CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 34
House of COMMONS
MINUTES OF EVIDENCE
24 November 2009
MERVYN KING, MR PAUL TUCKER, MR PAUL FISHER, DR ADAM POSEN
DR ANDREW SENTANCE
Evidence heard in Public Questions 1 - 82
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Taken before the Treasury Committee
on Tuesday 24 November 2009
John McFall, in the Chair
Mr Graham Brady
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr James Plaskitt
Sir Peter Viggers
Mervyn King, Governor, Mr Paul
Tucker, Deputy Governor, Mr Paul Fisher,
Executive Director, Markets, and Dr
Adam Posen and Dr Andrew Sentance, External
Members of the Monetary Policy Committee, Bank of England, gave evidence.
Q1 Chairman: Governor, we welcome you and your colleagues to the Committee's
inquiry into the November inflation report. Perhaps you would introduce
yourselves for the shorthand writer.
Mr King: On my right is Mr Paul Fisher, executive director for markets; on
his right is Dr Andrew Sentance, one of the external members of the MPC;
on my left is Mr Paul Tucker, deputy governor for financial stability; and on
his left is Dr Adam Posen, again one of the external members of the MPC.
Q2 Chairman: You have an opening statement to make.
Mr King: I do. When we appeared before you a year ago I described how a
remarkable set of events had transformed the outlook for the UK and global economies. At that
time in the wake of the financial crisis output was plummeting and inflation
was beginning to fall from its peak of 5.2%. A year on, the sharp falls in
output appear to have come to an end and we are encouraged by signs that a recovery
will soon be under way, but the recession means that the level of spending is
now markedly lower than it was in the first half of 2008 and, looking ahead,
the economy continues to face profound challenges. That lower level of spending
has opened up a significant margin of spare capacity in the economy which is
evident both in surveys of companies reporting that they are working below
capacity and in the labour market. Unemployment although relatively stable over
the past few months is now close to 8%, markedly higher than the levels to
which we had grown accustomed. That margin of spare capacity will act to pull
down on inflation in the medium term. Notwithstanding this effect, inflation is
likely to rise sharply in the coming months from its current level of 1.5% to
above the target, reflecting an increase in petrol price inflation and the
prospective reversal of last year's cut in VAT. But these are price level
effects. It is not sensible for monetary policy to respond to those types of
effect as they will influence measured inflation for only a year when policy
does not have much traction on inflation over such a short time horizon. In the
medium term when policy has its most significant impact it is the level of
money spending relative to the supply capacity of the economy that determines
inflation. Powerful forces continue to restrain spending in the economy. Banks
are actively trying to reduce their leverage. There is a long way to go in that
process and while it continues the availability of credit to households and
companies will be impaired. That combined with uncertainty about future incomes
and profits will make households and companies reluctant to spend. The need for
a credible plan to consolidate the public finances is clear to everyone and
will mean that a lower share of national income is devoted to consumption - either
private or public - in the future. Although there are encouraging signs of a
recovery overseas the level of world demand and hence demand for our exports is
well below its level before the crisis. These forces will act to restrain
spending for a considerable period. It is to counteract those forces that the
MPC has taken unprecedented monetary policy actions over the past year. Bank
rate is almost at zero and the MPC has now extended its programme of assets
purchases to £200bn. That programme is injecting additional money directly into
the economy. Investors are using some of this money to diversify into assets
that have a higher return and that in turn boosts the prices of those assets, reduces
yields and the cost to companies of raising funds in financial markets.
Ultimately, that will help to restore the level of spending to a path
consistent with eliminating spare capacity and ensure that inflation is on
track to meet the target in the medium term. The events of the past year or so
in financial markets and the bank's responses have been extraordinary. I have
sent a letter to the Committee to explain more fully one aspect of the bank's
operations that was prompted by those events: lending facilities that we put in
place at the height of the crisis for two individual institutions that we are
now able to disclose. Having experienced the wider economic consequences of the
financial crisis it is right that households and companies expect fundamental
reform of the structure and regulation of our whole financial system. As part
of that process, last week the Bank of England published a discussion paper
setting out its initial views on how so-called macroprudential policy might be
designed. We hope this will spur a debate and bring us closer to the point at
which we can implement lasting and effective reform. I am grateful for the
opportunity to make those opening remarks and I and other members of the
Monetary Policy Committee here today stand ready to answer your questions.
Q3 Chairman: A number of commentators have commented on the bank's optimistic
growth figures for 2010 and 2011 and said that when you announced your
inflation report your comments seemed to be at odds with the MPC's written
proposals, in that you seemed to be more downbeat. What is the situation?
Mr King: I think they are completely consistent. This is a point where we
need to look not just at growth rates but also levels of output and spending.
That is why on pages 6 and 7 of the report you see charts that show exactly the
same outlook, one representing the growth rate of GDP over the forecast horizon
and the other showing the level of output. In terms of growth the most likely
outcome is for rates above the long run average growth rate of the economy.
Taking into account the downside risks, the average growth rate for calendar
year 2010 in chart 1 on page 6 of the inflation report is around 1.5
percent and for 2011 it is around three percent. Therefore, over those two
years the average growth rate expected by the committee is slightly lower than
the long-run average growth rate of the economy. Given that we have been in a
period when there is a great deal of spare capacity from which the economy can
recover and expand without putting any upward pressure on inflation that is not
a particularly strong recovery. That is shown very vividly in chart 2
which indicates the level of GDP. That shows that for the foreseeable future
the level of total GDP is well below - that is, about 10% - the level we would
have expected it to reach had we continued to grow along the trend before the
crisis hit in 2007. In terms of the experiences of businesses and households
and what is happening to companies in the labour market the chart will
illustrate the experience that they will have. One should expect fairly buoyant
growth rates in the short run having come back from such a deep recession. I do
not believe there is any inconsistency between the two. Charts 1 and 2
represent exactly the same outlook for the economy but from different angles. I
think it is important for people to think in terms of levels, not just growth
Q4 Chairman: You have always said that. Thank you for the information on the two
banks, the RBS and HBOS. You said that the Bank of England extended emergency liquidity
assistance to these two institutions. We note that you have afforded them
£61.6bn. When I and my colleagues received this note we had a little intake of
breath and thought about how many universities, colleagues and jobs could be
supported with that money. It lends credence to the view that we need to fix
this situation; otherwise, we will go back to what we had before and accept the
status quo. Can you tell us whether all those moneys have been repaid to the
bank? Given the view of Professor Miles that the banks are still on life
support, for what are they depending on you at the moment?
Mr King: As spelt out in the letter I sent to you, the loans to RBS and HBOS
extended in October 2008 were fully repaid, one in December 2008 and the other
in January 2009. Those loans were short-term liquidity support of a
"conventional lender of last resort" kind that the central bank is there to
provide. It bridged to the recapitalisation of the banks that took place in
October and again in January, but those liquidity facilities were fully repaid
no later than January 2009.
Q5 Chairman: At the moment for what are they dependent upon you?
Mr King: Obviously, we will not comment on individual banks, but the total
scale of dependency of the banking sector on the public sector through access
to central bank facilities, the special liquidity scheme and the credit
guarantee scheme is enormous and runs into many hundreds of billions of pounds.
