CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 606-xv

HOUSE OF COMMONS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

BANKING STANDARDS

ANDY HALDANE, SIR MERVYN KING and PAUL TUCKER

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Joint Committee

on Thursday 22 November 2012

Members present:

Mr Andrew Tyrie (Chair)

Mark Garnier

Baroness Kramer

Lord Lawson of Blaby

Mr Andrew Love

Mr Pat McFadden

Lord McFall Alcluith

John Thurso

Lord Turnbull

Examination of Witnesses

Witnesses: Andy Haldane, Executive Director, Financial Stability, Bank of England, Sir Mervyn King, Governor, Bank of England and Paul Tucker, Deputy Governor, Financial Stability, Bank of England, gave evidence.

Q1141 Chair: Good morning, Governor, and good morning, Mr Haldane and Mr Tucker. Thank you very much for coming to give evidence this morning.

You are perhaps uniquely well placed, Governor, to guide us on this Bill-and it is on the Bill that we want to concentrate this morning-since you have been through a crisis during which you said repeatedly that you did not have the powers you needed to tackle the crisis at the Bank, and we are discussing a Bill in which your vested interests, so to speak, in the legislation are limited to the fact that your term expires in six months or so.

Sir Mervyn King: Seven months, eight days.

Q1142 Chair: Is it that bad?

Sir Mervyn King: It is good.

Q1143 Chair: Can I begin by asking you about the evidence that we have heard so far from both the Chancellor and Paul Volcker? Do you agree with the Chancellor-I am paraphrasing-that he has every confidence that the ring fence, as he has described it so far, will be robust, or with Paul Volcker that it will be permeable over time?

Sir Mervyn King: Well, in that old phrase, it all depends what you mean by the ring fence. We do not have precise quotes from those two great authorities.

Q1144 Chair: "Permeable over time" is a quote.

Sir Mervyn King: That is a quote, but let me go back to the basic principle. It all depends on how the ring fence is defined. In terms of being able to implement that as a regulator, there is always a balance between clarity and flexibility. Now, as a regulator, my experience is that I would put as much weight as possible on clarity.

I would be worried if the definition of the ring fence were left to the regulator to decide. You refer to my experience. If I had to pick up three things that have been important in determining why the regulators had real difficulties in coping with this crisis, it was, first, the absence of a resolution regime. Secondly, it was the absence of, I would say, equity but you could call it "loss-absorbing capital" in banks and, thirdly-this is where I come back to the importance of clarity-is that I have been struck in the last five years, learning more about how the regulatory process worked, by how much of it has turned out to be a negotiation between the regulators on the one hand and banks on the other. There is a lot that we can learn from the regulation of other industries.

I remember clearly that one of the big criticisms of the regulation of utilities and privatised industries in the past was that, if prices went up as a result of the regulated firms claiming that their costs had gone up and the regulators having to monitor and approve the cost increases, that negotiation was a disaster for the regulator and led to uncontrolled price increases. The great genius of the regulation that came in after privatisation was to have a very simple and clear rule.

Q1145 Chair: This is the RPI.

Sir Mervyn King: RPI minus or plus x, depending on the industry.

The regulated firms immediately stopped putting pressure on the regulator and started focusing on improving their efficiency, and cutting costs. I do not want to simplify this too much, but the big principle is that, to be effective, the regulator has to be able to use judgment. That is what we want to get to. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there is only one winner in that, and that will be a very bad outcome. Clarity is crucial to enable the regulator to exercise judgment within a very well-defined framework, and the regulator needs to be able to tell banks, "This is the capital requirement you will have", as opposed to merely entering into a negotiation.

Q1146 Chair: Does the Bill as currently drafted provide that clarity?

Sir Mervyn King: Well, we have not got to the clarity required because, correctly, the clarity will be in secondary legislation. It would be a mistake to have too much detail in primary legislation because that is notoriously hard to amend. Equally, it would be wrong to give it purely to the discretion of the regulator because that would increase the pressure of lobbying of the banks, both directly on the regulator and indirectly on Governments and parliamentarians, who will not really have an opportunity to understand the detail of it. They will simply want to find a middle course through it. The only way, I think, to do this satisfactorily is for you and others to be satisfied that the initial secondary legislation sets the definition of the ring fence in the right place, but then allowing Parliament later on to amend that, if and when it appears necessary to do so.

Q1147 Chair: That will not be an easy job for us to do, bearing in mind that we have not seen the secondary legislation.

Sir Mervyn King: Well, I think you should ask to see it in that case. I think that is an important aspect of this.

Q1148 Chair: I don’t know whether you have noticed, but we have been having a go.

Sir Mervyn King: I do not want to intrude on those discussions, but it is clearly difficult to define a ring fence properly without knowing what that secondary legislation will be. It will come, I am sure, and I think that is where the definition of the ring fence will come-that discussion of what is in that secondary legislation.

Q1149 Chair: We will be touching on some of these areas in more detail in a moment, but would you now give us the headings of the areas where you think that detail needs to be filled in at this time if we are to make sense of this primary legislation?

Sir Mervyn King: I am sure different people, probably including some amongst us, have slightly different views as to where the ring fence would be. The principle I would use is this. I start by saying: what is the purpose of the ring fence? It is to ensure that basic core banking services-the provision of retail deposits, the payment system and mortgage lending-are done within a framework where we know that if a bank screws up and mismanages itself, it can be resolved and ownership can be changed without any disruption to those basic services. If that is the approach, the natural thing to do is to start with the core banking services, define those and put the ring fence around those. I would need to be persuaded to go much further than that. That is how I would start doing it and that really, I think, illustrates the approach.

That is different from the Volcker approach. What he has done is gone to the other end of the spectrum and asked what it is that we clearly don’t want to have contaminating the basic core services. The answer was proprietary trading, so he said that we should put that into a different organisation, but he, too, has faced enormous difficulties in defining the ring fence between what is proprietary trading and other types of activity-market making and, indeed, other kinds of banking-so you do not get rid of the difficulty of coming up with a well defined definition merely by going to his approach.

I know that he said to you that a good banker can tell the difference between market making and proprietary trading. That is true, but that is not the issue. The question is whether the regulator or a court can tell the difference between the two and whether it is possible to pull the wool over the eyes of the regulator or to confuse the issue legally even if the banker can understand exactly what the nature of the transaction is. It’s can you prove it? To my mind, that is starting at the wrong end a little bit, because the principle is to worry about the core banking services, put the ring fence around that and then see where the difficulties are at the margins.

Q1150 Chair: Earlier in your remarks, Governor, you were talking about the risks of being dragged into negotiations with the banks, where, as you put it, there is only going to be one winner and it is not going to be the regulator-or the supervisor, if you prefer that term. That is because the banks have bigger firepower at their disposal in terms of the sheer volume of pressure that they can generate, and detail.

One idea that, in an exchange between me and you, Mr Haldane, we developed in an earlier evidence session was that we should arm the regulator a little with some kind of contingent power for full separation in the event of non-compliance. Have you given that further thought since we had that exchange, and in particular have you thought through the behavioural consequences? Will it increase uncertainty on banks on the one hand? On the other hand, will that be more than offset by the overall welfare gain from having banks not continually lobbying, not continually trying to burrow under the ring fence?

Andy Haldane: Chair, I have given that a little further thought, although I would say there is more thinking still to be done on the question of how you would make that operational and legally watertight. Let me mention a few points. First, I think the aim of this reserve power needs to be made absolutely crystal clear. It is not at all to unpick the Vickers proposals, but rather to prevent them from being unpicked. It is very much there, in my mind, as a means of reinforcing and ensuring that the Vickers proposals are as watertight as can be the case.

So what might be done to ensure that they are watertight? It is possible to think of three ladders of sanction. The first would operate at the level of the ring-fenced bank itself. There would be value in the directors of the ring-fenced bank having a duty to ensure the integrity of the ring fence, as the first line of defence against burrowing under. Secondly, the regulator will themselves have an obligation to police, and ensure the integrity of, the ring fence. They will have sanctions too; for example, they could require additional capital for a ring-fenced bank that is seen to have breached the ring fence.

Q1151 Chair: Although that power lies in large measure with the Treasury.

Andy Haldane: It would certainly be within the vires of, say, the PRA in the new world, if it felt that the tunnelling by the ring-fenced bank was raising risks, to require that extra capital or liquidity be held against those risks; that strikes me as fully possible.

The third rung on the ladder could be the possibility of vesting in the regulator a further sanction, which could be to require the reorganisation of the ring-fenced bank to ensure that the objectives of the Vickers Bill-insulation and continuity of core services-were preserved. It would need further legal work to see whether that ultimate sanction was practical. It would need further work, as you mentioned, Mr Chairman, on the behavioural consequences of having that sanction.

For what it is worth, in terms of thinking through the potentially adverse behavioural consequences of having that sanction power, I would make two points. First, I would be resistant to the notion that merely having this sanction power would cause banks to look inward-to hoard capital and not lend. We have heard that argument far too much over the last few years, and we must not be held hostage, in doing the right thing, by the notion that the banks will stop lending.

At the same time, I think the way to avoid any adverse behavioural consequences is to do precisely what the Governor mentioned a moment ago, which is to seek absolute clarity about where the boundaries of the ring fence were drawn. If there is ambiguity, blurriness or greyness in where the boundary lies, that could legitimately cause banks to hold back and to worry about getting on the wrong side of the line and then facing the ultimate sanction. The greater the clarity about where that line is drawn, the less the chances of adverse behavioural consequences from the ring fence.

Q1152 Lord Lawson of Blaby: May I follow on from the discussion we have just been having? The Chairman put to you the proposition, which we discussed before, of a sword of Damocles hanging over the banks, so that if it appears, to use his expression, that the banks are burrowing under the ring fence, it can be changed to complete structural separation. The variant he gave was that this would somehow be at the discretion of the regulator-the PRA, presumably-to decide. Bearing in mind that that is such a big thing, and bearing in mind the Governor’s warning that if you leave too much discretion with the regulator, there will be a negotiation, and, if I may quote what the Governor said, we know what the outcome of that will be, might it not be necessary, if you want an effective sword of Damocles-as you say, Mr Haldane, more thought needs to be given to this whole area-for it to be more than something that can be used at the discretion of the regulator?

Sir Mervyn King: To whom is that question being put?

Lord Lawson of Blaby: To the Governor.

Sir Mervyn King: I think you are right, and I would not want the sword of Damocles to be in the hand of the regulator. The regulator would know that if they were to use that sword, the industry would immediately descend on Parliament and say, "Why isn’t Parliament making this decision?" Indeed, Parliament might then replace the legislation to remove the sword just as we are about to use it. A better way of doing it would either be to ensure that secondary legislation had the capability of implementing that-ensuring that the remit of secondary legislation made that feasible-or, and this may be a better way of doing it, to ensure that the legislation now contained within it a provision to reconstitute this body, or a successor body, three, four, five years down the road to review how far the ring-fencing of Vickers had worked and whether any amendments were needed. In other words, a definite compulsory review should be built which could not just be avoided and put off; it has to take place in order that there would be an open study of whether or not there had been too much borrowing.

I am worried that the regulator would feel that there was a need to eliminate some of the activities that had burrowed under the ring fence, but the mechanism that it had for dealing with that was to implement the sword of Damocles. It would be stuck in a terrible dilemma. It could not really go to Parliament and say, "Look, you ought to legislate," because Parliament would say, "You have the power already. You use it or not." It will be deeply concerned about using that power because it would not have the legitimacy of Parliament.

