was coming? When you think back on it, why didn’t you spot the crisis coming?

Sir Jon Cunliffe: Well, I do not think we had the monitoring to pick up the risk. Some risks did appear and some risks were reported, particularly just as we got close to 2007. I do not think we had the monitoring to pick up the risk but, more important, I do not think we had the awareness to understand how much risk was in the system.

Q52 Mr Newmark: My last question has to do with who they effectively populate the Treasury with.

Chair: Very, very last question.

Mr Newmark: Do you think the fact that there was a lack of industry practitioners within the Treasury or enough industry practitioners is a problem and is still a problem, i.e. there are a lot of people with good technical backgrounds but not people who have been part and parcel of the market who are, in essence, gamekeeper turned whatever that expression is.

John Thurso: Poacher.

Mr Newmark: Poacher turned gamekeeper-yes, you would know about that, Lord Thurso. Poacher turned gamekeeper. There are not enough poachers turned gamekeepers who have been in the City, been in the markets. Do you think that is a weakness even today in the Treasury structure where people can spot these problems coming along?

Sir Jon Cunliffe: I have been out of the Treasury for nearly seven years so I am not that conversant with what is happening there. There were attempts, like the recruitment of James Sassoon and Charles Roxburgh now, in the Treasury to bring in people. It is often quite expensive for the public sector to do that.

Q53 Mr Newmark: But it is very expensive if we do not have the people as well, as we have seen.

Sir Jon Cunliffe: I would certainly take the point that I think both in that area and a number of others it would be good to bring in outside expertise.

Q54 John Thurso: How dangerous is the US situation for the UK financial stability?

Sir Jon Cunliffe: I should start by saying my hope-and I have talked about the future not being predicated on the past-and assumption from the past is that they will find a way out and the enormity of this is understood. If there were to be a debt default, this is the main risk-free asset in the global international system. It will not be a question that the US cannot pay, because it clearly can-as an economy, it is quite large enough to pay its debts-but if there were a politically induced shock in the financial system that cast doubt on, if you like, the basic asset that is being used in the financial system, I think the impacts would be very large. I think they would be felt in repo markets because US treasuries, US debt, is the biggest repo market. I think they would be felt in collateral because the value of US Government debt will change. There would be a range of other effects that would ripple through the financial system. I think it would have a big impact on financial stability globally. One of the lessons from 2007-2008 is how shocks can be transmitted so quickly through the international system, and we are a big international player. There is a risk there. How well UK banks and institutions are provided against that risk, I will be honest and say I do not know. At the moment, I do not have access to those things.

Q55 John Thurso: There are two points here. The first is your opening remarks, which is it probably will not happen, which is the view of everybody. What worries me is the fact that everybody reckons it will not happen, so if it does we are really in seriously uncharted territory. The second point is there is probably nothing anybody can do about it and whatever shock comes will just be a shock. Is there anything in that you would dispute?

Sir Jon Cunliffe: On the first point, because there is an expectation that the political system in the US will find a way through this absolutely does not mean that banks and others should not be planning for it. I would expect the Bank of England to be planning for it and I would expect private sector actors to be doing that, here and in other countries as well. There is some anecdotal evidence that you pick up through the newspapers, the wires, that banks and others are thinking about how they would manage this. As I say, because in the past it has always been sorted out is absolutely not a reason to fail to do the contingency planning you can. Could it be stopped? If it happened, there is a question of how long it happened for. Does it happen to all classes of instruments? There is a whole range of unknown factors that I do not know. You would want to look very hard to see whether you could take action to mitigate its effects.

Q56 John Thurso: We will leave it there and hopefully I never have to ask any more questions about that. Can I ask you one other question, which is regarding the public understanding of the FPC? In your evidence to us, having discussed the domestic and international debate on capital and liquidity as being complex and intense, you go on to say, "Starting from scratch, my impression has been the interim FPC was for a lengthy period not sufficiently specific on what quantitatively it thought was necessary on capital. It could not, therefore, communicate clearly to either the micro regulator, the industry or the public more broadly," which at first sight appears to be a rather damning and dismissive indictment of your predecessor body. Can you translate that for us? My last question: firstly, can you translate it and, secondly, can you tell us what you are going to do to rectify the problem you have identified?