There is still dependence by the banking sector on the public sector for
Q6 Chairman: You recognise that the banks need to restructure their balance
sheets and tighter capital controls are required. However, you also recognise
that lending will drive a private sector-led recovery. Would you prefer banks
to lend more or repair their balance sheets while we have a public sector-led
Mr King: It is not for me to say what banks should do and it is quite clear
that the incentives presented to banks at present are to run down the extent of
their leverage and get their balance sheets back into order. That is what
drives the restrictive supply of credit that we see not just in the United Kingdom
but also in other countries. That is the overwhelming driving force behind the
movement of credit at present; it is depressed by the actions of banks in
trying to restore their balance sheets.
Q7 Chairman: Dr Posen, you made an interesting speech a couple of weeks ago in
which you said that the UK lacked a spare tyre for lending to non-financial
companies. I was at a CBI conference yesterday where I was told that apart from
financial institutions 50% of lending went to commercial real estate and 5% to
manufacturing. We really need to do something to have a channel there. What is
your advice to us?
Dr Posen: I am glad to have the opportunity to respond to you on that, but
clearly I do not speak for the bank but for myself. There are many ways to skin
this cat. Part of it is to try to build up in a structural sense the ability of
small and medium enterprises to access capital markets. Large British firms can
but the bond market, as I cited in the speech which you kindly mention, is very
underdeveloped as a share of GDP. Apparatus and encouragement can be provided.
Government lending facilities can be put in place. There has been some
discussion in the past about whether these have been effective. I admit they
are not my first choice. There are efforts to use moral suasion on the banks
currently in public ownership; there is restructuring of the banking system to
create more competition; there is the use of moral suasion on banks such as foreign
banks that used to lend in the UK but understandably, like everyone else in the
world, have returned to their home markets in the past year. They can be
encouraged to come back. There are also efforts to try to broker deals with the
existing banking system to try not directly to mediate loans but make it easier
for small businesses to make applications and get them properly processed.
There are a number of things that this Committee and Parliament can consider
which essentially come back to two sets of measures. First, there are those
things you can do in the very short term to try to facilitate lending, because
we know that small and medium enterprises are hit worse during a recession. I
am worried that right now they are being particularly badly hit. Second, one
can think about the structure of the banking and financial system in the UK
over the longer term given that manufacturing and domestic non-financial
companies are not as well served as they should have been.
Q8 Chairman: Is it right that we need three or four years to think about
restructuring of the financial architecture?
Mr King: Yes. I share Dr Posen's view that the most optimistic outlook here
is the longer and not shorter term. I do not think it is easy to come up with
remedies in the short term, but in the long term to have a more diversified
pattern of funding the corporate sector would be an attractive route to go
down. That is often easier said than done, but it is worth exploring to find
out because we have seen how susceptible the small and medium enterprise sector
has been to problems that none of us anticipated would occur on this scale in
the banking sector.
Q9 Chairman: It appears that you and John Kay are in the minority regarding
separating retail banks from more risky activities. Bankers tell us that this
will lead to the mortgage market being controlled by a cartel. Previously, Lord
Turner said - he has expanded on his views - that it could outlaw perfectly
acceptable business activity. Have you been persuaded by the arguments of the
bankers on this?
Mr King: No. I think the debate has moved on. The most important point I
made was that if we are to think of restructuring the banking sector in the
future it does not really matter if we think that what banks do is socially
useless or useful; it does not matter whether banks are doing god's work. Let
us just think of something practical in the middle ground, which is that banks
must be subject to the same market discipline as all other industries. That is
a simple, obvious point. If banks screw it up and make bad decisions they
should be allowed to fail. In my view, there is no way you can run a system on
any basis other than that. Therefore, the real task of devising a regulatory
structure in future as well as the structure of the banking system is to think
through what you would need to do in order to get to the point where we accept
that a bank which made serious mistakes was allowed to fail and a regulator
that allowed that bank to fail would be able to do so safely and would not be
criticised for doing so. It would have got itself into a position where it said
that if the bank's management made bad mistakes that was just too bad; the bank
would fail and the creditors and the people who supplied funds must recognise
that they put their money at risk. That is the point which we must reach one
way or another. There are different ways of doing it. It will not be easy to
get there without further measures of separation. It is absolutely clear that
from now on all governments will want 100% deposit insurance for ordinary
retail depositors up to, say, the present limit of £50,000. If that is the case
it cannot make sense to allow banks to use that funding to go off and engage in
very risky activities in which they get to keep the upside and the taxpayer
must come up with the downside. Having restrictions on what kinds of deposits
are used to fund seems to me a very sensible change in the long run and in
essence that is what narrow banking is about. We need to have a much wider
debate about all the other ranges of banking activity and how that would be
funded. There is a three-legged stool on which it makes sense to try to rest
our approach; we should not rest it on just any one approach. One is structure
and it is important not to lose sight of that. You can already see one example
of that. In the debate about banks crossing borders many countries, including
emerging markets, now realise that it would be sensible for them to have
separate subsidiaries in their own countries of these global banks because they
need to have separate capital and liquidity requirements for those banks
operating in their territories. That is one example of structure but there are
many others. The second is capital. I am sure that capital and liquidity
requirements will change and be higher in future, but we at the Bank place a
great deal of weight on the potential contribution of so-called contingent
capital; that is, forms of funding banks that automatically convert to equity
when there is a call on them. Therefore, if the bank gets into deep trouble
that money counts as equity. Ultimately, that is the extreme case in which one
can ensure that no bank can fund itself by promising to make a guaranteed rate
of return and in the end is unable to deliver and the government feels that it
must step in to bail out the banking system. Therefore, capital is the second
leg of the stool. The third is resolution. In my Mansion House speech I
referred to wills. We have to do that. It will be difficult to push it far
enough, but regulators must be tough enough on banks to say they do not believe
their structure is simple or small enough for them to be able to allow them to
fail and therefore they must change the way they organise their activities. We
cannot end up in a situation where any regulator or government feels that an
institution is just too important or big to fail. That must now be the single
most important objective of the whole reform programme. There are different
ways to get there. I believe that to place weight on the three different legs
makes sense, but we cannot end up in a situation - there is still a way to go
in persuading some of our international colleagues of this - where we tacitly
accept that some financial institutions are just too big to fail.
Q10 Chairman: That is a core issue. You referred to a wider debate. This
Committee visited Japan in October 2007 and had access to the central bank and
policymakers. They said that two issues affected Japan: one was recapitalisation
and there should not be prevarication, which we have done; the other was public
anger and resentment and there had to be a strategy to deal with it. Do you
believe there is here a need for a more civic engagement to understand what the
future of banking is, what its purpose is and how it best serves the economy?
Mr King: Whether it is called "civil" or "political" I leave to you, but
there must be wider involvement. What strikes me most forcefully as I travel
round the country is that for a generation people adopted the view that market
discipline was the best route to prosperity. They accepted that if their
companies could not find customers they would fail and that if they worked for
such companies they would lose their jobs and perhaps they would have to get
other jobs perhaps on less attractive terms elsewhere in the economy. That
applied to every part of the economy until the bail-out of the financial
sector. That is wholly unacceptable not only from an economic point of view; it
will simply undermine people's commitment to the merits of a market economy.