In other contexts, we are always being told that the Bank of England is far too powerful, and this is another power that I do not want to receive. I would like it set up in such a way that whatever came out of this, there was an automatic mechanism for reviewing the ring fence and whether it was working, which could not be dodged or pushed into the long grass. Secondly, the decision as to whether the ring fence needs to be shifted has to be a matter for Parliament and not the regulator.

Chair: We have had a number of public exchanges on the extent to which Parliament needs to be involved. Paul Tucker and then back to Nigel Lawson.

Paul Tucker: It is important to make a distinction between whether this question is about changing the ring-fencing policy to full separation across the board as a general policy, which should lie with Parliament-we do not want to be legislators-or about specific institutions. On that, it is worth saying that if the resolution directive going through Europe is passed in its current form, it will give the PRA the power to say to a bank, including a ring-fenced bank, that it is not resolvable, "You need to do one of a number of things, including shifting around your organisational structure to ensure that you are resolvable."

In terms of dealing with individual banks burrowing under the ring fence and rendering themselves unresolvable or not super-resolvable in consequence, the regulator should have the power to say something. You cannot just tolerate an unresolvable ring-fenced bank. We may get the powers to do that from Europe, as it happens. That is quite separate from: should the country move away from a ring-fencing policy to a Glass- Steagall policy or whatever. There the really big question is: if you are going to do full separation where would you draw the line? Would you draw the line in the same place as ring-fencing? Those are questions for you and not for the PRA or the Bank.

Q1153 Chair: Are you saying that there is a prospect that the EU legislation will provide for, effectively, the scope to force full separation on an individual institution?

Paul Tucker: To require an individual institution to take actions to ensure that they are resolvable in the opinion of the regulator, and that could be by organisational structure or other things. There is a list of things in the directive at the moment.

Q1154 Chair: But if you think that that is a good idea, you are not going to want to rely on EU legislation.

Paul Tucker: It will get transposed into UK law.

Q1155 Chair: You will want us to have belt and braces domestically. Am I right?

Paul Tucker: It will get transposed into UK legislation, and the precise terms of the UK legislation would be for you.

Q1156 Lord Turnbull: May I clarify one thing? We are talking not just about moving an activity from the ring-fenced bank to the non ring-fenced bank but about the possibility that something that is going on in the non ring-fenced bank is creating such problems that you would say that they should divest themselves of it.

Paul Tucker: As the power is framed at the moment, it would be open to the regulator to say: "With the way you are conducting your business, we are not satisfied that either the ring-fence bank or the non-ring-fence bank is resolvable for the following reasons. You have to do something to assure us that it is resolvable." If they then cannot satisfy the regulator of that, there is a list of powers that the regulator can exercise. Included in that list of powers is organisational change. Quite how far those powers go-I think the Chairman is absolutely right-would depend on how it was transposed into UK legislation. It may not survive in the final form of the directive. I just wanted to make you aware of this. But the main point I am making is to underline the distinction between a general policy for the banking system as a whole-which is for you-and ensuring that individual banks are resolvable, which is the proper duty of the regulator. Where the regulator cannot do that with the power it ends up with, it should come back to you and say, "We have a problem here. The regime is flawed in some way; please help."

Q1157 Chair: Bearing in mind the notorious scope for very successful lobbying historically at EU level, I am not sure that we should rely on it yet.

Paul Tucker: We certainly should not rely on it yet; it is only a draft.

Q1158 Chair: But it ends up being directly applicable in our law. It strikes me-perhaps you might like to comment-that if we were to get it on to our statute book, it might concentrate the minds at a European level as they take that legislation forward.

Paul Tucker: And as they debate the Liikanen report as well.

Q1159 Lord Lawson of Blaby: Governor, you have given the reason for the Vickers ring fence in terms of resolution and all that, which is absolutely right. That was how it evolved and those were the terms of reference. It was particularly in the terms of reference of the Vickers Commission. We have different terms of reference in the sense that, in addition to the pre-legislative scrutiny of the Bill-although, as you pointed out, it is very difficult when the things we really want to scrutinise have not appeared yet, but we will leave that to one side-we have been set up because there was a widespread feeling inside and outside Parliament that there had been an alarming decline in banking standards and culture in all too many areas. Question 1: do you agree that there has been this problem of banking standards and banking culture? Question 2: if the answer to the first question is "yes", do you think that, fortuitously, the ring fence will assist in dealing with the problem?

Sir Mervyn King: The answer to question 1 is yes, and the answer to question 2 is that it will certainly help. Any move towards separation will help. The choice between different methods of separation is more a technical one, but I think that putting in place a very clear move towards separation-which is how I interpret the aims of the Vickers report-is a good thing and will help enormously. I also feel that the economics of investment banking are changing and have changed considerably. That itself is driving the new generation of leadership in banks to recognise that it is now in their own long-term interests to change the culture. It is very visible in some of our big banks; that will change. That is no reason not to pursue a very clear move towards separation.

Q1160 Lord Lawson of Blaby: Thank you. Given that, do you not think that possibly, ideally, it would be better to have complete structural separation-two quite separate companies which would simplify matters considerably and avoid the tricky governance problems, for example, in the Vickers formula? There may be some disadvantages, but do you not think that the advantages might outweigh them?

Sir Mervyn King: I have made no secret of the fact, and I have spoken about it for five years, that I have always felt that total separation was the right way ultimately to go. I have been joined in arguing this by some distinguished company, but it has been a lonely and difficult furrow to plough. I am glad that many more people are now coming on board the idea that a move to some kind of serious separation is the right thing to do. Even the Financial Times has now advocated a move in this direction.

I really do not want the last five years of effort to go to waste through the whole issue being kicked into the long grass by not implementing Vickers. We appointed the Vickers Commission in the UK, and I think this is the best-qualified group of people to serve on such a Commission in my lifetime in the UK. These are very impressive individuals, and they have thought about it.

There is one aspect of their proposals that I had not thought of before, which influences me into the thinking that my position now is, "Let’s do Vickers now, but let’s make sure we build into the process a review to see at some later fixed point whether we need to go further." The point that the Vickers Commission raised was that it saw benefit in not going for complete separation now in terms of making it possible for the non-ring-fenced bank to provide capital and support to the ring-fenced bank without infecting it because the ring fence was carefully defined. That has some weight for me in the following sense.

If we lived in a world with a large number of banks, none of which was enormous, the argument for full separation would be pretty compelling. But we do not, and in the UK at present we have a small number of big banks. The purpose of the ring-fenced regime is not to stop a bank from failing, and I hope that all of you on this Commission will do a great deal to make all your colleagues in both the Lords and the Commons aware that the purpose of this legislation and the ideal policy is not to get to a world where ring-fenced banks are guaranteed by the Government. That is not the case, and it will be very important for all of you not to stand up in the House and complain bitterly about losses to your constituents, whether debt holders, shareholders, or deposit holders, above the insurance limit if a bank fails. That is absolutely vital. You can undermine the whole regime by behaving in that way.

Back to the main point, if a large retail bank were to fail in the UK behind the ring fence, we may have a perfectly good resolution regime, which ensures that, because a bank has enough loss-absorbing capital, it will not fail completely, but we feel that it will be necessary to change the management. Who will take over that bank? We may have the most perfect regime in terms of transferring deposits to another bank. It may be easy to do that and no one loses, and on Monday morning another bank could take it over, but it is so large that no other bank, even if it appears financially attractive, is willing to take it over because it would immediately put it into the territory of being so large that the competition authorities here and in Europe would be all over them.

In essence, that is the problem we faced when HBOS was taken over with Lloyds, and the competition legislation was in effect suspended for that period. I do not think this is a healthy outcome so, as a practical challenge, to be able, in those circumstances to get the non-ring-fenced bank in the same group to contribute perhaps new management and new capital to enable the existing ring-fenced bank to keep going, rather than have to sell it or transfer the operation to another bank, has some merit. That has persuaded me that the first sensible step in this process is to implement Vickers now. Let us get Vickers on the statute book, because it is important that the banks have some certainty as to where we are going. Do Vickers now, but put in place an absolutely binding provision so that a Commission, like yourselves, independent of Parliament, will guarantee to review the operation of the ring fence after three, four or five years, so that everyone knows that, if people are burrowing under it or going round it, legislation may well follow.

Q1161 Chair: It sounds as though you might be talking yourself into a job there in a few years.

Sir Mervyn King: Oh no. Absolutely not. I would have a conflict of interest.

Chair: I note the seven months and nine days-

Sir Mervyn King: Eight.

Q1162 Chair: But perhaps an interval of a few years might change your mind.

Can I ask you, Mr Tucker, whether you agree with the Governor’s preference for full separation?

Paul Tucker: Not completely.

Q1163 Chair: You either have to agree with it or not.

Paul Tucker: Hold on. First, I absolutely agree that we should get on and do Vickers. I think it will be damaging in all sorts of ways-most importantly, to credit conditions-if there is a further prolonged period of uncertainty.

Q1164 Chair: I would just like you to answer the question I have asked.

Paul Tucker: The question about whether there should be full separation is not well defined. Do I think we should go back to Glass-Steagall? Do I think we should draw a line between the ring-fenced bank and the non-ring-fenced bank? Those are completely different things. Under Glass-Steagall, securities dealers could not take deposits. If you draw a line between the ring-fenced bank and the non-ring-fenced bank, the crucial thing would be that the non-ring-fenced bank is a bank. It can take deposits: non-insured deposits.

We have also learned, since Glass-Steagall, that securities dealers, even in their narrowest form, are now runnable, because they finance themselves by repo. The really big question, if the economy went for full separation, is not about how to make the domestic retail bank super-resolvable, but what kind of beast you want to allow in the rest of the financial system. The thing that has worried me most about this debate from the beginning-the Government are not guilty of this-is that people fall into thinking that if only we can make retail banking safe, the financial system will be safe. Frankly, I think that is nonsense. I think the financial system and the economy will be capable of being blown up by vast wholesale dealers and non-banks. The question of separation is part of a much wider debate about how you make non-banking finance safe. We would need a very careful review of how to do that.

Can I add one thing to Lord Lawson’s question about culture? Even if we were to go to full separation, the challenges of culture in retail banking stem in part from infection from investment banking, but I do not think they arise entirely from that. There has been an industrialisation of high street banking-banking for small and medium-sized enterprises. They have drifted away from relationship banking. Branch managers are much less in power than they were 20 or 30 years ago. That is a major programme of cultural change in its own right, irrespective of what happens to global investment banking and separation or non-separation.

Q1165 Lord Lawson: Could I ask a quick question for clarification? Most of us here-certainly I speak for myself-are not thinking that there is a silver bullet that will solve every single problem. The question is whether this particular proposal would be helpful.

Paul Tucker: I think it would be helpful. It may not be sufficiently helpful, and if it is not, we should come back to it.

Q1166 Baroness Kramer: I suppose those last comments move us in a way towards the issue that I want to raise, which is about resolution. I know that Lord Turnbull will focus specifically on areas such as the financial services compensation scheme, so I will ask some of the more general questions.