Sir Jon Cunliffe: On the first, it was not supposed to be a damning indictment of the predecessor body. Again, these are my observations from where I have been and for some of the period I was out of the country. The point I was trying to make, and it is also the point I make in establishing the operational framework and making a reality out of macroprudential, is that we are trying at the same time to mend the system and the system still needs mending. On capital, the end point for Basel is way past 2018. The interim FPC was trying to take action to mend the system while it was trying to develop its framework and its theory and its principles for explaining to people what the system should look like. What happens after a crisis, and particularly a crisis this size, is that you do not get an ordered policy response, you get wave after wave of policy. We did the G20 action plan in Washington in November 2008, but that was not the end of the story. We have had Vickers and Dodd-Frank since. We have had the parliamentary commission since. What happens after an event of that magnitude is wave after wave of action and debate about the underlying causes and so on. I just think that operating in that sort of period was quite difficult for the interim FPC both to deal with what it thought the problem was and communicate clearly what its principles were. It clearly identified there was a need for more capital in the system. It took a long time to say how you would calculate that, how much capital and so on, and throughout that period I think banks and others were uncertain about what the operational framework was. Given the circumstances in which it was operating, it was not intended at all to be a damning.

Q57 John Thurso: The second part to the question: how will you engage with the public?

Sir Jon Cunliffe: I found that one of the most challenging answers. For the financial sector, I can see we have technically sophisticated communications. The record, the report, academic articles; you can think of ways of getting the message across and, of course, the explanation of how we have acted and why. For the public as a whole, I have done a sort of test asking people in my immediate surroundings and family if they have an idea what the FPC is. I am afraid they do not. If I say it is what we are setting up to avoid another crisis, that resonates, but if I say it is a committee of the Bank with these tools, it does not. I think we have to find a way to get the message out in much simpler terms. That is possibly by speeches but maybe also by media. The Bank has done a lot of very good work on education on monetary policy, some very impressive work, which you could think of replicating for financial policy. One has to try to relay the actions that are being taken if necessary on loan-to-value ratios or whatever back to, "This is the risk we are trying to avoid and this is why." It is a long job.

Q58 Andrea Leadsom: Can I ask you, Sir Jon, whether you think that enough has been done to avoid a further eurozone crisis and whether you think that the state of the eurozone remains a risk to UK financial stability?

Sir Jon Cunliffe: On the second question, yes, I think it does remain a risk. I think the size of the risk has got smaller. On the first question, I do not think enough has yet been done and implemented to deal with the problems in the euro. Enough has been identified, but there are still big political decisions to be taken for the euro countries as how they are going to implement the steps they identified.

The risk to the UK in the financial stability from the euro arises from two things. It arises from the fact that in the periphery economies growth is still weak. I expect it to be weak. There is an overhang of structural action that has to go through. Unemployment is high in those countries and their political systems are quite stressed under the pressure of all that. That is one risk. The other risk is these key questions around how much solidarity, how much mutualisation, how much collective discipline in the euro area are still being worked through.

Q59 Andrea Leadsom: Bearing in mind you were very much involved in representing Britain’s interests politically in the eurozone, do you see that it is feasible for a European banking union to be completed politically? We have had many representatives from the Bank of England here saying that a European banking union is by no means yet complete and that there are challenges to the completion of it from the point of view of the political acceptability, not least of which is Germany, to issues like a single resolution mechanism and to mutual underwriting of customer deposits and so on. Politically, how big a hurdle is that, do you think, in the eurozone?

Sir Jon Cunliffe: I think it is a pretty substantial hurdle. This goes back, I suppose, to my first answer. I have maintained that you can make things better than they were and those improvements are worth having, but I think the countries of the euro recognise that they have unfinished business that they need to come back to. How big are the hurdles in those countries to making the changes? I do not sense yet in both the countries on the debtor side and the countries on the creditor side the support for the collective discipline that is needed. There are also concerns about some of the ideas on coordination of economic policy more broadly, fiscal policy and so on, and on the creditor side for the idea of mutualisation. That does not, to me, make it impossible that consensus will develop, but I think, firstly, it takes time and, secondly, the consensus is being developed in many countries in the middle of a pretty searing crisis with high unemployment. It is quite difficult to get support for that. I think that is an issue the euro countries have to come back to to take the action they need.

Q60 Andrea Leadsom: Obviously, the last time the eurozone took action it was following very strong testing by the markets. Now that the German elections are behind us, is that likely to start again, do you think? Will the international markets start to pressurise eurozone politicians to show their commitment to eurozone fiscal union?