That would be tragic. One of the great achievements of the market economy has
been greater prosperity not just to the citizens of this country but also
billions of people around the world who have been dragged out of poverty. We
must not lose sight of the merits of a market economy but we must apply its discipline
to the banking sector. That is why I place so much weight on dealing with the
issue of "too important to fail".
Q11 Chairman: The Committee is very much taken with that. The concept of "too big
to fail" and macroprudential tools are the two big issues in future. You have
said that a credible path to the reduction of government debt is necessary.
What is your view of the ideal of debt reduction given the current conjecture?
For example, is it better to reduce debt in three years rather than six?
Mr King: It is difficult to say what that number is; it needs to be
contingent on the state of the economy and no one can be precisely sure. But it
needs a credible plan over the lifetime of a parliament to bring down very
significantly the deficit contingent on the state of the economy. It must
depend upon that, but it must be a plan of action that would explain what would
be done in order to achieve that objective.
Plaskitt: On page 43 of your report you talk
about some permanent changes in the outlook for government revenues as a result
of the recession. For example, you talk about the path of lower output and
refer to lower tax revenues from particular sectors of the economy. I assume
that you mean the financial sector. Would you expand on the extent of the
permanent changes you see and the scale of the impact on the outlook for
Mr King: I think it is implied by chart 2 which shows the level of GDP. You
can see that for quite a long period that is expected to be well below the
level we might reasonably have expected had the economy not hit the financial
crisis in 2007-08. That is a pretty large figure of anywhere between 5% and
10%. On top of that is the fact that those sectors that generated significant
revenues in the UK, particularly the financial sector, and other transactions
taxes could not credibly continue to generate such large taxes; it was likely
to be the case that the turnover in the housing market, for example, would fall
back to more normal levels at a certain point and that the rate of increase of
profits in the financial sector would not continue indefinitely. Obviously,
that turned out to be true. Therefore, there are effects from both the impact
of the crisis on particular sectors that contributed heavily to revenues and
the impact on the total level of GDP. That means the amount of revenue will not
be of the order it would have been reasonable to expect.
Plaskitt: You are saying that even if there
is a return to overall GDP growth somewhere along the track that you project in
this report it will not have the same revenue buoyancy effect as growth has in
Mr King: Certainly, the level of revenue for the next five to 10 years is
likely to be well below that which would have expected in the middle of 2007 when
we were unaware that the financial crisis was about to hit.
Plaskitt: Given what you said in your
opening statement about the need for a credible plan to consolidate the public
finances, what are the ingredients of that credibility? What boxes must be
ticked for you to believe that the plan is credible?
Mr King: There must be elimination in large part of the structural deficit
over, say, the lifetime of a parliament which is the period for which a
government is elected. Anything beyond that is a statement of intent or hope
rather than a plan to which someone can be held accountable, but it will depend
on the recovery of the economy. If the world economy fell back and we found
ourselves in another period of downturn it would not be sensible to expect the
deficit to be eliminated that quickly. The path must be dependent on the state
of the economy. Nevertheless, it must be capable of being implemented over a
period for which an administration can be held accountable.
Plaskitt: Is it sensible to argue that if
government tries to consolidate the public finances too aggressively it may be
counterproductive in terms of support for the economy and may help to trigger a
Mr King: It is certainly true that if you eliminate the deficit too
aggressively it will have an adverse consequence. It is equally true that if
you implement it insufficiently aggressively it will also have an adverse
consequence. As to the debate about whether we should remove the stimulus too
soon or too late we should do it at the right time. That makes clear that it
must be a credible plan based on actions so people can see what would be done
in order to bring about the reduction in the deficit, but it needs to be
contingent on the state of the economy.
Plaskitt: Does not that qualification make
it really difficult to determine whether or not it is credible? You keep saying
that it is contingent on the state of the economy, which is an obvious factor,
but as it is not known you really cannot plan for it?
Mr King: To set out exactly what would be done each year for the next five
or six years is an extremely difficult thing to do, but contingent upon a
particular central path of the economy you can say that if that path did emerge
you could expect to achieve a certain scale of fiscal consolidation and set out
the actions to take to bring that about. It can be done but it is important to
recognise that subtlety in saying that the precise timing of measures should
depend on the state of the economy. Equally, the plan needs to be credible, not
just a broad-based statement of intent.
Plaskitt: Do you believe that at the moment
there is any risk to the UK's credit rating as a result of the public finances?
Mr King: I do not believe there is any immediate risk, but the longer there
is not a credible plan that sets out what actions will be taken the more that
is a risk. I do not believe there is any impediment to the UK putting in place a credible plan
which will convince financial markets. The risks arise more from possible
concerns in financial markets that might arise if other countries got into
serious fiscal difficulty and it created a more generalised concern about
fiscal deficits around the world. That includes the United States which also has a
large deficit. I do not believe this is a UK-specific issue. It is true that
our deficit is large but by putting in place a credible plan and following it
through it is quite possible over a period of time to bring down that deficit
and it is important that we are seen to do that.
Plaskitt: Is it more important to watch the
rate of reduction of the deficit than its absolute level?
Mr King: I think it is both. You have to take action to bring down the
deficit of the size we have - it is a very large structural deficit - but to do
so at a rate that is consistent with the restoration of growth in the economy.
Fallon: The permanent secretary to the treasury
told this Committee a fortnight ago that quantitative easing was a journey into
the unknown and we did not understand every aspect of it. At its last meeting
the MPC split three ways: some wanted to extend the programme by £40bn, others
by £25bn and others to leave it unchanged. Do you really know what you are
Mr King: Yes. I do not accept that this is a journey into the unknown. There
are uncertainties but there always are in monetary policy. We have had
three-way splits before when dealing with the level of bank rate. You can
certainly say there are different views about the likely future path of the
economy. We have the Monetary Policy Committee precisely because no one person
has a monopoly of wisdom and it is a good idea to try to aggregate together the
views and judgments of a diverse range of individuals. It is not surprising
that when one is at a turning point in the economy there are different
judgments about what are after all relatively small differences. No one
advocated that we immediately launch and sell back the assets. The range of
views about the additional asset purchases was between zero and £40bn.
Fallon: The sum of £25bn represents quite a
difference. At your press conference you described worrying about asset prices
as "peculiar". Can you elucidate?
Mr King: In present circumstances what I worry about is that it has become
very fashionable to think of almost any upward movement in any asset price as a
bubble and any downward movement as the bursting of the bubble. I do not
believe that is particularly helpful. It is not surprising that there have been
sharp movements in asset prices over the past six to nine months. At the beginning
of the year we had experienced two quarters when the world economy, in the
words people around the world have used, fell off a cliff. This was true not
just of one economy but every economy. This was wholly unprecedented. World trade
was falling at a rate even faster than during the great depression and there
was enormous concern and uncertainty about what that might mean. Since then those
falls in output have come to an end and many countries start to see positive
growth rates; all countries have seen the end of those sharp falls in output.