In a sense, this is a question for the Government, but perhaps particularly for Mr Tucker; it is about bail-in. Can the big banks be resolved without a workable bail-in, not only power, but capacity, within in the institutions?

Sir Mervyn King: I will give you a one-sentence answer, and then hand over to Paul, who is the world expert on resolution. What is important is that banks have sufficient loss-absorbing capital, whether in the form of equity or in the form of bail-inable debt. The two together add up to the stock of loss-absorbing capital, and there must be enough of that. You can debate how big is enough, but you need a lot of it. Let me ask Paul to explain how the bit of it that corresponds to bail-inable debt would work, and how it links to resolution.

Paul Tucker: I agree with that, by the way.

First, I think this is the most important element of the current work to solve the "too big to fail" problem globally. If it does not work, we will have to come back to questions of separation, capitalisation, liquidity and absolutely everything else.

Secondly, as these big beasts are constituted, both in their geographical scope and the nature of their business, the standard resolution toolkit, which we belatedly imported into this country from the US-the FDIC-would probably not work. That is not just my view but the view, I think, of the FDIC.

Q1167 Baroness Kramer: That is because of the different structure-much bigger banking institutions?

Paul Tucker: The way a standard resolution works-if only we had had this in place in this country before Northern Rock-is that you take the most elemental services, deposit taking and payments, transfer them to another bank and put the rest of it into administration or liquidation. Taking Barclays or Citigroup, making sure that their payments business was safe-which is vital, the most elemental thing to do-and saying that all the rest can go into liquidation would cause absolute mayhem, I am sure of that.

The essential idea of bail-in is that if you have enough debt somewhere-let’s say at the top of the whole group-and you can make a reasonable estimate of the size of the hole in the group, the size of the losses, you write down the equity and, once that is exhausted, you start writing off the first layer of debt, subordinated debt. If that is exhausted, you move on to the next layer of debt and write that down. The last layer of debt to survive become the owners of the company: you convert part of the residual debt into equity.

This is not outlandish, this is more or less exactly how chapter 11 for corporations works in the United States. They applied it to non-bank financial institutions, including CIT, during the financial crisis. The difference with banking is that you could not do it through a slow motion court procedure and negotiation between creditors and shareholders; you have to do it quickly and therefore you need an agency of the state to do it. This works only if there is enough debt; whether it is defined as subordinated debt, or normal senior unsecured debt, or a new layer of debt, you need sufficient of it. This is a matter of providing the resolution authorities with the requisite legal powers and with a set of safeguards, and then the regulators following up and saying, "This is the kind of capital structure, in the broadest sense, that you need." That idea is embedded in Vickers. What Vickers says about that, and where, I think, the Government are going on this, is consistent with the global plans.

I have one final point. All that is at the level of ideas. Behind the scenes, there is a lot of serious work going on between various authorities, including ourselves and the FDIC, to operationalise this. That will see the light of day at some point; and we will retreat if we don’t think we can make it work.

Q1168 Baroness Kramer: I would like to push this a bit further. I fully understand your view, and I would not dispute it-the good bank/bad bank strategy just cannot work under the circumstances that you describe-but I just want to push on whether or not bail-in, which, as you say, is at the heart of everything that is being discussed, is something real that we can hold on to. It is untested, for a start. Is it, to some extent, a chimera? As I look at bank balance sheets today, the layer of bondholders is thin.

Paul Tucker: No, no, it is thick. I am sorry to interrupt, but some of the witnesses in front of you have talked as though the only thing that can be bailed in is a special class of bonds with "coco" or "bail-in bond" stamped on them. If you take Barclays, it has, very roughly, £100 billion of debt outstanding. I refer you to a study by the FDIC about how they think they would have applied bail-in to Lehman Brothers if only they had had the powers then that they have now. Where I completely accept the point-this is one dimension in which the Vickers proposals are so important-is that what ring-fencing would do is, if a top-down bailin strategy for the whole group was not viable, then you retreat to ensuring that the most elemental part of the group, the domestic retail bank, can be resolved through a normal good bank/bad bank structure. Neither in the UK, nor in any other country, nor globally, are we embarked on a resolution strategy in which all our eggs are in one basket-that would be a reckless thing to do.

Q1169 Baroness Kramer: Let me just push a bit more, because I am trying to understand. You are talking about a distinct group of bondholders, and there is always the interesting question about whether, with that additional sense of liability, they would still be there, or certainly still be there at the current price. There is that set of issues, and I want to come back to that, because there is the question of who would hold those bonds, if they had that perceived risk attached to them. You obviously would not want other banks to be holding them or you will have contagion. There is a real question mark about whether or not pension funds could hold them, so we come to the very interesting question of who is left. It is starting to look like hedge funds and sovereign wealth funds, and they would have to do it for the global banking system, so the size is huge. I am trying to work out essentially, when you say unsecured to creditors, how much is actually talking about the uninsured depositor?

Paul Tucker: And also the uninsured bondholders, of whom there is a vast quantity in existence now, and they know bail-in is coming.

By the way, it is important to say that they now realise, not least because of Lehman Brothers-that demonstrated that, in a democracy, institutions that will cause great damage if they fail are sometimes allowed to fail-that they can take losses. That is reflected in secondary market bond prices and in new bond prices now, which are trading at about 100 to 150 basis points over the risk-free rate.

The point you make about pension funds, and one could say the same about life companies, is whether they should be allowed to own regular senior unsecured bonds issued by banks. I do not see why not, as long as they did not have concentrated exposures. They own corporate bonds, and they sometimes default. Insurance companies and pension funds do not only hold risk-free assets. They lose money on their bond holdings, and their equity portfolios go up and down in value.

It is quite important not to think about the world investor base as completely averse to default risk. When I have talked to some of the biggest asset managers in the world and have put this to them as a question, they have said that they would rather be able to take losses on their bank bond holdings if that helped to insulate them from the mayhem caused by the latest financial crisis, which devastated the value of their overall portfolios.

The point about bank holdings-I know the point was made by Adair Turner when he appeared in front of you-is absolutely right, and it is true whether or not we do bail-in. One of the most disturbing things to discover in this financial crisis was that for the medium-sized banks-more like the retail banks-more or less all of whom failed, the core idea of their liquidity was to hold floating rate notes issued by other banks. This is absolutely disastrous, so stopping that kind of thing is essential, whether or not any of the resolution policies are taken forward.

Q1170 Baroness Kramer: Before we pass on, could I just push you on this issue of the uninsured depositor? Over the £85,000 benchmark, we know we are going to have small businesses and charities, but we also have what one could call systemically important businesses. All of the supermarkets, for example, who have to have very high cash balances, are going to be within that category. Is there ever going to be a situation where any Chancellor will, as it were, exercise bail-in over that category for a large institution, with its inevitable knock-on effects for the economy, or do we effectively have to say that that is not going to be a bail-inable portion and that bail-in has to be concentrated in the narrower area we have described?

Paul Tucker: There will be two ways of dealing with that; there are more, but I will mention two now. One would be to extend depositor preference beyond insured depositor preference-just a straightforward depositor preference-which would mean that all the people who you have listed would rank behind bondholders as the losses were being absorbed. There are disadvantages with that, as well as advantages.

The other way of doing it would be-if you have a group structure with a holding company, a ring-fenced bank and a non-ring-fenced bank-the holding company issues debt, and you bail-in at the level of the group. Those bondholders are structurally subordinated to the creditors that you are concerned about and they would be protected under that scenario. The most important thing for me to say, though, is that as we work through the details of this-globally, in Europe and in the UK-we are cognisant of the point that you are raising.

Baroness Kramer: I think I should probably pass on it.

Chair: Andy Love wants a quick question, then Andrew Turnbull.

Q1171 Mr Love: It is about the future of living wills. You mentioned that the American system, which you tried to import, just doesn’t work for very large and complex banks. Does that mean living wills are dead in that case, or have you got other alternatives that you are looking at?

Paul Tucker: A living will is another way of describing the exchange that we have just been having. A living will is, how do you manage the distress and demise of a particular company? I think the most important thing to say about living wills is that these aren’t just things that the firm or group themselves can write and send in the post to the regulator, who says, "Thank you very much for your 10,000 page essay." It is actually something that the authorities-we, the Bank of England-will have to own and assure ourselves that the firm is resolvable and, most crucially, that the ring-fenced bank is resolvable.

Q1172 Mr Love: But is it resolvable just through bailing, or are there other structural-

Paul Tucker: There are other structures as well. I don’t want to give the impression at all that the "good bank, good bank, bad bank", or "purchase and assumption", as they call it in the United States, is off the table; absolutely not at all. I mean, my God, if only we had had those powers in 2007.

Q1173 Lord Turnbull: I would like to turn to a specialised bit of this debate, around the FSCS. A lot of the comment has been, on the one hand this, on the other hand that. There is a familiar trade-off that the more creditors are preferred, the more burdens are put on those who are preferred, who then see that they are more exposed and are more likely to flee if they see danger. So you introduce instability. On the other hand, if you do not prefer the FSCS, all the good banks will have to bear a larger burden, and that could come to the point where it begins to threaten them. Do you have a preferred structure for this? Where would you want to draw this trade-off, if you were writing the final detail on it?

Paul Tucker: The first thing to say about the FSCS, if I may take the opportunity-and I know that the Governor and Andy feel very strongly about this, too-is that the general public must understand what is insured and what isn’t insured. This policy that, with our encouragement, the FSA has now introduced of "Put posters in every bank branch and say on every internet connection that you are protected up to £85,000, and-if it is a branch of an Icelandic bank-you are protected up to ‘that’ by the Icelandic deposit insurance authority," could not be more important. It is absolutely vital. In slow motion, I think it will radically change UK retail banking, because the general public will come to understand that £85,000 is safe. One of the reasons US retail banking is different is precisely because of this.

In some respects, I would prefer not to have insured depositor preference, because this would make no difference to the insured depositors whatsoever. They would be safe, because the losses, as you say, would go to the rest of the banking system. It is quite important to harness the good banks, in terms of monitoring the weak banks. This is true for the bondholders as well. A nightmare for you and, narrowly, for us as an institution is: first line of defence, management; second line of defence, regulator. Misery follows that. We must harness the board, the auditors, the equity holders, the bondholders and the rest of the banking system. The best way to do that is to expose them to loss. The best case against depositor preference is precisely that.

The best argument for depositor preference is, what happens when the banking system is so rotten that the rest of the banking system can’t absorb the cost? On balance, I would probably come down against depositor preference- in a world of ring-fenced banks. If we stayed where we are at the moment, without ring fencing-I think I was one of the people who floated depositor preference, including with John Vickers and his team-I would support depositor preference. I think ring fencing may be sufficient to make the elemental deposit-taking payments system service safe without depositor preference. I do not feel strongly about it.

Q1174 Lord Turnbull: The clear message I get from this is that we must not set up a system that says it is going to work in this fashion when it does not actually reflect the realities of what is likely to happen. Here is an opportunity to set up a system and mean it and not have a system where, in the end, it is going to get overridden.

Paul Tucker: Absolutely right. I think that not just in this country but in lots of other countries the regulatory authorities and central banks are trying to tie ourselves to the mast with no bail-out.