Sir Jon Cunliffe: I do not see that happening at the moment. I do not see any signs that it is happening and my view on it is mixed. On the one hand, much of what I talked about, the euro countries in July 2012 identifying what needed to be done, setting a timetable, was under the most acute market pressure, particularly on Italy and Spain, and knowing that they did not have a way of taking those countries out of the market as Ireland and Portugal and Greece have been taken out of the market. From that point of view market pressure was good but, of course, if we are talking about social acceptance for change and quite carefully planning the changes that are needed, you do not really want to be doing it in crisis conditions. I think the euro countries will come back to this because the lesson of the crisis for them has been pretty deep, but there is an awful lot of negotiation and political movement to happen before they get there.

Q61 Andrea Leadsom: What do you think is the likelihood of seeing a eurozone member country leave the euro at this point?

Sir Jon Cunliffe: Much lower than it was a year ago.

Q62 Andrea Leadsom: But still feasible?

Sir Jon Cunliffe: Had you asked me before the crisis I would have said- Actually, you probably would not have asked me because nobody was asking that question. It seemed unthinkable. The prospect of redenomination in one or more countries, one or more countries leaving, was, if you like, let out of a box in 2011-2012. I do not think it has completely gone back in again, but I think it has gone a long way back from where it was. The countries of the euro looked at that possibility in the summer of 2012 and decided that it was just too costly and impossible.

Q63 Andrea Leadsom: Does the creation of the single supervisory mechanism make it harder for a country to leave the euro or not really?

Sir Jon Cunliffe: I think it makes it less likely that a country would have to. That is the objective. You ensure more even supervision of banks and that enables you to mutualise the risk. I guess it is another layer of integration and engagement from which you would have to withdraw, so yes.

Q64 Andrea Leadsom: Yes. For the last question, I just wanted to know whether you think that there are particular European countries that are against still, as some of the rhetoric was, the Anglo-Saxon style of financial capitalism. Do you think that there are euro member countries that are particularly keen to try to restrict the growth of financial services and, if so, which?

Sir Jon Cunliffe: It is difficult to talk about countries because euro area countries like the UK are made up of lots of different opinions and political parties and institutions. I do not know of any national positions that are strong there. The financial crisis followed by the euro area crisis has led some people to the explanation that the euro area crisis was caused entirely by the financial crisis and, therefore, by Anglo-Saxon market capitalism. That view is strong in a number of countries. It is strong in some parts of the European Parliament and in Brussels. You have seen some of the pressure that we have had on things like a financial transaction tax or whatever has been linked to that. It is strong in certain places. I do not think I would want to identify the governments of particular countries as espousing it, but the rhetoric you certainly hear. You hear a very anti-market rhetoric. You talked about financial services. The big distinction to me has not been so much financial service versus no financial service. It is actually a distinction between a banking-driven financial sector and a markets-driven financial sector. That is the kind of tension in Europe between the continental model and the UK/US model and the tension is still there.

Q65 Mr McFadden: Sir Jon, you have had a long history of being at the centre of the UK’s relationship with the EU on a whole number of issues. The Financial Times in September this year reported Goldman Sachs executives as saying that banks would leave-[Interruption.] I think we are voting, Chair.

Chair: Okay. Is this us? It must be. Well, we will have to suspend for 15 minutes and we will resume at 18 minutes past.

Sitting suspended for a Division in the House.

On resuming-

Q66 Mr McFadden: I was going to ask you, Sir Jon, about the comments attributed to Goldman Sachs that banks would leave the UK if the UK left the EU. What is your view on that?

Sir Jon Cunliffe: Well, that is Goldman Sachs’ view and I do not know what it is based on. I think it has been a benefit for much of the UK financial sector to be in the single market for financial services over the years. It is difficult to speculate what would happen if the UK were to exit the EU. It would depend on the circumstances at the time, but that is Goldman’s view.

Q67 Mr McFadden: Let me put it another way. Do you see any dangers to the UK financial sector in leaving the EU?

Sir Jon Cunliffe: As I say, it has been a benefit to much of the UK financial sector. If the single market in financial services were not available to them, then that would affect them and that would affect some of them adversely. You would have to think about what other circumstances might happen at the time as well. It is a bit difficult to comment on what to me is a situation that at the moment you cannot predict.

Q68 Mr McFadden: Can I ask you about something else then? You talked earlier in your evidence about how, following a major crisis like that, you are going to get a lot of new regulation and new proposals and so on and cited some new things. From your point of view of dealing with this, is the regulation coming out of the EU something that we should broadly welcome because it is in our interests, having a big financial sector, to have a safer big financial sector, or is it, as is often portrayed, a threat to the strength of the financial sector in the UK?

