Examination of Witnesses (Questions 80
THURSDAY 20 SEPTEMBER 2007
Q80 Mr Mudie: Okay.
Mr King: The lender of last resort
facility was announced on the Friday and on Sunday I was askedto
be quite clear because it was a facility we were extending and
if any bank were to bid for Northern Rock they would need to know
the terms for the bank that they were acquiringvery explicitly
would the lender of last resort facility that had been extended
to Northern Rock be rolled over with the rest of the bank to a
bidder, and I said yes. I encouraged the bid process. However
I can tell you that last Sunday the only solution to stopping
the run was a Government guarantee; anything else was a sideshow.
Only a Government guarantee would have been sufficient to have
persuaded the depositors to leave their money in Northern Rock.
Q81 Mr Mudie: Just going on to one
last question in terms of the second major matter of the three-month
money. The Chairman asked you that question at the beginning and
you said later on to one of my colleagues that there were four
reasons. I wrote down, not in shorthand but as best I could as
a poor Scot, your four reasons. I got two of them, if I can read
my writing, queues was one, the media was one, and I am not sure
I got the other two. In that letter that you wroteand you
knew about Northern Rock when you wrote this letter that put you
in the corneryou said "strong reasons" and then
you said to one of my colleagues "four strong reasons".
Could you spell out
Mr King: The number four was referring
to the four unconnected pieces of legislation that were relevant
to the difficulties we had.
Q82 Mr Mudie: So what were the strong
reasons then because you needed strong reasons to depart from
your macho line? Tell us the strong reasons then.
Mr King: As I said in the statement
to the Chairman, the balancing between concerns about strains
in the banking system as a whole and the moral hazard that I have
described is a balancing judgment that we were making almost daily,
and we did make it daily, and after the weekend we had seen some
volatility in the overnight rate, we had seen some upward movement
in the spread in longer term markets, and we had seen people worried
about the reputation of the British banking system and strains
in it, and I judged at that point that the right balance to strikeand
people can reach different views on it, I do not pretend there
is an absolute right or wrong hereI reached the judgment
on balance that it was better to conduct a limited operation which
minimised the risk of moral hazard but did inject at that point
through the announcement of the auction to be held next week some
additional liquidity. That balance is one that everyone has to
strike in a central bank and I struck it in that way.
Q83 Mr Mudie: What do you think of
the FSA meeting the bankers in the morning, when you met them
in the evening, either directly or implicitly indicating that
they thought you should do this U-turn?
Mr King: I cannot comment on the
meeting with the FSA but I can comment on the meeting that I held.
I had asked for a confidential meeting with the bankers and they
came along and I had hoped that it would have been regarded as
confidential. In that process of course they said they would prefer
to have more liquidity at a lower price. That is not very surprising.
If I were in their position I would ask for exactly the same.
I tried to explain why if they were in my position they would
understand that I had to make a public policy judgment which is
to balance the use of providing free liquidity to them against
Q84 Mr Mudie: But it was not the
rate that you were charging, it was the assets that you were prepared
to take, you were extending them.
Mr King: And what I discussed
with them at that meeting quite explicitly was to ask them why
they felt that extending support with liquidity injections against
a much wider range of collateral would be helpful to them and
they explained that it would. In the auction that we announced
yesterday we announced that we would be willing to allow people
to bid against collateral for a very much wider range of liquidity
including mortgages. That is not something that either the Fed
or the ECB have done and we did that because we felt that it was
the breadth of the collateral that was important rather than the
size of the operation.
Q85 Peter Viggers: Is there a qualitative
element in the guarantee you are giving to retail deposits? Does
the guarantee cover less prudent as well as more prudently run
banks or is it a blanket guarantee?
Mr King: The Chancellor said that
the guarantee would be available to banks who found themselves
in a similar position. I think what that means is depositors should
be reassured that when they put deposits in a British bank they
will be completely protected. In the long run that is clearly
not a sustainable resting position but in present circumstances
I think it is absolutely vital.
Q86 Peter Viggers: How severely do
you think the principle of moral hazard has been compromised since
you wrote us your rigorous and lucid letter?
Mr King: I hope that it has not
and I do not believe that it has but, as I said, this is a balancing
judgment. When I listened to the banks I do not believe that they
felt that offering them an ability to bid for liquidity at a 100
basis point premium over bank rate was something that they regarded
as entirely generous, so I think there is still a fair chunk of
restriction against moral hazard in what we have done.
Q87 Peter Viggers: When you make
advances under the proposed auction it will be against, as you
have just explained, a very wide range of collateral including
mortgage collateral. How rigorously will you be able to scrutinise
the mortgage collateral that has been offered to you? Will there
be collateralised debt obligations, securitised mortgages, which
will be in a bundle and which will not be capable of proper analysis
Mr King: Let me ask Mr Tucker
who is responsible for dealing with the practicalities of this.