Sir Mervyn King: Can I go back to the point that Baroness Kramer made? It is of fundamental importance. I am very concerned about the £85,000 limit, because, as you rightly say, it does not make sense to have a regime where people believe it does not matter what it says on paper-they’ll pay up. What we have at present is a situation in which we have learnt that big banks can fail. Six or more years ago, everyone discussed deposit insurance in the context of whether small banks might fail, and the numbers involved were not very large. It was the case that they did not get 100% deposit insurance. There was no guarantee up to £85,000. You still lost 10% of your money. That was supposed to be an incentive to monitor the bank. No one could do it, and in reality, it was never likely to be implemented. So we had to move to 100% deposit insurance to prevent a bank run. Above the £85,000 limit, if any big bank on any given day happens to fail, there will be thousands of people who, through no fault of their own, happen to have deposits in their bank accounts of more than £85,000. There will be people in the middle of a house purchase and people who received an inheritance.

Q1175 Lord Turnbull: The day after you retire, you will have a very large lump sum.

Sir Mervyn King: I won’t, I can assure you.

You will find other people who are beneficiaries of divorce and court settlements-for a period. They might not intend to hold the money in banks for very long. It is not a conscious decision. They certainly are not going to say, "Gosh, I’ve got this money for two weeks before I put it into some investments, so I must spread it around banks, even for two weeks." On any given day you will find thousands of people in that position, and this is when I would understand if you in Parliament stood up and said, "This is deeply unfair." We have no means at present of handling that.

Paul Tucker: That is a massive point. I completely accept that.

Q1176 Lord Turnbull: Is there some insurance scheme? You have received a retirement lump sum, sold a business, sold a house and inherited money. As you say, you could just be sitting there on the day the bank fails.

Sir Mervyn King: And it is unrealistic therefore to say that in all circumstances we will stick to the £85,000 limit. If you have a very small bank that fails and only 12 people hold deposits above £85,000, in three different constituencies, I am convinced that the Chancellor will decide not to intervene. If you have thousands of people involved, I think the pressure on the Chancellor will be enormous. There is no easy way around this. It demonstrates the key principle of this. Retail deposits are a basic banking function that we think people should have access to, and they should not find themselves losing money as a result of highly risky activities, including lending on commercial property. I think that having some kind of comprehensive retail deposit insurance is inevitable. That very much colours my feeling that you need a narrow definition of the ring fence. I totally accept Paul’s points that you also need to worry about what happens outside the ring fence, but, as Lord Lawson said, that is not a reason for not trying to make sure that you have properly organised retails.

Q1177 Lord Turnbull: Are you questioning the £85,000 limit?

Sir Mervyn King: I am saying that you as legislators need to think very carefully about whether having a simple absolute limit captures all the people we care about. My belief is that, if you move to the world of retail ring-fenced banks, having an upper limit may be undesirable. How many people with very large sums of money-several million pounds-will choose to invest at very low rates of interest? The return on retail deposits now, particularly as you move into a world where competition may lead the rates of interest offered on pure retail deposits to be even lower, is not going to be an investment that many people will find very attractive.

I don’t think you will find many people voluntarily choosing to have all their wealth in this form because it is guaranteed or insured. What you would do is get round the problem of capturing a number of people who, in the unlikely event that a bank fails, you will then find that, ex post, you will not want to implement the £85,000 limit.

Paul Tucker: I completely agree that we need to find a solution to that.

Q1178 Chair: How do you feel about uncapping the 85K?

Paul Tucker: Not very happy. I don’t think that is a happy prospect at all. Certainly, I think if we do that, the ring-fenced bank would have to become narrower. Then we would lose some of the liquidity services to the economy.

There are possible solutions, though I am not saying that I am confident any of them would work. One is that, if you have a massive mortgage payment going through or a legacy coming through, the bank is obliged to put it in a trust account rather than on its own balance sheet. That is something that in the stockbroking world, if they still refer to them as stockbrokers, people used to do for many decades. I don’t see why that should just be a privilege of the rich rather than a service that is available on a compulsory basis.

Maybe there is some other kind of insurance scheme, which Lord Turnbull mentioned. We do need to solve it. The Governor must be right that best-laid plans get blown up because it turns out that there are a number of such people and it is politically unacceptable to do it.

Q1179 Lord Turnbull: It could be quite a large number. One observation: the National Savings easy access account, I think takes deposits of up to £2 million. People would be well advised, if they were receiving a big payment, to pay it into that until they can break it up.

Sir Mervyn King: Yes, but if you take the United States, people have got used to a world in which they spread their deposit accounts around. The trouble is that that is something that is done by people in a calm moment when they know the money is coming in. Here we don’t have enough banks to make that a terribly attractive proposition. There is such a small number of big banks that I don’t think that is a very sensible route to advise people.

Secondly, for many of the moments when people will receive large amounts of money, I don’t think you can be entirely confident that you can just rely on them to say, "Ah, I have got this large receipt. What shall I do with it?" If you are planning to pay it out in two weeks’ time to an investment that you have already decided on, most people I think would say, "Well, it’s only two weeks; I’ll just take the risk." But once the bank does fail, that won’t help you.

I do think there is an issue here. It is not the most important issue, but it is an important question that was never tackled or resolved. We did frequently raise this question particularly for house purchase. There are many other examples-it isn’t just that-where, just for a few days or weeks in their lives, people have unusually large amounts of money, which go above the £85,000. Particularly for people who don’t normally have large amounts of money, they are not going to be in the frame of mind to say, "Ah, I know what to do if I have suddenly got £400,000 in my account. I have listened to all the expert advice. I go along to this special trust account or whatever." I think you have to worry about people who don’t think about it in those terms.

Q1180 Mark Garnier: Governor, we have talking for the past 20 minutes or so about the absolute certainty that, no matter how hard we try to avoid it, there will be another bank failure. We have to be clear that it is resolved in the best possible way.

My point is slightly outside the remit of Vickers, but you will be well aware that there is a large debate raging about account portability, in terms of having a utility payment system. The debate mainly goes around promoting competition. Do you not think that account portability utility payments argument also applies in terms of resolution of banks? One of the problems, if your bank does go bust underneath you, even if you have below £85,000 and think everything is absolutely fine, you still have a huge problem ahead of you. Do you think this resolvability argument also includes having a utility payment system and reinforces that argument for a utility payment system?

Sir Mervyn King: It does, and I find the principle of a utility payment system very attractive. The question is the cost. As Andy has said on other occasions, we need a dispassionate assessment of the costs and benefits, because this is a classic free-rider problem. The individual banks are not going to be very enthusiastic about this, but we are talking about the system here, and I would find that very attractive. It would also be a means of encouraging competition and making resolution a lot easier. One of the key elements of resolution, even in simple cases, is how you handle the transfer of retail depositors from the bank that gone into resolution possibly into a new bank between Friday night and Monday morning. A mechanism in which that was simple and straightforward would help. So I am in favour of the principle, but one has to look at the cost, and from that point of view, there is no point in asking the banks. I do not think you should ask the regulators. You should find a group of people who actually understand how to operate systems of this kind and get them to do an appraisal, perhaps for a parliamentary Committee.

Q1181 Mark Garnier: Andy Haldane, when you came before us a couple of weeks ago, you made the very important point that something like 80% of the IT spend by banks was on sellotape and chewing gum to hold the creaking system together. Is it not an argument that, although a new utility clearing system may be created, the banks’ legacy IT systems are basically rubbish? Are we not absolutely ripe for a complete restructuring of the whole IT system within banks, because we would then have a much clearer idea of what is going on within the system, which would make the job of the FPC that much easier?

Andy Haldane: Yes, I think that is right if not for all banks, then for a large number of them. Their legacy IT systems are not at the frontier technologically and that does come with costs, which include costs in their inability to look across their whole balance sheet and to manage the risk on a consolidated basis. If there were to be some external review of the costs and benefits, that ought to weigh very importantly, as you mentioned, Mr Garnier, the costs of maintaining legacy systems. As I said to you a couple of weeks ago, it strikes me that, given the existing state of the systems, no change is not an option, because these systems are becoming more obsolete over time.

The real question is how far you want to go next, and that requires some careful weighing of costs and benefits, the like of which has not happened so far. That would include not just the resolvability benefits, which I agree are very substantial, but also the benefits, which are as important, that might be conferred on new entrants in terms of ease of entry into the payments system, which is a complaint that I think you have heard in this Commission and more externally. There are also points about resilience-both managing individual firms and resilience across the system-so we need a drains-up, across-the-piece evaluation of both costs and benefits. That would serve us all pretty well.

Q1182 Mark Garnier: Thank you. I want to turn to permeability in the long term of the draft Banking Reform Bill, which we touched on earlier with the Chairman’s questions right at the beginning. Yesterday, when we were talking to the Chancellor, he kept coming back to the one, single objective that is on the face of the Bill, which is the continuity of provision. However, is that not far too wide? Does that not allow, at some point in the future when all of this is a long-forgotten memory, for that continuity of service to be interpreted in myriad different ways, which allows the exposure to be lobbied quite aggressively in order to respond to what are then healthy banks’ better ideas of making more money out of the consumer?

Sir Mervyn King: Any legislation put in place now for any kind of separation, whether it is Vickers or Volcker or Liikanen or total separation, will be vulnerable to lobbying down the road. After all, that is how Glass-Steagall got undone. Parliament has the responsibility of resisting that and keeping a collective memory. One of the objectives, which I hope my successors at the Bank will follow, is not to allow the memory of this period to be forgotten. The great role of institutions is to act as a collective memory. So I do not think the fear that there can be that is a good argument for choosing between different types of separation today, but it is an argument for making sure that whatever we do today has clarity, so that the regulators are clear. I think the objective is clear, and that the regulators and the PRA will know what their job is, which is to ensure that they are in a position to allow badly run banks to fail without damaging the basic banking services that the system as a whole can provide.

Paul Tucker: Technically, the continuity objective in relation to the Vickers changes has to be read alongside the safety and soundness objective of the PRA. Casting the objective like that is a massive breakthrough for bank and insurance supervision in this country. Safety and soundness is defined in the Bill to include, if the institution fails, not unleashing massive damage on society.

The other thing I would say in response to your question is that this is why it is so important that the meat of the regime should be in secondary legislation-not in primary legislation, because that is harder to change. The meat of it should not be in PRA rules either. These are social choices that you should make, not some changing composition of the PRA board. Once it is in secondary legislation, that secondary legislation has to be kept under review, not just for the massive question of whether to move to full separation, but also for keeping it up to date.

This is not just to do with burrowing under the ring fence in some wicked way. In a completely benign way, finance will be different in 25 years’ time, in ways that we cannot imagine today. So keeping the regime in secondary legislation refreshed will be immensely important over the years and decades.

Q1183 Mark Garnier: I think that is absolutely right, and I am certainly sold on the "built to stand the test of time" argument, but the one problem might be that the continuity provision is a very wide remit and, actually, when you look at where it is defined-if you like-within the models that we have had, it is somewhere from John Kay to somewhere nearish Paul Volcker. Anything can happen in the middle. But what slightly troubles me is that in the policy document that went with the Bill they felt it was necessary to talk about curbing "incentives for excessive risk-taking", "improving resolvability of banks" that do not get into trouble and "minimising the risk" to taxpayers. If they felt that it was important to put that in the policy document that goes with it, why do you think that they did not feel it was important to put it as a point of reference in the Bill?