Sir Jon Cunliffe: I think we benefit from there being good regulation in the EU, which supports our financial stability, and we benefit if there is financial stability in other EU countries. That is not just about regulation but we are linked to the EU quite closely. We have talked about the risk to the UK economy and banking system from the eurozone, so if there is financial stability in other EU countries that is a benefit to us. We have just had an example of that with the last phase of the euro crisis where the interim FPC identified the risk to British banks from that.

For me, the key is that the regulation is well founded. There are two important points to that. One is we are trying to deal with very different types of financial sector in the EU. In some countries, some of the new member states, the financial sector is not very developed, it is not very sophisticated and it is relatively small. The UK probably has one of the most complex financial sectors in the world, not just in terms of scale but in complexity of the sort of business that is done here. We have to ensure that EU regulation and EU laws enable the financial stability needs of both of those to be recognised. Sometimes we will have to do things in a way that we would not otherwise have done them, but that is okay if we can get to the outcome we need. We need some recognition as well in the rest of the European Union that we just have a financial sector of a scale and complexity that is not matched. There are big financial sectors in Paris and Frankfurt but they are not international, truly global, like London is. The answer is yes, it is a benefit, but it must allow us to take the financial stability action we need to take.

Q69 Mr McFadden: Do you think that recognition is there of the specific scale and global reach of the City of London?

Sir Jon Cunliffe: In the main, yes, but the process of making EU law is a complicated one. The expertise you need to understand some of our issues are complex and you are always in a situation where you have-I am speaking as the UK Representative now rather than my prospective post-a lot more issues than anybody else simply because you have a bigger financial sector. In the main, our interests have been recognised. I could give an example of the macroprudential policy, the countercyclical buffer, where we had quite a long and difficult discussion on the CRD 4 directive that the UK would have the ability to vary, say, risk weights within sectoral capital or vary the countercyclical buffer, because other countries had a different view, had a different need. When you have a financial sector that is six or seven times GDP you also want to make sure it is safe. They did not have some of those problems themselves. It can be difficult on occasion; by and large, I think we have got there but it is something that one has to be very alive to.

Q70 Mr McFadden: If you take something like the recovery and resolution directive, all this talk about who bears the costs if a bank collapses-should it be taxpayers, should it be investors and so on, which came to the fore during the Cyprus crisis-given the size of the UK sector doesn’t it make more sense that if we are going to have things like bail-in mechanisms and tools like that, that we design them here rather than doing this at a common European level?

Sir Jon Cunliffe: Whether it is the EU or whether it is the US and maybe Asia, our financial sector is so integrated that we will need to be sure that if-I hope it does not come to that-we came to the point of having to do a bail-in, we will almost certainly be dealing in some cases with home host issues with global groups. We will need rules on the other side in the other jurisdictions that work with us. It was a very difficult negotiation also to work out what the creditor stack was-how you bailed people in and in which order. Different countries had different structures of financial systems so we came out with quite a complex solution. We will want to make sure that if we are dealing with a UK subsidiary of a European bank or of a US bank or whatever, decisions can be enforced and the approach is the same. There is a lot of benefit from approaching this in a common way. In a way, one of the big problems is those parts of the world where you cannot have a common structure.

Q71 Chair: Sir Jon, you will understand that when you are in your new job we hope that you will have shed the reticence that comes with your current position, but you are in a sense also speaking today still as a Government official and, therefore, having to be particularly cautious about a number of questions that you were asked that have a bearing on Government policy. You are agreeing with that. Do you also agree that part of the job will be demonstrating a much higher level of transparency for the Bank than the Bank has historically shown, except with respect to monetary policy where they have already shown a good deal, and that we have to translate a good deal of that transparency into the financial sphere if the Bank is to be a success at that task?

Sir Jon Cunliffe: Yes. I would very much agree. I think the Bank has been transparent about monetary policy for two main reasons. One, accountability, and this goes back to the point about powers with unelected Bank officials. The other is the policy is more effective because of the transparency. If people understand how you act and why you act-the theory I think since pre-1998 has been proved-it shapes their expectations and it shapes their behaviour. The same is true of macroprudential policy. If the financial sector understands why we have done what we have done and how it will impact, then it will shape their behaviour. Going back to the earlier point, if the public understand that, we will retain public support.

Chair: And legitimacy.

Sir Jon Cunliffe: And legitimacy, yes.

Chair: Yes, okay. Well, thank you very much, Sir Jon. That is all the questions we have for you this afternoon.

Prepared 21st October 2013