Because asset prices are forward looking I would have expected them to respond
to that by sharp upwards movements, and they did. In addition the whole purpose
of our asset purchases was to try to raise asset prices, so I believe it is not
surprising we have seen an increase in asset prices. Of course if we maintained
our policy and bought assets month in month out indefinitely we would end up
injecting so much money into the economy that we would generate not only asset
price inflation but consumer price inflation and fail to meet our target. We
take the target very seriously. There are differences of view and judgment on
the committee, but it is there openly to express those differences about the
precise scale of what we need to do, but everyone is committed to ensuring that
the path we follow for asset purchases and bank rate is one that is consistent
with meeting the inflation target.
Fallon: Dr Posen, when quantitative easing
was first authorised you were told by the treasury that you should spend up to
£50bn on private sector assets. You have spent only £2bn on such asset and all
the rest has gone on gilts. Should you not all along have been buying a wider
range of assets?
Dr Posen: One hopes the question is moot because we are coming to the end of
a large-scale quantitative easing exercise. There are clear advantages and
disadvantages in buying gilts or private assets. If we have done enough and the
forecast as we have it in the inflation report, as the governor described,
comes out the way we hope then what we should or should not have done in the
past is irrelevant; we will have moved the economy enough to have made things
happen. There is genuine uncertainty about the impact of quantitative easing.
As my colleague Dr Sentance said in his written report to you today, the
impacts of quantitative easing are however highly uncertain particularly given
that the operation of the banking system is impaired by the financial crisis.
The MPC's forecast is based on the assumption that quantitative easing is
highly effective and its effects are lasting in the same way that a cut in bank
rate would be. I believe that is the right guess but we do not have a
guarantee. Were we to get into a situation where quantitative easing turned out
to be less effective or long-lasting in its impact than we think it has been
there would be a case for buying non-gilt private sector assets because we
would be back in the situation where we had a serious problem related to the
financial system that impacted on the credit markets. My expectation as well as
my hope is that this is moot and we are passed that point, but it behoves the treasury
and the bank to prepare a contingency plan for the kinds private assets one
would buy and how in case such a bad
outcome did occur. That contingency plan would be locked into a drawer and, god
willing, we would never have to look at it.
Fallon: Governor, in your opening statement
you talked about restoring the level of spending to a path consistent with eliminating
spare capacity. What is your current view of the amount of spare capacity in
Mr King: There are various charts in the inflation report that spell out the
view that within the labour market there is clearly spare capacity. Unemployment
is above the level which we had become used to and which seemed to me to be
sustainable. Surveys of companies also suggest that within firms there is spare
capacity. I will not put a number on it but clearly there is a large margin of
spare capacity and that is true whether you look at the labour market or
companies' own perceptions of the amount by which they could increase output if
demand was there and they could find the credit supply to finance it. There is
a large margin of spare capacity and that is simply the other side of the coin
of the extraordinary fall in output we saw which clearly is the largest in the post-war
period. As we discuss in the report, it has accompanied a reduction in
potential supply because of contraction of the financial sector and its ability
to supply credit, so it is not easy to know how much spare capacity there is.
One of the difficult judgments which the committee will have to make going
forward is that even though output may appear to be well below its previous
level how much spare capacity is there? At present there is clearly a large
Fallon: Do you want to eliminate what you
cannot wholly measure? How much of the GDP we have lost since 2007 will we not
Mr King: That is very hard to judge, but the figures of the IMF and those on
which our report is based suggest that for some considerable period - the
indefinite future - somewhere between 5% and 10% of output will be lost
relative to where we might reasonably have expected it to be had we continued along
the growth path we had been on for many years.
Fallon: Lost for ever?
Mr King: Lost for an indefinite period. I suspect that eventually we will
claw it back and return to that level, but it will take many years, so for a
considerable period there will be output well below the level that we would
otherwise have attained. That is the magnitude of the cost of a financial
crisis of the kind we have experienced and why it is worth putting a great deal
of effort into designing an appropriate structure and regulatory framework for
the financial sector to avoid getting into this set of problems again.
Brady: How do you see the effects differing
between reversing quantitative easing and increasing rates?
Mr King: Do you mean increasing bank rate versus selling the assets we have
Mr King: I do not think there is an enormous difference. Both of them are
designed to subtract money from the economy and they have similar types of
transmission mechanism, in that the effects spill over to many other asset
markets. That will reduce asset prices and raise yields, making it more
expensive to obtain finance. Therefore, it will tighten monetary policy. They
are very similar. We would want to co‑ordinate with the Debt Management
Office so as not to get in the way of the auctions that it holds. When it comes
to asset purchases and bank rate the committee will simply make its decision,
but it will have to look at both of those and decide where it feels most
confident in making the initial adjustments. That is something we will do when
we get there, but certainly over a period of two to three years we would engage
in both forms of action.
Brady: You say that the transmission
mechanisms are similar. Would you expect one to have a more immediate effect
than the other?
Mr King: No. To go back to what Dr Posen said, one of the problems at
present in using either asset purchases or bank rate is that the transmission
mechanism has been impaired because of the way the banking sector is
de-leveraging. That has made our life more difficult in terms of both dampening
the potency of monetary policy but also creating a degree of uncertainty about
it. I do not believe that is specific to asset purchases; that is true also of
changes in bank rate. These are things we shall have to face as and when we
feel the time is right to make that judgment, but I do not think there is any
technical impediment to our engaging in what many call an exit strategy. We
know what we would do; it is technically straightforward. The difficult
judgment which is far and away the overwhelming problem is to know precisely
when and by how much to do it. The timing of that decision is very difficult
and it is something we will look at carefully month by month.
Brady: Given that you do not see any real
difference between the two mechanisms, it would be reasonable to assume that
the two would begin broadly at the same time?
Mr King: They might or might not. It may be easier to explain the movement
of one instrument rather than the other. I do not think there is anything
terribly significant about moving one rather than another. I am sure that over
a period of two to three years we will operate both but whether we want to do
both each time we make a change is something to be
Brady: Dr Posen, I want to return to the
question of the split between the assets that have been purchased. Would it
have made a difference to the exit strategy had different assets been
Dr Posen: That is very fair question. This is the place where one is lucky if
one did not buy private sector assets. Our counterparts in the Federal Reserve,
for example, have a very large portfolio of private sector assets to offload.
When it has to withdraw and unwind that position it has a lot of market
distortions and risk. As to selling it to the gilt markets, our colleagues
Mr Fisher and Mr Tucker have the technical task of figuring out with the
Debt Management Office how best to do it, but when you are selling it to the
deepest and most liquid and transparent market in the United Kingdom, and in
the world, you do not have all these extra headaches as well as balance sheet
risk you would have if you had bought lots of private sector assets. That is
not to say that that was a priori the
right choice, but now we are at this point we definitely reap the advantages of
having on the bank's balance sheet only or primarily gilts.
Love: Is there any sign that the rebalancing
of the UK economy towards net exports is taking place?