Sir Mervyn King: The drafting of legislation is a wonder. You would think you would start legislation with a clear statement of its objective. I rather doubt that this has much to do with anything other than the parliamentary draftsmen. There ought to be an objective in legislation, I agree, and it is stated that we have one.

Paul Tucker: The safety and standards objective of the PRA helps you quite a bit-perhaps not completely, but quite a bit. I do not think that you should evaluate it just in terms of the continuity objective; you have to see the continuity objective alongside the safety and soundness objective.

Q1184 Chair: Are you giving us a steer that this is something we should address?

Sir Mervyn King: I think it would be sensible to put the objective in the Bill. The Government have given the objective-it is not as if there is not one. There is an objective. I have never understood the drafting of legislation. This is your responsibility, you pass this stuff. Mostly it is incomprehensible, and it does not include basic statements like the objective of the legislation or in clear words what it is all about.

Chair: I will take my share of collective guilt. In due course, I am sure you will have to bear some of yours, Governor.

Q1185 Mr McFadden: I want to continue the theme of clarity and flexibility. When you came before us a couple of weeks ago, Mr Haldane, you gave us a very clear list of what you thought a ring fence should look like. You talked of how there had to be entirely separate governance, entirely separate-very importantly-treasury and debt-management functions for the two sides of the bank, and an entirely separate remuneration structure and human resources functions to deal with the cultural problems we have been discussing. We put this list to Sir John Vickers when he came before us about a week after you. He said, "I would agree with that, and I would add to it", and he talked about liquidity functions as well. The issue is how to bring this about in terms of this issue of clarity and flexibility. I want to go back to the discussion we have just been having.

We have had representations from the FSA, which is worried that the PRA will not have the powers to create that kind of ring fence and that the Bill does not necessarily give it that. I will just read what the FSA said on this continuity of provision point. Its worry is not that the Bill is too broad, but that it might be too narrow. It said that these objectives "are currently narrowly focused on the continuity of the provision of core services in the UK. This by itself does not meet the broader objectives intended by the Government." It goes on to say: "Spelling out the objectives of the reforms in the draft Bill in this way would provide clarity for the Treasury and the PRA when exercising their delegated powers. It would have the broader benefits of both providing clarity to firms and regulators over what the draft Bill is intended to achieve and also should help avoid the dilution of the reform objectives over time." That is right in the centre of our pre-legislative scrutiny responsibilities, so I will start with you, Andy Haldane, because you gave us the list. Do you agree that there should be more clarity on the face of the Bill about what the objectives are in order to arm the regulator with the confidence and the power to have the kind of ring fence that you outline?

Andy Haldane: Yes. As the Governor said a few minutes ago, a greater degree of clarity about objectives would be helpful. So too would be somewhat greater clarity, if not in the primary legislation, then in the secondary, about the different dimensions that Mr McFadden mentioned. Right now, the draft Bill has some detail on how governance would work in a ring-fenced bank and the extent to which that is arm’s length from the non-ring-fenced parts. Mention is made of the potential need for a separate risk committee and, possibly, a separate remuneration committee. That is all directionally right. For the secondary legislation, it would be useful to set out in much clearer terms the different dimensions I set out to you and how that separation was to be achieved in practice, because the devil here will be in the detail.

I will give one example of that at the governance level, which I know has come up in previous discussions in the Commission. What do we mean by "separation" and "separate"? Lord Turnbull asked me that question when I was with you two weeks ago. At one level, it is just about having a separate legal personality. The Vickers proposals and the White Paper make it clear that the ring-fenced bank will have a separate legal personality, but what does "separate" actually mean?

Another level is membership. Vickers and the draft Bill both say something about membership. The draft Bill asks that no more than a third of the membership of the ring-fenced board can be represented on the holding company board as well. That is also worth spelling out in greater detail. What should be the objectives of that ring-fenced board? I mentioned one objective already that I think is important, which is that they should preserve the integrity of the ring fence. Should they have the same objective as the holding company, which is maximising value for the company as a whole?

Q1186 Mr McFadden: So you are talking about different directors’ duties to different parts of the bank.

Andy Haldane: Exactly. There is a degree of ambiguity here about how the objectives of the ring-fenced bank are to be cast. Are they cast in terms of the objective of the holding company or should it have some subsidiary objectives? More thinking is needed to fill in some of the colour on governance and the other dimensions of separation that you mentioned. That is probably not for primary legislation, but it is important that that is clearly set out in the secondary legislation.

Q1187 Mr McFadden: Do you share the fear-it is obviously expressed by the FSA-that, absent this, the regulators will be in the negotiation process that the Governor referred to at the beginning and will be vulnerable to lobbying, chipping away and so on as the banks try to get around this?

Andy Haldane: That will happen, with probability one. It is not set out clearly.

Paul Tucker: I do not think that the objective in primary legislation needs great clarification. I think that’s broadly okay. I think what the FSA is concerned about, and certainly what we are concerned about, is that, as drafted, the primary legislation allows the meat of the regime to be set out in secondary legislation, or in PRA rules, or in a combination of the two. Technically, therefore, it would be possible for the secondary legislation to be almost silent, leaving the whole of the regime to be set out in PRA rules.

We are clear, and I think that if Adair and Andrew were here they would say the same, that it is important that the meat of the regime is set out in secondary legislation; that the PRA board does not become a quasi-legislative body. I completely agree with Andy that the things that he has set out, and that type of thing, should be in the secondary legislation. As an aside, the only quibble I would have is that it is absolutely vital to have separate treasury functions. It is also vital to frame that in a way that does not preclude the holding company issuing debt, in view of the debate we had earlier about resolution. I think that’s where Andy is too, but that’s for him to say.

Q1188 Mr McFadden: I may come back to that in a second. Governor, can I tempt you to do a bit of drafting here? If we are talking about putting clear objectives in the Bill, roughly how would you do that?

Sir Mervyn King: I think the objectives are in the policy document. As you said, it’s a question of lifting them from the policy document and putting them into the legislation. I am much more sympathetic to being clear and putting stuff in secondary legislation about the treasury function, risk management, HR, the board and so on.

What I am somewhat less interested in is creating pretty vague wording about people’s responsibilities. I am not sure if we actually need to have legislation to give a legal responsibility to the directors of a ring-fenced bank to monitor the ring fence. The supervisor will make it quite clear to the ring-fenced bank where that boundary is, and the directors of a bank now have a legal responsibility to listen to the supervisor. What I am nervous about is turning not just meetings of regulators but meetings of banks, into meetings where, on every single issue, you have to check if you have complied with 16 legal provisions-and the whole discussion is dominated by the legal advice and not the substance. We have discussed in the Treasury Committee the enormous importance of judgment-led regulation. It is not just the box-ticking regulation that was described as characteristic of the FSA. It is a way of thinking about regulation whereby, instead of making people check that everything they have done is in compliance with various legal provisions and sign everything off with their legal adviser, you look at the bank and say, "They don’t really understand this. There is too much risk. We don’t understand it. Let’s make sure they have enough capital to absorb losses if they occur." That is, in essence, what it is about, and the more legal restrictions you put in a Bill that give people responsibilities to check this and check that, the less it will be easy to have judgment-led regulation.

So I would focus the drafting. Certainly there ought to be an objective at the beginning, but I think we’ve got one and I don’t think there’s any disagreement about it. I think you need to focus on the list of specific things that Andy mentioned, which ought to be separate-legally separate-from the parent bank. And if it turns out-after three, four or five years-that this is proving very difficult or too much bother to monitor, then one can think of going to separation. I think that the very interesting issue would be, once we go down this road and after a few years, how many banks decide to choose to go down the road of separation? I said before that the economics of investment banking are changing quite radically and none of us know what it will look like in 10 years’ time. And it may well be that the nature of banking will look very different and that actually separation may emerge as the natural outcome of all this, but I don’t know that.

Q1189 Mr McFadden: Which was the experience in the 1930s, I believe. Glass-Steagall was not the Government and the regulators coming along and imposing something entirely new on banks; it actually followed investor decisions to cast doubt on the previous model. The investors may get there before the regulators and the Government.

One final thing, to change subject slightly with you, Mr Tucker. Can I take you back to the discussion that you were having a little while ago with Susan Kramer and Lord Turnbull about bail-in? Slightly unusually for this country, which has jealously guarded its financial services regime from European encroachment, this is all being discussed through the recovery and resolution directive. Directives are difficult things to get agreement on. There are 27 member states and they all have their own view. That might be a happy consensual process, but it might not. Given your stress on the importance of this alongside the structural discussion that we are all engaged in, what would your view be if that directive could not reach agreement, ran into the sand or did not bring about a Europe-wide bail-in regime? Should the UK bring in one by itself, given the size of the banking regime and the potential danger to which it exposes our economy?

Paul Tucker: The simple answer is yes, but the European Union is actually obliged to do this. There is a global agreement-the Financial Stability Board key attributes for resolution-which is an international standard agreed by the G20 leaders. All of the G20 countries, which of course is more than 20 countries-there are 23, or something like that-are obliged to put a particular regime in place. Actually, the draft recovery and resolution directive produced by the European Commission is very faithful to that international standard.

It may get diluted; I do not disagree with you about that at all. So far, the signs are promising, for what it is worth. If it happens, we should do two things. At a national level, we should go ahead anyway. America basically has this regime already, and Switzerland is pretty close to having it already. We should ensure that the three jurisdictions with 10-plus of the largest global banks have that regime. We could do that domestically.

Secondly, at a global level, Adair and I, or whoever, would go to the Financial Stability Board and say that the European Union needs to be held to account at the G20 level for not having implemented an agreed standard. The Financial Stability Board has procedures for doing that. In fact, there is a peer review under way at the moment of the progress that countries are making in implementing the Key Attributes, and there will be another one next year. But in a narrow sense, my answer to your question is yes.

Q1190 John Thurso: Governor, you have reminded us of our genius at legislating for unintended consequences, and you have enjoined us to keep it simple and make it clear. Can I ask you some questions about the location and width of the ring fence, so that we can try to have clarity? The first is a relatively straightforward one that the Government have asked us. Should ring-fenced banks be permitted to sell simple derivative products? What is your view on that?

Sir Mervyn King: No, I would not have that within the ring fence. I would put that outside it.

Q1191 John Thurso: Santander, in their submission to us, made the point that they broadly consider themselves to be something that could be entirely within a ring-fenced bank. They made the point that simple hedging products or simple exchange products are very helpful to SMEs dealing overseas. It is a very small part of their business-well under 10%-and their argument is that there should be some form of de minimis and that if it is a small part, they should be permitted to do it. Do you have any sympathy with that view?

Sir Mervyn King: I certainly have sympathy with the basic problem that they face. One thing that has not been given enough attention is the idea of having banks that are solely ring-fenced banks rather than being part of a wider group. Whether you get round that by making it easy for them to set up a non-ring-fenced entity for SME lending or whether you do it through a genuine de minimis, it has to be minimis and not large, otherwise we will get right back into the problem of people burrowing under the ring fence and bringing in more and more complicated products. It is almost impossible to differentiate between a simple and a complex derivative.

Q1192 John Thurso: That was going to be my next question. Is it possible to differentiate? If one were going to permit something, one would have to pick numbers that made it very difficult to get into any form of serious trading. It would have to be, therefore, a risk management service that was being provided, not a product-profit centre.

Sir Mervyn King: Yes.