Mr Tucker: We will announce the
details tomorrow. There will not be collateralised debt obligations.
There will be triple A tranches of prime mortgage-backed securities.
The issue that you raise is an important one. It will be addressed
by conservative haircuts so that we would lend against X% of the
value of the security and the haircuts will be conservative for
precisely the reason you say.
Q88 Peter Viggers: Perhaps for those
who are not conservatives and do not know about haircuts you would
just explain that?
Mr Tucker: Sorry. Say a security
is valued at £100. We might lend £50 against that £100
security or £70 against that £100 security and that
would protect us against a fall in the value of that security
during its life. That is the first step. The second is that the
loan will be for three months. If the value of the collateral
we hold falls during that period we will call for more collateral
to protect ourselves and then if a borrower were to default we
would be protected by the haircuts I described at the beginninglending
a fraction of the value of the securities that we hold.
Q89 Peter Viggers: Very well. Governor,
when the Memorandum of Understanding effectively took direct banking
supervision away from you and gave it specifically to the Financial
Services Authority it is now quite specifically responsible for
the prudential supervision of banks, building societies and for
the conduct of operations in response to problem cases affecting
firms. You happen to be here today and the original intention
was to talk about the Inflation Report
Mr King: Indeed!
Q90 Peter Viggers: But it should
really have been the Financial Services Authority which should
be answering many of the questions which are being put now. Yet
on the other hand when a proposal came through to provide a lifeline
and a rescue operation it was the Bank of England, as you have
explained to us, which led on this. Would you not agree that the
comment originally made in 1997 that the Memorandum of Understanding
was "unworkable in a crisis" has actually been proved
to be correct?
Mr King: No, I do not accept that.
One of the very good reasons for taking supervision away from
the Bank of England was that it was becoming more and more impracticable
to regard banks as being part of the financial system that could
be regulated independently of a wider range of financial institutions.
The whole process of supervision now is much more formal, much
more legalistic, much more international. I think it is a full-time
job. It takes up all the energies of senior people to do that.
In the event of any crisis like this it is inevitable that those
responsible for supervision, those responsible for central banking
activities and the Government have to work together irrespective
of where they are actually located, so even if two of those had
been in the Bank of England we would still have had to work with
the Government so having all three people there I think is crucial.
The MoU in my experience has ensured very effective, speedy communication.
Callum McCarthy, the Chancellor and I have talked regularly and
frequently. We have a team of deputies under us who speak even
more frequently. I do not believe that the communication or the
effectiveness of the tripartite arrangements have been in any
way responsible for this. Indeed in my experience it has enhanced
it. I just do not believe that one institutiona central
bankcan manage in today's world both monetary policy and
the entire range of financial supervision.
Q91 Peter Viggers: And is the communication
between the three members referred to formalised and will communications
between the three of you be published?
Mr King: I think that will depend
on the chair of the tripartite arrangements. I would expect a
lot of the conversations that we have held to remain confidential
because they are market sensitive. We have had many communications
both formal and informal and the informal collaboration and communication
between the Chancellor, Callum and myself has been absolutely
crucial in dealing with what was a fast-moving set of events.
Q92 Peter Viggers: Finally can I
ask Paul Tucker if he would comment on the current state of the
commercial paper market?
Mr Tucker: A little bit better
than a week ago. This is important and over the last few weeks
the underlying problem has started to be addressed. The underlying
problem is that investors should distinguish between one type
of security that has got real difficulties and other types of
security that are maybe okay. That process will take a while and
it does seem to be gradually underway. I think there is still
a long way to go and there could still be setbacks. The last ten
days in terms of global markets as opposed to our local position
have been very mildly encouraging.
Q93 Peter Viggers: And how important
was it that banks were unable to raise money on the commercial
Mr Tucker: I think the fact that
banks and these so-called conduits were not able to raise commercial
paper or were only able to raise commercial paper at very short
maturities is right at the heart of the problem. It is difficult
to see that the problem will be resolved without either that market
being restored to something like normality or, alternatively,
a lot of that paper coming on to banks' balance sheets, reintermediation
if you like from the capital markets into the banking system.
It is because of the latter possibility that banks have been stockpiling
liquidity and trying to protect themselves against that eventuality
and that has been individually rational but collectively deleterious.
Q94 Ms Keeble: I wanted to ask a
bit about the role of the credit ratings agency. I have also got
some questions, Paul, on some of the things you have just said.