Mr King: There are some signs. Indeed, the company visits I make and the
people to whom I speak suggest that those involved in either exporting or
competing with import industries have found that the conditions in which they
operate, although difficult because of the collapse in world demand and trade,
are better than they might have feared. In part the fall in the sterling
exchange rate is helping from that point of view, but there is a long way to
Love: But has there not been a surprisingly
slow fall in imports considering the large depreciation of sterling and the
recession? Similarly, as far as exports are concerned we see a global economic
recovery. There has been a significant depreciation but again our export
performance does not appear to have improved to match that.
Mr King: The point that really troubles me is the speed at which the
imbalances in the world economy are likely to adjust.
Love: It will be slower?
Mr King: We have a short-run reduction in the imbalances because of the
world depression, but as the level of output in the world starts to expand
again my concern is that those imbalances will simply re‑emerge and as
before we will be on one side of them again. This is a major problem facing the
world economy. We should put at the top of the agenda two major difficulties:
one is the structure of the banking sector and its regulation - the "too
important to fail" issue - and the other is the world imbalances and the need
for a world monetary system that prevents these imbalances emerging. If we go
back to where we were I have no doubt that as those imbalances become large
again the pressure for protectionism will build up to an almost irresistible
level because there will be nowhere to go; it will be the only policy solution
that seems to be left, which would be a tragedy. The G20 are now committed to a
framework in which they will challenge each other and talk about the frameworks
of their macroeconomic policy. We discussed this at St Andrews two or three
weeks ago. This is a big step forward. People recognise the problem - perhaps
it was not fully recognised before - but the proof of the pudding will be in
the eating. The real test over the next year or so will be whether the G20 are
willing to confront the question of what mechanisms can be put in place to
prevent the build-up of imbalances on the scale we witnessed because that was
one of the major contributory factors of the problems we have experienced.
Love: That is a very interesting question
which I am sure someone else will pursue, but I want to stick to demand in the
UK economy. I want to press you about the outlook for business investment
considering the uncertainties you have talked about in relation to access to
finance and demand in the economy. Will we see a recovery in business
investment, and what will be the long-term impact if we do not?
Mr King: I am sure we will see a recovery at some point.
Love: But again it will be slow?
Mr King: Business investment is volatile and has fallen sharply. We have
been surprised and concerned about the pace at which business investment has
fallen; it is sharper than anything we have seen in the post-war period, and in
part it reflects the adverse impact on the supply of credit of problems in the
banking sector. At some point you will see that reversed and there will be a
pick-up in business investment, but there is a long way to go. If you look at
certain components of investment commercial property prices are 45% below their
peak. That certainly puts the movement in house prices into perspective. There
are small signs. We have seen a couple of small pick-ups in commercial property
prices and maybe this is the turning point, but you can see why it will be
difficult for people to be confident to invest in projects like that; and it
will be just as difficult, if not very difficult, to persuade banks to lend on
that when they will still be realising large losses over the next couple of
years on past investments in commercial property.
Love: I move to consumption. We have seen a
shift back towards savings. There is great uncertainty out there in relation to
these issues. We talk about debt consolidation. What are the prospects for a
recovery in consumption over the coming period? Will that come to our rescue?
Mr King: I do not think we should keep looking at consumption to rescue us.
We did so in the past. I do not think consumption got to an unsustainable level
from which it must fall back, but savings ratios are likely to be higher in
future as part of the rebalancing of the UK economy. In all of these factors
what we ought to expect is a gradual recovery in business investment at some
point and a switch in demand away from consumption, both public and private,
towards net exports. That is the sort of rebalancing we will need. I have been
talking about rebalancing for 15 years. I do not know whether I was ahead of my
time or completely out of date. These rebalancings are hard to predict. It is
very difficult to ensure that when one component of spending contracts another
picks up at the right time to replace it. That is the challenge we face. That
is what makes the particular shape of the recovery very hard to predict. I
suspect that at this point the most important thing is to try to stick to two
or three very clear principles. We are providing a great deal of stimulus from
the monetary side to ensure that inflation does not fall too far below the
target. That gives us a clear anchor for our policy and we will withdraw that
stimulus when we think it appropriate to do that.
Love: As you have correctly indicated,
consumption will not be a rescue; business investment does not look as if it
will recover for some time; and rebalancing towards net exports may take much
longer than perhaps we had thought originally considering depreciation. What
does all of that mean for the stimulus that is currently being put into the
economy? Does it mean we will have to maintain the stimulus longer than perhaps
we had originally expected?
Mr King: If private demand remains extremely weak we shall have to maintain
a substantial degree of monetary stimulus, but I do not want to anticipate
that. The great virtue of monetary policy is that it can be flexible month by
month and we shall watch the data very carefully, as I am sure this Committee
will, and see what happens.
Love: What you are really saying is that we
should not adopt ideological positions about what to do with stimulus measures
or the fiscal deficit but look at how the economy is tracking and take
decisions based on the best estimates of where we are going?
Mr King: The Monetary Policy Committee has never been ideological. We hope
it never withdraws stimulus too soon or too late. It tries to do it at the
right time but these are difficult judgments and we are bound to make mistakes.
But the great virtue of our inflation target is that we, you and everyone else
know the framework in which we are operating which is that, if we can, we want
a broad balance between demand and supply in the economy to keep inflation
close to our 2% target. In our last report our judgment was that inflation
would rise in the short run, not because it had been pushed up by asset
purchases or quantitative easing but because of the bounce back in VAT and the
enormous turn-round in petrol price inflation, but once those effects have come
through at the beginning of next year we will expect the margin of spare
capacity to bear down on inflation again. That was why we felt the most likely
outcome for inflation for much of the next two to three years, once we got
through the short-term impact of petrol and VAT increases, was that it would be
below the target. That is why we have maintained the stimulus. There will come
a point when we feel private sector demand is recovering sufficiently rapidly
that we need to withdraw the stimulus and at that point we shall withdraw it. We
will explain that in the report to you. We may get it right; we may get it
wrong, but I believe the framework is pretty clear.
Thurso: I turn to the question put by the
Chairman about narrow banking. I was much taken with your speech in Edinburgh.
You discussed the differences between John Kay and Paul Volcker and said
that the common element was the aim to restrict government guarantees to
utility banking. I take you to the other end of the spectrum which is the
merchant investing banking side. You also said that the sheer creative
imagination of the financial sector to think up new ways of taking risk would in
the end force us to confront the "too important to fail" question. Is it not a
fact that in addition to protecting utility banking we need to liberate the
investment merchant banking side and realign the risk it takes with its
ownership so it is not protected by the utility banks?
Mr King: Absolutely, and that was very much what I meant by that statement.
One of the big mistakes we could make in the regulatory debate is focus
attention on measures that will stop banks taking too much risk. There is no
way we will be able to guarantee that. If the managers of banks make mistakes
from time to time, as they will, and take on too much risk which with the
benefit of hindsight goes wrong the rules of the market economy are that the
institution is allowed to fail. People need to know that in advance when they
are providing capital to that bank either as equity or in the form of loans.
They will then have an incentive to monitor the risks that the bank is taking.