Paul Tucker: And if this were done and also probably that the derivatives were centrally cleared: you know that a requirement for being centrally cleared is that they would be standardised and liquid, and all of that stuff.

Q1193 John Thurso: The summary of your advice to us would be "Don’t do it".

Sir Mervyn King: Don’t do it?

Q1194 John Thurso: Don’t permit the sale of derivative products in a ring-fenced bank. In other words, "Don’t do it", but if you feel you really have to do it, make it a very small number and do not attempt to define the difference between a simple and a complex product.

Sir Mervyn King: Yes.

Q1195 John Thurso: Can I come on to the second area that I want to ask about? It is the other end really. It is what must be in the ring fence. Governor, all the way through your comments, you have made it very clear. At the beginning, you said that it all depends on the definition of the ring fence, that there should be clarity on width and that clarity is crucial.

At the moment, Vickers sets out three basic reasons for the ring fence. Number one is resolution and the protection of services. He also stated that number two was insulation from extreme shocks in the financial system and that number three was securing the sustainability of the UK banks’ resilience by making domestic retail banking stronger and allowing international wholesale banking to continue to be internationally competitive.

At the moment, the legislation is suggesting that deposits and overdrafts alone are the "musts" that have to be in the ring fence. One of the resolutions will potentially be a bridge bank. It is quite a likely one actually, something that gets sold on as a stand-alone, smaller competitor. Is it realistic to define the narrow end of the ring fence as simply being deposit-taking and overdrafts, without more of a corresponding other side to the balance sheet, if it will have the potential to be a bridge bank that is viable? Should we therefore be looking at slightly widening the definition at the small end in order to ensure that there is actually a viable entity capable of being resolved?

Sir Mervyn King: I will give a two-part answer. I shall then ask Paul and Andy to comment. It is very important to go much further than the current statement about where the ring fence is. Secondary legislation has to contain more detail about what is in the ring fence and what is outside it. If you allow far too much flexibility here and leave it to the regulator, we will be right back to the problems that we discussed earlier. I would like to see more specification of what’s in and what’s out. Mortgage lending, for example, is likely to be in. There is a good debate to be had about what to do about SME lending, because I worry about the definition of "SMEs". You must certainly spell out much more clearly what is in the ring fence.

On the technical aspect of the bridge bank, both Paul and Andy are experts, so let me turn to them for advice.

Paul Tucker: The most elemental service to preserve complete continuity is in the deposit-taking and payments side. That is why both John Vickers and the Government define that as the core service. It certainly is the most elemental service. I think that we may have different views on this. I would not want to prescribe that SME lending has to be done in the ring-fenced bank, and there are two reasons for that. The first is that we have absolutely no idea how large these ring-fenced banks are going to be, and we do not want to end up in a position where, perversely, credit ends up being rationed, because the only place where domestic credit can be done is in the ring-fenced bank but banks have chosen, which they will choose, to allocate a small amount of capital to the ring-fenced bank. The other reason, and this is more a point about MEs rather than SMEs, is that it is quite important that they grow. Not all of them will grow, but some of them will grow into LEs, and I have no difficulty in that respect with a non ring-fenced bank providing services to medium-sized enterprises. Having said all of that, I would be disappointed if the ring-fenced banks did not do SME lending. All of which is leading up to the fact that the concept that the legislation does not contain-I think it will probably be too complicated-is something that must be done within the ring-fenced bank but may be done outside the ring-fenced bank. Unless we are going to introduce that concept, which would be a dimension too far, I favour SME lending being committed-

Q1196 John Thurso: Let me just press you on that point, because it is a critical one. There may be things that have to be done inside the ring-fence, but that could also be done by a non ring-fenced bank. I am slightly grappling with the oxymoron that you have to do it in one place, but you can do it somewhere else.

Paul Tucker: Yes, and I am saying that where the Government and John Vickers ended up was that you should be committed to doing SME lending either in the ring-fenced bank or in the non ring-fenced bank.

Q1197 John Thurso: So you could say that in the ring fence, it must offer that. You could also offer it in the other one as well. It is about plurality of services.

Paul Tucker: Exactly, because the important thing about SME lending or mortgage lending is that the ring-fenced bank has the capability to do it, by which I mean the technical capability, or the know-how, to do it. In the worst crises, that is the bit of the financial system that needs to be super-resolvable. That is the bit that we will somehow keep going without taxpayer money. The fact that the ring-fenced entity should have a capability to do those things does not mean that they should do all of that business. This is quite different from insured deposit taking, where you do want all insured deposits inside the ring-fenced bank. I hope that that is clear.

Q1198 John Thurso: What I am really driving at is that continuity of service is the number one priority, the over-arching priority, of the legislation, but number two is a resolvability that ends up not detracting from the banking architecture. In other words, it might end up in, say, a small new competitor bank. If you start with a construct that is purely as defined in the minimum, with the other side of the balance sheet presumably being whatever safe instruments they are allowed to keep and quite a lot of capital, have you not created something that is not worth creating going forward and removed that as an option for resolvability?

Paul Tucker: In circumstances where the whole of the asset side is toxic, which could be the case-even if there is mortgage lending and SME lending there could be circumstances in which the assets are terrible-you can still transfer the deposits, and that is the most important thing and then whatever good assets they have got. The question of resolution is slightly different from the question of what lending services have to be provided in the ring-fenced bank, and may only be provided in the ring-fenced bank.

Q1199 John Thurso: Very briefly, Andy, do you concur with that?

Andy Haldane: In some ways, yes. I have already handed in my essay question on this one, so I would. Working backwards from the continuity objective, I would personally mandate a broader set of services to lie within the ring fence, including loans, mortgages and SME loans. The reason for doing that is to think backwards from the unintended consequences, to use your words, of not having that. So, however stylised, imagine a world in which all SME lending is done by one bank, which is permitted to do all of that lending out of the non-ring-fenced part of its business. Alongside that, it decides to run a proprietary trading operation that gets itself into trouble. We then find that, overnight, there is a hole in the non-ring-fenced bank’s balance sheet, which craters the capacity of the whole economy to supply loans to SMEs. In that situation, however stylised, we end up concluding that the ring fence failed, as we had not protected those services that, in all states of the world, we want to be in continuous supply. Personally, I would not want to imperil the ring fence concept by putting too much outside of it, and that certainly includes SME loans and other types of loans.

Q1200 John Thurso: If I could just summarise, I think what I am hearing is that there is a clear desire that the ring-fenced bank should be a real bank, capable of operating as a real bank, but I do not hear a desire to legislate in the secondary legislation beyond what Vickers suggests. Is that-

Paul Tucker: I would not, but I think that Andy would. I think that, on this, the example Andy gave is a good one, but it would be terrible for all sorts of reasons. It would be terrible also if we had only one ring-fenced bank that provided SME services. We need diversity, and something that I think we will eventually end up coming back to-not now as there is too much change going on-is that we should not feel comfortable with great concentrations of lending business. It has been terrible for this country that 40% to 50% of business banking was done in two banks, both of which went bust.

Chair: Susan Kramer has a quick rejoinder, and then Andy Love.

Q1201 Baroness Kramer: Just a point of clarification, if I could go back to Mr Haldane. When we heard the Chancellor yesterday talk about the concept of the ring-fenced bank, the whole focus was that the ring-fenced bank, essentially, contained those elements that had to keep functioning on Monday morning following a decision made on Friday night, and SME lending need not be in that category because it is something that you could work out over several weeks and months; it does not have that element of urgency. Are you taking a somewhat different, broader approach to the role of the ring-fenced bank? I am trying to resolve what seem to be differences of perspective and priority.

Sir Mervyn King: I would share Andy’s perspective here. What you need to ensure can continue on Monday morning is that people can get mortgages and that there is, at least, an opportunity to access SME lending. I find the SME question difficult because both Andy and Paul make good points. The real difficulty is that if there were a certain category of firms that you could immediately define-rigorously and legally-as SMEs, and they remained SMEs for ever, I would follow Andy’s solution.

But Paul is right in saying that SMEs can change and grow, and it seems a bit odd that, when you pass some arbitrary threshold, you have to change your bank. I do not find that question particularly easy to answer. Paul described a good outcome in which a lot of SME lending was to be done behind the ring fence, and possibly some of the more sophisticated lending for the SMEs that were about to graduate to bigger companies done outside the ring fence. It is easy to say that, but hard to translate it into a clear statement in secondary legislation. But I think that Andy is right that if we were to find that a bank behind the ring fence got into trouble, or a bank outside the ring fence got into trouble and we did not have small business lending, that would be bad and the regime would be deemed to have failed.

The conclusion I draw is that certain things need to be defined. I do not think that you can just take the description of Vickers as enough; much more needs to be in secondary legislation. Much more has to be-

Paul Tucker: I do not think that there is a great deal between us on this. On mortgages, I prefer the capabilities approach, but even if, say, the Chancellor decided that mortgage lending could be done only in the ring-fenced bank, I do not think that anyone would suggest that the non-ring-fenced bank should be prohibited from owning mortgage-backed securities, and I think that it would be a very bad thing if they were.

On the liabilities side, it is much easier as there is a very clean definition of insured deposits. As soon as you get to anything on the asset side of the balance sheet, you are into greater degrees of subtlety and it becomes easier to burrow under the ring fence.

Stepping back, one of the things that we should absolutely avoid with this is the problems that have plagued the Volcker rule. When we appeared in front of your other Committee, you asked the Governor and me what we thought about the Volcker rule, and we both said, in my words, that it was very good in principle, but it might be quite difficult to frame in practice. We must not jeopardise this regime by trying to define things that it is not actually possible to define, because then the regime will end up in disrepute.

Q1202 Lord Lawson of Blaby: Governor, you quite rightly said how important it is to have clarity. In answer to John Thurso, you said it might be okay for the ring-fenced bank to be able to offer its SME clients simple derivatives, provided it was de minimis-well, he asked if it would be all right if it was de minimis, and I think you said, Mr Governor, "Yes, if it is very de minimis." Would you put a figure to that?

Sir Mervyn King: No, I do not want to put a figure to it; I would need to think carefully about that. But I do think that the line of argument here is that, if a bank is doing a lot of SME lending and wants to be able to offer derivative transactions for SMEs not necessarily on a large scale, but nevertheless not on a trivial scale, the right thing to do is to set up a separate entity, which is outside the ring-fenced bank. It would be either a sibling relationship or a parent-child relationship, but it would be under a separate balance sheet. The key point that Paul makes, which I strongly support, is that we should not restrict banks to offering products to companies solely within the ring fence. I think the derivative one is a very good way of saying, "If you want to get into the sophistication of derivatives, do it outside the ring fence."

Paul Tucker: On an agency basis. Can I add one thing to this? I am absolutely comfortable with saying that if a ring-fenced bank wants to provide derivative services on an agency basis, it should create a separate legal entity. All I would add-and I think this is really important-is that that separate legal entity should be regulated. In the United States, what has happened for decades-this is a nightmare, frankly, for the US bank regulators-is that Congress prevents a particular activity from being done in banks, so that activity goes into another legal entity in the group; that legal entity is not regulated, which basically means, broad brush, that the regulators have no right of entry into that institution. This was why the so-called Lincoln amendment, about derivatives not being done in commercial banks, fell in the United States. There is a cure for this, which is that you make that derivatives entity a regulated entity, also under the PRA, not the FCA.