Sir John, I wonder if you could say from the FSA's point of view
if you think that the ratings agencies have provided markets with
the kind of information that they need on which to base their
Sir John Gieve: I think this is
something that we are going to look at on an international basis
with other regulators and central banks in the future. I think
that people definitely relied on ratings agencies' ratings in
an inappropriate way. The ratings agencies would say that if they
had read the fine print there was plenty of explanation about
the limited assurances that they were putting forward. But I think
many investors and people setting investment remits did just say
"if it is triple A it is all right", not distinguishing
between different sorts of instruments. What we obviously need
to look at is did the ratings agencies do it wrong or was it the
investors who did not use the ratings agencies properly and put
too much dependence on them?
Q95 Ms Keeble: If I can just come
back on that. Firstly, why so late and, secondly, it is fairly
well-established, is it not, that the ratings agencies work very
closely with the banks to compile the vehicles to attract the
kind of ratings which are then required to be attractive on the
market; would you accept that? Why so late and do you not think
that it is really unacceptable to have the ratings agencies virtually
colluding with the banks in the construction of vehicles which
are then, as the Governor has accepted, risky?
Sir John Gieve: I think the ratings
agencies' response to that is that their reputation and their
future business depends on producing ratings which stand up in
Q96 Ms Keeble: But what is your response?
Sir John Gieve: I think there
is a question about whether they went too far in relying on their
models to put firm ratings against products which did not have
an obvious market value. Particularly in the sophisticated credit
derivatives field, where they have, I think, as good models as
anyone, maybe those models were simply too limited to justify
a firm rating.
Q97 Ms Keeble: And then for Paul,
because you are obviously working at a different end of it, when
you did your report on July 25 warning of the risks, what did
you rely on and in saying now that this week is a little bit better
than it was a week ago, what are you actually looking at and what
real risks are you taking into account? Then I wanted to ask the
Governor something about this as well.
Mr Tucker: What are we relying
on? First of all, we are relying on two sources of information.
One is conversations with people in these markets around the world,
both people who are selling commercial paper, coming back to that
particular question, and people who are buying commercial paper.
This would go not just for the commercial paper market but across
a whole range of markets. The second source of information is
published information on the prices at which, in this case, commercial
paper is being issued and also the quantities that are being issued.
It is virtually always a blend of market intelligence drawn not
just from the banking system but from asset managers and from
many others as well and hard information produced from all sorts
of sources, some of them official.
Q98 Ms Keeble: If I can just ask
the Governor because this issue about risk assessment is something
that the Committee has looked at in the private equity investigation
as well and you referred to the possibility in the coming weeks
of what would happen if the banks were forced to take riskyand
I have not got your exact words because I have not got perfect
shorthand eitherrisky conduits and special investment vehicles
back onto their balance sheets? Which are those risky investments
and how do you know where they are if you have not got the ratings
agencies giving a good, robust assessment of what the risks are?
Mr King: Can I step back one point
because I think it is very helpful to put this in the context
of the real financial crisis that started on 9 August. I know
most of the questions naturally have been about Northern Rock
but we should not forget that all this came out of this general
problem that you are referring to.
Q99 Ms Keeble: That is right, I want
to know where the risks are and if there are more out there.
Mr King: I will come on to that.
There is one point I want to make about ratings agencies. There
is a very important call and longer term analysis to be made of
how ratings agencies behave. The conflicts of interests that you
have alluded to are clearly part of that, but it would be most
unfortunate in present circumstances if for political reasons
pressure was brought to bear on ratings agencies to have a knee-jerk
response to go completely in the opposite direction and to downgrade
everything at sight because they might be held responsible for
their behaviour. That would lead us into a really difficult position
and I know you are not suggesting it but it has come up in various
international fora. We need a long look at that. In terms of the
risks, what has happened is that many of the banks created these
vehicles to hold off balance sheet (perhaps sometimes to avoid
regulatory capital requirements). These vehicles hold securities
in which the market is now illiquid. The banks will now have to
take back onto their balance sheets these assets which may well
be perfectly good value in the longer term when the markets re-open
but they are highly illiquid. That will require some use of capital
of the banks to finance this in the short term and that is why,
as Paul said earlier, banks are currently hoarding liquidity in
order to finance the taking back onto their balance sheets of
these vehicles. They know what these vehicles are, they set them
up, and the FSA and the parallel regulatory authorities around
the world have been talking to the banks and finding out whether
the banks know about their exposures. They say to us that they
are confident that all the major banks know about their exposures
and that they could take these back onto their balance sheets
without any major hit on their capital so that they would still
be left with capital well above their capital regulatory minimum.
It does mean that the banks will have to find more expensive sources
of liquidity than they had expected or hoped, they will pay a
price in terms of profits. There is absolutely no difficulty in
due course in their doing so but in the meanwhile there is this
great demand for liquidity. You can get liquidity at a price and
this is a matter of price.