If the bank is felt to have an implicit guarantee from elsewhere there is no
incentive for people who supply the money to monitor the risks and those risks
will expand. It may be said that a regulator can say something is too risky and
stop it. With the best will in the world, if regulators are that clever why not
let them run the banks? By definition, it is a way of saying that they must be
better at running risks than the present incumbents. That cannot be true in the
real world. People make mistakes; risks will be taken and things will go wrong.
The important thing is to allow the institutions that have taken those risks
and the people who have supplied the money to those institutions to lose; that
is what a market economy means. We do not want that to happen to retail
depositors up to a certain level and that is why we need to protect those
activities and give guarantees because that is part of the utility aspect of
banking we want to protect. I believe that that needs to be ring-fenced from
other kinds of banking.
Thurso: Where does that leave the FSA's
Mr King: In itself I do not think it is a direct comment on it, or certainly
it is not meant to be. It is a statement that supervision should try to lay
down rather simple, clear and robust rules which you want banks to follow to
prevent them doing things that are not in the public interest. We care
enormously about the utility element of banking. Therefore, we want rules to
prevent that and ring-fence it from risks that are being taken elsewhere. In
other parts of it it does not make sense to believe that by having a
sufficiently intensive regime of regulation we will stop banks making mistakes.
That is not true of any industry. The real value of John Kay's
contribution is to ask: why not try to learn from the regulation of other
industries? In other industries we have said we have an absolute care about the
continuity of service. It is important to have continuity of service in
networks, whether it is energy or telecommunications, just as it is in the
payment system, but that does not mean continuity in terms of the individual
provider. The provider may fail and disappear but the service continues. We
have to devise a form of regulation that is robust with respect to the mistakes
we know people will make. There is no reason why people should not be allowed
to make mistakes. One of the most interesting aspects is that two years ago
many of our colleagues in Europe talked about
the dangers posed by hedge funds. We have heard nothing about this for 12
months. Why? Because over 2,000 hedge funds have failed during this crisis. Some
did well; many failed. The great virtue of hedge funds is that they can fail
without the government feeling it has to step in to protect them. If people
want to take risks let them take them but not in a way that will involve the
government feeling it must step in to bail them out.
Thurso: To pick up that point and return to
the merchant investment banking end, most of these started off as partnerships
where there was an obvious link between high risk and high reward. Would it not
be helpful to see a return to that model? Has not incorporation smudged the
Mr King: It is well worth debating. The application of the principle of
limited liability to institutions that have borrowed a lot of money from
elsewhere and then engaged in risky transactions has undoubtedly made this
problem much worse. If you talk to people who work in the most highly regarded
investment banks given their ability to control risk they will say openly that
one of the reasons they feel they can do that is that over many years a culture
of risk management has grown up because they are a partnership and they are
managing each other's money. That is a pretty powerful incentive to ensure you
do not run excessive risks. It does not prevent you making mistakes and it is
still important to ensure that if people do so they understand that market
discipline applies to finance just as it does to any manufacturing industry.
Thurso: How concerned are you that the banks
are going back to business as usual regarding leveraging up because of the
supply of relatively low-cost money? There has been a tremendous rebound in the
debt derivatives market. Is that connected to QE?
Mr King: I do not think it is directly connected to it. Any increase in
asset prices across the board would be likely to have the impact of raising
bank profits where those arose from mark-to-market instruments on the trading
book. That is not a reflection of activities undertaken by investment banking
but in part the consequence of a rise in asset prices. In one or two instances
I have been concerned that banks, particularly those in receipt of government
support, felt it was more attractive to go down the road of re‑establishing
an investment banking operation as opposed to what I thought was their original
intention which was to go back to some good old-fashioned commercial banking.
Thurso: Mr Tucker, in a recent speech you
referred to avoiding perverse incentives on which liquidity insurance was
provided. You discussed two pricing options: an ex ante fee or a premium
interest rate. What are the pros and cons of those?
Mr Tucker: The approach we have adopted so far is to charge a premium rate at
the point at which the bank draws on the liquidity insurance facility. The
advantage of that is you can make a judgment at the time about whether or not
you will permit an institution to draw on the facility, on whether it has
fundamental problems of solvency and viability, whereas if it pays a commitment fee upfront through an annual
premium it will be harder to say no at that point. That is quite an important
distinction. The ex post approach we have adopted is much easier to tailor to
the amount it borrows from us, the type of collateral and the particular
circumstances. I think that is the best approach for now, but I would not want
to rule out switching the approach over the next 10 to 20 years. That was why I
said I thought that was something for our community to debate. I do not think
that it is a great priority just now.
Q43 Chairman: On the question of narrow banking, you gave a speech at Barclays
which the press interpreted as being different from the view of the governor.
What is your view of this issue, in particular the "too big to fail" aspect?
Mr Tucker: I said in that speech and in a number of others that the "too big
to fail" problem is massive. We must solve this problem. The great difficulty
with "too big to fail" is that for a generation no-one talked about it in case
it created more hazard. Guess what? It was there in the background all the
time, so our generation, in Parliament as well as officials, has the
opportunity to put this right. This is not just a UK issue; it is being debated
actively in the House of Representatives, and it goes absolutely to the
question of whether our society wants a market economy. If we do, we had better
have market discipline in all parts of the economy, including banking. That is
to do with allowing banks, as well as dealers, to fail in an orderly way. What
we must not do in the period ahead is kid ourselves on either side of the table
that we have reached a nice position where after all banks can fail in an
orderly way. We must not find ourselves in the position we were in five or 10
years ago when we were blinding ourselves to an awkward truth. That is where
contingent capital comes in. At root this debate is about ensuring that not
only equity holders can take losses, as they have, though perhaps not as much
as they might have done in some cases. It is to do not only with protecting
retail depositors, but ensuring that unsecured wholesale creditors take losses.
That is where market discipline can come from. There are two routes to that: we
can put these banks and dealers into some form of liquidation when they are in
distress, or essentially, we can switch their debt holdings into equity
holdings at the point of incipient distress. A lot of people believe that the
latter approach is much the better and will provide for a more orderly path for
our financial system and economy. Contingent capital is one way to do that. The
Lloyds issue is encouraging in that respect. There is quite a lot of commentary
to the effect that not too much can be drawn from it because people were
swapping one type of debt for contingent capital and they really had no choice.
And there is some truth in that, but it means that in a month or so from now institutions
around the world, not only in this country, will be holding contingent capital
so it will begin to be a debate not just in the official and academic worlds
but among real world investors. That is a modest but potentially significant
Q44 Chairman: The benefit of bringing you here is we can get your unvarnished
views that are not filtered through the press. I am sorry that we have not so
far brought in Dr Sentance and Mr Fisher. Given this is a big issue, what
are your views?