Sir Mervyn King: And the Financial Policy Committee has the responsibility of making recommendations to Parliament, to say, "This kind of institution ought to be regulated."

Chair: Colleagues are very interested in this.

Q1203 John Thurso: One point, Governor: you said that the ring-fenced bank might have a sibling. Is it not proposed that that is the one thing ring-fenced banks can’t do? It would therefore have to be a parent that did it, and if you have a bank like Santander, which is intending to be one entity, a ring-fenced bank-certainly a lot of their evidence is indicating that they would like to be that-it could not have a little sibling; you would have to create a parent.

Paul Tucker: You would have to form an intermediate holding company in the UK, so that there is a UK parent.

Sir Mervyn King: It has a parent already.

Paul Tucker: It would go: UK intermediated holding company, then ring-fenced bank, then derivatives subsidiary, rather than the derivatives subsidiary for UK business falling from the group holding company, because otherwise the UK bank supervisor would have no jurisdiction over it.

John Thurso: Thank you for that clarification.

Q1204 Chair: Would it also be fair, Mr Tucker, to summarise what you said about 10 or 15 minutes ago-if you can remember that far back-as saying that many of these problems are made more difficult by the fact that we have such a small number of banks in the ring-fenced category and that therefore opening up choice, competition and market entry, to get more players into the market, can itself have systemically beneficial implications?

Paul Tucker: Absolutely. One of the lessons of the crisis, and one that has not been discussed enough, is that we had a great concentration in UK business banking and that has ended up being a bit of a disaster for the UK. We and the FSA, as I am sure Adair and Andrew described, are doing things. One of the things we believe very strongly is that with a good resolution regime already for small banks-because, if you like, barriers for exit are lower-we can reduce barriers to entry. One of the hardest things-I think we have to lead on this-for a line supervisor is that you are there doing the analysis of a new applicant. You feel terribly jeopardised if you let this new applicant through and it fails after a year or two years.

But in a world of 100% insurance for up to £85,000 and rapid payout, and in a world where if this new entrant bank fails, it can go through the good bank/bad bank purchase and assumption resolution technique, the Bank has to ensure-the PRA board has to ensure-that the line supervisors are less cautious about this. I don’t think anyone should criticise them for being cautious. It happens to be probably the second or third task I ever did in my Bank career. I cannot remember whether we were cautious, but I can remember thinking, "Oh, what happens if this fails?"

Q1205 Chair: It is a very difficult problem to resolve. It would prolong the discussion on that point now and we have covered it quite a lot anyway elsewhere, not least in the Treasury Committee. It would be extremely helpful if you produced a short note on whether you think that problem has been cracked in the proposed legislation and, if not, what further measures might be required.

Sir Mervyn King: I don’t think you can expect legislation to achieve this.

Chair: I don’t want to prolong the discussion on it now.

Sir Mervyn King: As we said earlier, 40% of mortgages in the UK come from two institutions, one of which is almost entirely in state hands and the other is half in state hands

Q1206 Chair: We have had these exchanges before. That is why I suggested that we go on to something else. There is a related issue that has scarcely been raised this morning, which is the regulation of non-banking or "grey" banking-new entrants through institutions that don’t score under the current definitions.

Paul Tucker: You should firmly expect that the re-regulation of banks in this country and globally will mean that more banking-the economic substance of banking-migrates out of things that are de jure banks. That is why in the Financial Stability Board we have been working on this for about 18 months. In the last 10 days we issued a big package on this. There is a very big global debate on this.

Q1207 Chair: What we need to know for our review of this legislation is whether it is fit for purpose in tackling what may be a growing systemic risk outside the formal banking sector.

Paul Tucker: It doesn’t address that. All the things we are doing about banks in this country will leave a regime that is not fit for purpose unless, in parallel, we tackle malign forms of shadow banking. That does not mean that the re-regulation of banking itself is a mistake: on the contrary, but we would make a great mistake if we were blind to the inevitability, almost, of regulatory arbitrage and it just being cheaper to do certain kinds of financial intermediation outside of banks. Therefore, by re-regulating banks we have to widen our vision. As the Governor said, the FPC has a right under the other Bill to make recommendations to the Treasury on the perimeter of regulation. That is a very important part of that Bill and a very important part of the FPC’s responsibility.

Chair: This Commission will be returning to the question of regulatory arbitrage, and in that context we will probably look at some of the points you have raised.

Q1208 Mr Love: Governor, may I come on to the relatively simple issue of the leverage ratio? Is the adoption of a lower leverage ratio than that recommended by the Vickers Commission the right decision?

Sir Mervyn King: No.

Q1209 Mr Love: Tell me why.

Sir Mervyn King: I have always put a lot of store on the importance of ensuring enough loss-absorbing capacity in banks, whether it is equity or bail-inable debt. A metric for deciding how much you need is probably better measured by the total of assets rather than risk-weighted assets of a bank. I have three concerns about relying too much on risk-weighted assets. One is that risk weights are set in an international process which is very hard to negotiate and therefore extremely inflexible, so obvious things do not happen. We got into a situation where, in the Basel regime, sovereign debt has a zero risk weight. Nobody in Basel setting the regime up today would ever want to do that; it is where we are because of the length of time it takes to negotiate.

The second concern is that risk weights change over time. The whole conceptual framework of a way of looking at the different components on a balance sheet and attaching a risk weight to those and then adding them up has no solid, theoretical foundation whatsoever. You do not measure the riskiness of a whole portfolio of assets by looking at them individually and saying, "This has a certain degree of risk" and adding them up. You need to look at all the interactions between assets and the riskiness of the portfolio as a whole.

So it was a rough and ready approach that was adopted in Basel. That worked well in normal times, but the difficulty-and this is where I think the most important thing comes in-is that when you have a major financial crisis, almost by definition it is a time when the things you thought were risky or less risky turn out not to be. Often, everything becomes risky at the same time and, most important of all, very highly correlated. The risk weights are not timeless variables that any group of experts-let alone committees-can actually determine and set down. That is why a far better predictor of the institutions that failed in the crisis turned out not to be by measure of risk-weighted assets and the traditional capital ratio, but by leverage ratio.

In normal times, risk-weighted calculations may be a very helpful tool for the supervisor to use because it tries to ensure that banks do not just go for the riskiest assets. But it is not going to help when there is a real crisis, which is why-whether you call it a back-stop or a primary function of regulation; whichever approach you take-a leverage ratio is absolutely fundamental. Vickers proposed that leverage would be restricted to 25:1; the current legislation says 33:1. For my taste, 33:1 is much too high, but it is a matter of judgment. If you ask me, I would go back to the original Vickers proposal.

Q1210 Mr Love: The 33:1 is the Basel standard?

Sir Mervyn King: For all banks, and Vickers makes the point-and it is a fair point-that, for those banks outside the ring fence, which are in an internationally competitive market, maybe we should have the same standards as other countries. Even there, there is a caveat because where your banking system is very large-as in the case of both Switzerland and, to some extent, Sweden-they decided that it was in their national self-interest to have a tougher leverage ratio than the Basel minimum because it reduced the risk to taxpayers in those countries. That is a decision that we ought to be free to take; I would certainly not want to be any more lax than the original Vickers proposal.

Q1211 Mr Love: Are any further steps being taken to mitigate the risks you have just explained in risk-weighted assets? If we are going to live by an international standard-

Sir Mervyn King: Yes, they are. There is a serious attempt under way in the Basel committee-in which Adair Turner, Paul Tucker and Andy Haldane are involved-to increase the risk weights applied to the trading book of banks. That will clearly affect the amount of capital which the large international investment banks or universal banks will have to set aside. A lot of work is being done to try to reduce banks’ ability to use their own models to produce risk weights that they can use to calculate their required regulatory capital. It is very hard to monitor the models, and you end up with an absurd degree of complexity. A lot of work is going on to try to reduce the extent to which banks can gain the system by using models.

Work is being done, and it will lead to a significant increase in the amount of regulatory capital. There is no doubt about that. The problem we have is that before the crisis, banks did not need very much capital at all, either to satisfy the regulations or, interestingly-this is most important of all-to persuade people to fund them and finance them. People were willing to lend money to banks, even though they were unbelievably fragile. People did not realise how fragile they are.

The problem we have now is not that the regulations are going up-they are going up slowly but steadily to what I regard as a minimal level for safety in the future-but that the market has said, "Now we’ve seen how risky banks can be, we need them to have a lot more capital. Forget the regulators. We are not interested in what the regulators want. We want a lot more capital in banks to persuade us that it is safe to invest in those banks." That is the real constraint being faced at present.

Q1212 Mr Love: But that is a constraint at the moment, and there may come a time when that constraint lessens. We have to guard against that.

Sir Mervyn King: Absolutely. We have always said two things at the Bank. First, it is important that there be a sufficient minimum degree of equity capital and maximum constraint on leverage in the long run. Secondly, there is no rush to get there as part of the Basel process. You can take time to get there as part of the Basel process, because the constraint that is coming now is largely from the market.

Q1213 Mr Love: What do you say to the representations that have been made before this Commission that the 4% leverage ratio creates problems particularly for mortgage-focused lenders-low-risk lenders-and that that will have an impact on not only them but the wider economy?

Sir Mervyn King: This goes back to Andy’s earlier point that banks will always say, "Gosh! If you impose tougher regulation, we won’t lend." For one individual bank, that may be true, but let me remind you of the example of Northern Rock, which was not germane to the financial crisis. It was a tiny pimple on the sea of what was going on in the world financial system, but it mattered to the UK and to the debate. Northern Rock was one of the first banks to adopt Basel II. The risk weights enabled it to operate with an effective leverage ratio of not far off 80:1-a staggering degree of leverage. It was incredibly vulnerable.

It would not be sensible to allow a mortgage lender to build up to that degree of leverage. It is important to constrain the degree of leverage. If for that one bank it means that it will be lending less than it otherwise would, it means that we are minimising the risk that something will go badly wrong.

Q1214 Mr Love: But the point that has been made to us consistently is that you will incentivise them to take on riskier assets.

Sir Mervyn King: I find it rather peculiar that somehow a bank would say, "Let’s find a lot more risk to take for the sake of it." That does not seem a very rational commercial strategy. I think the markets will see what activities banks are undertaking, and the cost of capital will change for those banks if they undertake a riskier set of activities.

Paul Tucker: It is very important that banks have to disclose a lot more about where they are taking risks, because what you described plainly happened and could happen again, and the underlying problem is that the asset management industry is not looking at risk-adjusted returns. I think they could fairly say at the moment that it is quite hard to do that when they cannot see what is inside the banks. The industry has come up with a disclosure framework internationally that goes a lot further than anything the regulators have demanded so far, and we and the international community have welcomed that.

This is a difficult thing to get right. First, on the points the Governor made about Northern Rock, even a 33% requirement will improve things from where they were. It may not improve things enough, but be in no doubt that it will be a real constraint. The real question is that if the rest of the world is on 3% and we are on 4%, does that mean that there will be new entrants using the passporting right from the EU to do retail banking in this country on slightly more lax terms? I am not saying that will happen. At the very least, if the Government do not go as far as implementing Vickers in full, the regulator needs to have the power to say to the ring-fenced bank, "Your business is too risky, the leverage constraint on you is lower."