Dr Sentance: I agree with the governor and Mr Tucker; it is their main areas of
expertise on financial stability. The Monetary Policy Committee focuses mainly
on the monetary aspect of the bank's role, but there are big issues in terms of
the structure and regulation of the banking system. These will not be resolved
quickly because they raise profound issues about the way banks operate. I also
believe that the globalisation of the world economy creates pressure on
businesses in all sectors to try to become bigger and more international. Part
of the tension we see in the banking sector is to do with how we manage that
pressure, which was undoubtedly a factor in the build up to this crisis where
banks extended their international reach and became much more internationally
active. The possibility of creating subsidiaries rather than branches is one
way to deal with that. To my mind, that is a very relevant tension that somehow
must be managed, because we will not take away the pressures of globalisation
and business to become more international and the financial sector is not exempt
Mr Fisher: I am not sure I can add very much to what has already been said. In
discussions with banks they are themselves very focused at the moment on all these
issues: the regulatory agenda, the funding markets and the particular structure.
There is a great deal of interest in the Lloyds issue, for example whether or
not that might develop into more widespread use of contingent capital.
Q45 Chairman: Dr Posen?
Dr Posen: The two key points were the governor's reference to simple, broad,
robust rules and Mr Tucker's comment about wholesale creditors coming under
fire. My concern is that as good as contingent capital, deposit insurance and
all these things are if we leave too much discretion to the supervisors and
regulators it will go against hammering the wholesale credits when push comes
to shove. Therefore, I tend to argue for dumber and even more robust, broader
and strict rules that may preclude some activities. Thus, I am spiritually on the
side of the John Kay/Paul Volcker arguments. I am also more of the
simple-minded view that "too big to fail" means we should be taking another
look at the size of institutions in the system. The governor and others at the
table have correctly used the term "too important to fail". While obviously you
can think of institutions that are systemically important even if small,
nonetheless I do not believe we should lose sight of the fact that there seems
to have been real governance and information problems as well as political and
economic problems from the outside when you have institutions that are too
Chairman: I do not think that at the moment the banking community is willing
to look at the issue of size. That is a big issue. There is an element of
blinding oneself to an awkward truth. There is a huge debate still to be had
and we are grateful for all the views that have been put forward.
Peter Viggers: I am reluctant to leave the
issue of banking, but the main thrust today is the inflation report. I should
like to turn to the consumer price index and inflation. There are a number of
differences between the projections and fan charts in August and those in the
latest edition. One significant difference is that the quantitative easing
limit has been increased. Can you recalibrate for us what you regard as the
main differences between the two fan charts?
Mr King: The set of differences between the August and November projections
in this inflation report reflects a number or factors that have changed between
the two. First, the yield curve on which the projection is conditioned is
significantly lower in November than in August, so there is more monetary
stimulus implied by that. Second, the volume of asset purchases is higher, so
for those two reasons the projections are conditioned on a more stimulatory
policy than was assumed in August. Third, the exchange rate is lower than it
was in August, so that is another factor which increases both the outlook for
activity in the short run and also the outlook for inflation in the first year
or so as higher import prices pass through. Fourth, in our view the world economy
is stronger in November than in August. All those reasons mean that the outlook
for inflation and activity is somewhat stronger than was the case in August.
Peter Viggers: Turning specifically to the
spike in inflation, which is much lower than in the August inflation report,
you pick out one item as being the end of the VAT cut. Would you please
calibrate for us the reasons for the change in the spike?
Mr King: In part it is the movement in petrol prices. It is also the fact
that oil and commodity prices in general have moved in such a way as to change
our view about some of the movements in energy prices that might otherwise have
occurred in the first half of 2010. But each time we do it we sit down and form
the best judgment we can about the very short run movements of energy and
petrol price inflation, plus other stated government plans for taxes and
duties. The view we came to in November was the judgment you see in the chart.
Peter Viggers: If GDP growth were lower than
expected in your analysis - some commentators said that it was a little
optimistic - how would it affect the inflation projections?
Mr King: I do not think it would have much impact on the short-run
projections, but looking further ahead it would mean that inflation would be
more likely to be below target and less likely to return to the 2% target at
the end of the forecast horizon. Obviously, that is conditional on the
assumptions for monetary policy on which the charts are based. If activity
turned out to be weaker you would expect us to reflect that in our own actions.
Peter Viggers: Some siren voices, notably
from the United States, urge that a measure of inflation and control would be
helpful to the economy generally. Looking at your central inflation
projections, after an inflation spike you estimate inflation to be below
target. Are you content that the expectation is that you will undershoot the
target whereas a tiny measure of inflation would be quite helpful because of
the effects on lower real interest rates?
Mr King: There are two senses in which your description of "a tiny measure
of inflation would be quite helpful" can be interpreted. One is in terms of the
impact on the real interest rate; the other is that in some generalised sense
inflation will be helpful to deal with debt problems, for example. I do not
think it is sensible to change our target; indeed, one of the messages from the
inflation report is that the 2% target is one which, if activity is weaker than
we think, will be difficult for us to achieve from underneath, not on top.
Therefore, we will have difficulty keeping inflation up to the 2% target in the
medium term if activity is weaker than in our central projection. It would be
nice if we had instruments that enabled us to hit the inflation target exactly
month by month all the way through, but we do not; it takes time for monetary
policy action to take effect. We start with the consequences of the
extraordinarily sharp fall in output which has created a big margin of spare
capacity. Even if we wanted to I do not think it would be possible to eliminate
that margin of spare capacity quickly. There are reasons for not trying to do
it too quickly. For those reasons we have a very stimulatory monetary policy
and it is quite hard to see how it can be more so, yet we will face this
prospect of inflation. But if we feel that the outlook for inflation is even
more on the downside than we anticipate we will return to the question and ask
ourselves whether we should carry out more asset purchases. Equally, if the
outlook for inflation appears to be moving up we will return to the question of
at what point we should start to withdraw the stimulus.
Cousins: This morning the Committee found
some very interesting information on the table in front of it. Perhaps I may
ask Mr Tucker to help me understand it. The Committee has been told that the
liquidity support for RBS and HBOS peaked at just over £60bn on 17 October
and the bank required collateral of £100bn plus to cover it, which is a pretty
substantial imposition. RBS and HBOS paid a considerable premium for that
support. In turn the treasury charged the bank 1.7% over two months for an
indemnity to cover the costs of the liquidity support. If I have understood
that correctly, is that really countercyclical support?
Mr Tucker: If we had not done it the cycle would have been a lot worse than
otherwise, so looking at the big picture the answer is most certainly yes,
whether one likes the expression "lender of last resort" or "emergency
Cousins: If RBS and HBOS had been able to
get an American Express credit card they would have been better off, would they
Mr Tucker: But American Express may not have been.
Cousins: This is tough stuff.
Mr Tucker: It was tough stuff; it was an absolutely classic lender of last
resort operation where the only point of doing it was whether it bridged to
something. This applies to every single lender of last resort operation that
has ever been carried out. Either you bridge through some panic that will pass and
the organisation can resume its life or you bridge to some private sector
purchase of it, which was not remotely available to RBS in these circumstances,
or some state equity support which was where we ended up. Can lender of last
resort buy time? Yes, it can. It was very effective in buying time. It would
have been a great mistake not to buy time. Can lender of last resort make all
the problems of the world go away? No, it cannot. What should the price be?