Q1215 Mr Love: The passporting danger has been highlighted by other witnesses. There is a second issue in relation to PLAC requirements. I quote from the document produced in October by the Treasury: "The Government does not believe it is appropriate to set PLAC requirements against RWAs held in non-EEA operations of UK-headquartered banks, where they pose no likely threat to UK or EEA financial stability." Is that something you agree with, Governor?

Sir Mervyn King: I think this goes back to the original Vickers proposal about the onus of proof on not requiring enough loss-absorbing capacity in the group as a whole. Vickers thought that it should be on the bank and it has switched to being on the regulator. I think that is unfortunate. I think it needs to be on the bank itself.

I add one further point, which is most important: if, irrespective of where the onus of proof is, there is to be a reliance on loss-absorbing capacity in the group as a whole, rather than in the ring-fenced bank, it is absolutely vital that the holding company be regulated by the PRA. The worst outcome here would be to allow banks to say, "We’ve got plenty of loss-absorbing capacity somewhere in the rest of the world and it’s in a holding company, but sorry chaps, you don’t regulate our holding company." That would not, I think, be a happy outcome. I would not rule out the fact that it is possible to use loss-absorbing capacity outside the ring-fenced bank to provide comfort, but the onus of proof should be on the bank, not on the regulator. That would really alter the terms of trade in the discussion and that is what Vickers proposed. I think that in addition to what Vickers proposed, it is rather important that the PRA has the ability to regulate the holding company.

Q1216 Mr Love: What is the appropriate test for judging whether an overseas operation poses a threat or not?

Sir Mervyn King: I am going to take advice again from the two people I regard as experts in this area. They have much more experience of it than I have.

Mr Love: We will let Mr Haldane start off.

Andy Haldane: The test is very similar to the one that Paul outlined earlier: is it possible that this overseas entity, say, could be wound down in a situation of stress without requiring support from the parent institution or indeed, prospectively, from the domestic taxpayer here? That would be the test. As I understand the recovery and resolution, or to use your words earlier, the living-will process, that is exactly the test that will be required. Paul is up on the detail of that, so he will be able to tell you more.

Paul Tucker: The only thing about that is that we, the UK authorities, have an international obligation to ensure that the worldwide group of any UK-domiciled banking group is resolvable. That is not the same as saying we must be the resolver. If you take a group that has massive businesses in Asia, America and Europe, we need to hold the ring and ensure that it is resolvable everywhere because otherwise the chaos goes to the global capital markets and comes back to the UK through that route. This underlines the Governor’s point, which I agree with very strongly, that you cannot do that unless you have some kind of regulatory power over the group holding company.

Q1217 Mr Love: Does the regulatory power stretch to non-EEA countries? Is there international agreement?

Paul Tucker: Indirectly, if you have power over the holding company you can say these overseas subsidiaries are undercapitalised, or the group as a whole is undercapitalised, and you should do something about that. This is a massive subject, which I have just not done justice to.

Q1218 Chair: We will have one more go, if you can bear it, at discussing it in relation to HSBC.

Sir Mervyn King: I think that it is difficult for us to discuss individual institutions, and not helpful. But the key principle is-

Chair: Everybody knows the key institution we are talking about here.

Sir Mervyn King: No, I think it is important to make clear that we approach this from a point of view of a principle, irrespective of how many institutions it might apply to. The principle is that if there is to be a holding company that is meant to give comfort to the ring-fenced bank, we should require the holding company to have issued enough loss-absorbing capacity to provide adequate comfort. We do not want to rely on capital issued by an overseas subsidiary; really, you ought to be at holding company level. We have had very productive discussions with our American colleagues on the question of how we would, in practice, resolve banks that span our borders. The reason we have had to do that is that it is impossible to find a legal resolution framework that will give the answers to everything, because Congress is not going to sit down and discuss easily with you whether they should amend their legislation.

In practice, what we have to do as supervisors is ensure that the legal structure of the banks in place makes it feasible for us, within the existing legal structures, to resolve banks. We put a great deal of weight on both sides of the Atlantic on the holding company itself having enough loss-absorbing capacity, so that it can be resolved at that level. If that could be done, there would be a case for the regulator saying, "Well, you have made a good argument to me; I will allow that to provide comfort to the ring-fenced bank." But the onus ought to be on the bank, not on the regulator.

Chair: We have had that message, and it has come across very clearly.

Q1219 Lord McFall of Alcluith: Governor, I have four short questions. First, I was a bit dismayed to hear the debate on depositor protection, because the then Treasury Committee in 2008-09 recognised that there was risk in all banks. In fact we were not convinced that £85,000 was the right limit, because customers have to be educated in terms of risk. It could have been less; in fact, we called for adverts in every bank, but we also called for the industry to look at the issue of short-term loans. I just wondered if any thought has taken place in the industry, or if you know of any initiatives. If not, is there not a case now for asking them to go on and look at that particular problem?

Sir Mervyn King: No, I think it is absolutely right. One can make a very strong argument for, say, not raising the limit in general-I am very happy to consider this-but for combining a strong advertising and educational campaign to say that the limit is £85,000, provided there is some extra set of provisions that will cater for people who find themselves holding large deposits for short periods. It ought not to be beyond the wit of man to devise that. We have been pressing the argument and the case for considering that for some time without much response, which is why I raised the question that I worry about the fact that this is precisely the kind of issue you raise for a bit and then after two or three years people say, "Oh, well, we’re not going to get another case like that, are we, for quite a long time." It is exactly the same problem that occurred with the issue on resolution, where well before the crisis, we said, "You have got to have a resolution framework for dealing with banks." "Okay, we’ll think about it, but it can’t possibly be an urgent problem." It was not an urgent problem until it happened. That is a very good example of something well defined and relatively narrow. We need a technical solution to that problem, and then I would certainly agree with you about a proper educational campaign to say, "Think very carefully. If you want to hold more than £85,000, it will not be insured."

Q1220 Lord McFall of Alcluith: Good. Paul, how big is the risk to the world economy from complex and unregulated derivatives? We have had many estimates, from the trillions to-I googled-£1.2 quadrillion. If we have a large number of derivatives unregulated and that market is still going, when we look at the banking system, aren’t we, in a sense, dealing with a mouse compared with the dinosaur of the unregulated non-banking system?

Paul Tucker: It is a very important point; it is a very serious threat. The key measure that is being taken to protect against that threat is to require what I hope will be a very big proportion of that market to be centrally cleared, through a so-called central counterparty. I think this was touched on when Andy gave evidence to you a couple of weeks ago. This is the first time that the international community-the leaders-effectively mandated financial institutions, the so-called central counterparties, which will be too important to fail. In parallel to everything we have discussed, there is a very significant exercise in this country and globally to ensure that there are adequate resolution arrangements for central counterparties, including, domestically, ensuring that central counterparties have to have rules that allocate losses. Something that I think is now in the Bill is a right for the Bank of England to direct central counterparties to ensure those rules are in place. Inevitably, they have somewhat resisted that, and that resistance must be ignored.

Q1221 Lord McFall of Alcluith: But we are a long way off from that and there is still a big cause for concern.

Paul Tucker: I know. I think so far, so good on this. Whether in this Commission, in the Treasury Committee or elsewhere, you should come back and ask us about this. This is in parallel to the shadow banking debate. We can make banking safe and blow up the world by allowing some non-bank, a central counterparty, to be vulnerable.

Q1222 Lord McFall of Alcluith: Governor, are there going to be aftershocks with LIBOR? Is financial stability going to be threatened by, for example, class actions on a global scale?

Sir Mervyn King: There are two areas in which there might be, in your phrase, aftershocks. One is that we do not know how the class action suits will evolve. One of the additional burdens on banks at present, for which they will need to provide capital, is the increasing consequence of regulatory fines of all kinds-not just LIBOR. The class actions could potentially be large, but I am no lawyer and I do not understand how big they could be. It is certainly one of the uncertainties that is weighing on banks and will add to the difficulty they will have in obtaining funding. That is one aspect.

The other aspect, of course, is that, as the financial conduct agency-to-be has said, the problems may not be confined to LIBOR, but to commodity markets or other areas in which quotes were used as a basis for transactions. The biggest consequence of all this is not a shock of any kind but a big improvement, in that people around the world, and certainly the central banks in Basel, are discussing it to try and encourage the market to move away from quote-based transactions-the prices set by quotes-as far as they can. It does not make sense to have so much of the derivatives market linked to a quote based on a small number of banks that cannot easily be monitored or checked.

Where it is possible to devise alternatives to that system, we should try to encourage the market. Because there is a free rider problem here, it may mean that we will need to do some work to encourage the market to come together and collectively decide that from a certain date onwards they will shift away from these quote-based systems. To my mind, that is the biggest question here.

Q1223 Lord McFall of Alcluith: Governor, in a pub in the shadow of Adam Smith’s alma mater, I was approached by a number of guys in a disrespectful way and asked why only two guys, who were from west of Scotland council housing estates, were collared for the financial crimes of the crisis. I bought them a pint and they calmed down, but I also said that I knew some erudite people and that I would ask them the question. So I am asking that question and will deliver the answer in the shadow of Adam Smith’s alma mater.

Sir Mervyn King: I cannot comment on the actions of the FSA or the prosecution authorities.

Q1224 Lord McFall of Alcluith: There is a deeper aspect to the question, as you know.

Sir Mervyn King: There is a much deeper aspect. I do not want to comment on the question of prosecutions. To some extent, what is most important is that we do not think that the answer to this crisis, and to avoid a repetition of it-this is what I would spend some time talking to these guys about-is to find another 15 guys from different backgrounds, send them to prison and say, "That’s fine, it won’t happen again." We can debate and discuss the fundamental causes of the crisis, but, in essence, they were not individual wrongdoing; it was a failure of a system. All of us have a responsibility to put in place a framework for the operation of the financial system that removes the incentives for people to take such risks or to get themselves into a fragile position. The big answer I would give to the people you met is, "I understand why you are angry, and I understand why, in some sense, you want to see people punished, but it isn’t going to do any good." What will do some good is to change the system, and that is what we should be doing.

Q1225 Lord McFall of Alcuith: In terms of changing the system, what things should we keep in mind as a banking commission?

Sir Mervyn King: We have debated a lot of detail and a lot of important questions that will need to be resolved before the legislation is passed. But as I said earlier, I have been arguing for some move along these lines for five years and not many policy makers were prepared to stand up and say that at the time. It was very unpopular. I will feel deeply disappointed if the outcome of this debate is that we do not implement Vickers now. If we implement something better now, it may be even better, but that is not the choice. I think the real choice is to do Vickers now with proper scrutiny of the secondary legislation with the detail put in, and to put in place some mechanism to review its success a few years down the line, so that we then have the option of going further if it turns out to be necessary. But please do something, and do it soon.

Chair: Thank you very much for that clear, almost valedictory message. The seven months and eight days tick by.

Sir Mervyn King: Since I come back to see you again in only four days’ time, Chairman, far from being valedictory, there are probably many more occasions.

Chair: The time has flown very fast this morning, as it always does when we are listening to high-quality evidence, which is why we feel the need to see more of you, and I am sure that we will before long. As you say, it is only four days before the Treasury Committee comes round.

Sir Mervyn King: See you on Tuesday.

Chair: Thank you very much for coming this morning. It has been extremely valuable, and we will probably be having further exchanges in the new year on related subjects.