Cousins: Do you agree that this is a heavy
Mr Tucker: Perhaps I may come to the price in a moment. First, the collateral
is there to protect the bank and the state from risk. The price is there - this
goes back to the earlier conversation about "too big to fail" and incentives -
so everybody knows that if a bank gets itself into such a mess that it cannot
rely on publicly-available liquidity insurance facilities provided by Paul
Fisher's Market Area, then when it is in deep distress there is a high cost to
that. It is not a new thing which has been invented by the Governor and me or
by the Governor's predecessor and the Bank team; these are principles that have
applied in central banking for more than a century. It would be a great mistake
not to apply them. It would also be a mistake to think that lender of last
resort in those particular cases or in others was waving away all of the
problems. It has to bridge to some more fundamental solution. I am afraid that
in these particular cases the fundamental solution was state control.
Cousins: The Bank asked for £100bn worth of
assets to cover £60bn of liquidity. That implies a very large risk of
impairment. Over the next few years the banking system in Britain faces an
enormous risk of impairment and needs to refinance a very large scale of
commercial property debt and an even bigger sum of money to refinance private
equity. Does that not suggest we will need genuine countercyclical support from
the bank and the government, not the kinds of impositions made last October?
Mr Tucker: You have to make a distinction when considering how to handle an
emergency. You ask about the scale of the collateral that we took. Within
months the government had massive equity stakes. Effectively, that is saying
that these institutions were bust which means that the assets on their balance
sheet were significantly impaired. We had to take a big margin of surplus
collateral; otherwise, we would be sitting in front of you being asked why we
had lent recklessly or on terms that could endanger the state's fiscal
position. Those are not judgments for us but for the fiscal authority, the
government, and those are represented in the equity stakes that the government
took during that month. We are in complete agreement with you on the broader
issue of whether or not the authorities can develop and apply instruments that
would be countercyclical in the way you describe and that is what the
discussion paper on macroprudential instruments released on Friday and Saturday
is about. But one must distinguish the use of countercyclical instruments in
that sense from handling a dire emergency, which this was.
Cousins: In the inflation report there is a
reference to the scale of the maturing funding problem faced by the British
banking system. If we cannot succeed in dealing with the impairments in the
existing loan book or the requirement to refinance the enormous scale of
maturing funding will not the consequence for employment in this country be
Mr Tucker: But if the banks set out now to think through a credible plan for
their funding over the next two to three years, there is no reason why they
cannot do it. What they cannot do is simply take no action and then throw up
their hands two or three years down the road and say that the taxpayer must
come in to support them. It is very important that they are made to put
together a coherent funding plan that may well mean raising funding at longer
maturities and reducing profits to the banks' shareholders below where they
might otherwise have been in order to make sure they have access to funding.
Cousins: Are you not in some danger of
adopting a scorched earth policy when you want to keep the market economy going,
so you say?
Mr Tucker: No, not at all.
Mr King: I am astonished to hear you defend the banks. It appears that you
want the taxpayer to be there.
Cousins: Someone has to do so.
Mr King: Do you think that the taxpayer should just hand over money at no
cost to support the banks? I am astonished that you of all people would suggest
Cousins: This exercise of moral hazard that
you and Ben Bernanke have been conducting has already put a lot of parts of the
British economy at risk. I indicate to you that the problem of maturing funding
and the level of impairment implied by requiring £100bn of assets to cover £60bn
of liquidity suggests that we will have to nurse the banking system very much
through the next few years.
Mr King: I am afraid you have completely confused two separate things, as Mr
Tucker pointed out. The facilities extended to the Royal Bank of Scotland
and Lloyds were repaid, one in December 2008 and the other in January 2009, and
the collateral was returned to them. There is no question of our hanging on to
this collateral at all; it has been returned and the loans repaid. I fail to
understand why you think this is remotely relevant to the funding challenge of
the banking sector over the next three years.
Cousins: It is the scale of cover for the
impairments that you required and its implications for the future.
Mr King: But that is now over and done with. Why on earth do you think that for
something which was put in place for a couple of months when we had to take raw
mortgages and no means of investigating their merits given the speed with which
the operation had to be mounted we should put taxpayer's money at risk? The
operation was successful: we made the loans, they were repaid and the
collateral was returned to the two banks. That was over and done with almost a
year ago. That has no relevance to the funding challenge over the next two to
Ainger: At the press conference when you
launched this inflation report you were asked a question about rising asset
prices and said that it would be peculiar to worry about asset prices now. In
response to Mr Fallon you also said it was not surprising asset prices had
risen, but you have also told us that output fell off a cliff and it will be a
long time before we get back to the levels of output we saw before the financial
crash. Is it not peculiar that we see such high rises in asset prices? Should
we not be worried now with the price of oil at $80 a barrel and the doubling of
gas prices in future?
Mr King: You should look at each individual asset price and ask the question
separately. I do not believe there is a common answer to all asset prices. We
have seen quite a remarkable turn round in the growth in the emerging market
economies of the world which in part has played into the level of commodity
prices including oil. I think the resilience in those parts of the world is
partly responsible for the strength in the oil price. The same factors do not
play into understanding what has happened to financial asset prices where I believe
that part of the reason for the dramatic fall in price was the concern that we
might be about to revisit the great depression. It now looks as if we will not
and that itself may explain why there has been a rebound of asset prices. I do
not think it is ever easy to say that you would have expected prices to rise by
37% or some precise number; you cannot because these are very difficult
judgments, but most asset prices are still well below the levels they were at
when the crisis began. It is not the case that they have rebounded to levels one
might have thought were unsustainable at that point. There is however one
immense issue here which is very hard to judge, namely that world long-term
real interest rates are still very low. That was so in the build up to the
crisis and that was partly why asset prices were rising. They remain very low
in large part because people believe that the large amount of savings coming
out of Asia will carry on. If that is to be a
permanent feature of the world economy we will have to get used to low levels
of long-term real interest rates and higher levels of asset prices, but if it
turns out to be the case, which obviously financial markets at present do not
anticipate, that real world interest rates rise as the Asian economies save
less and we save more and there is a better balance in the world economy maybe
we will see an adjustment of all asset prices across the world at some point in
the future as real interest rates pick up. But that is not a factor to do with
financial policy or central bank liquidity provision; it is to do with the
functioning of the world real economy. It is conceivable that people may have
made a misjudgement there, but it is not at all easy to be sure or to know what
to do about it if they have.
Ainger: Earlier this year the Prime Minister
and President Sarkozy jointly authored an article in the Wall Street Journal on their concerns about prices on the oil
exchanges in particular. That indicated to me that they were extremely
concerned about this issue. Are you aware of any further development to try to
address this issue? One commentator has said that a new western carry trade has
developed whereby because of extremely low interest rates people borrow and put
money into assets which then forces up the price of those assets, although the
fundamentals that should dictate the price of those assets indicate they should
be far lower than the current price.
Mr King: I would distinguish between a so-called world carry trade on the
one hand and the concerns that the Prime Minister and President Sarkozy
expressed about the oil market on the other. Perhaps we can take them in turn.
As to the oil market it would certainly be valuable if the G20 now, not G7,
were to discuss the possibility of creating a deeper futures market for oil. We
had a G7 discussion about this some years ago and the outcome of it was a
genuine recognition that it was difficult to know what to do about it but the
fact that potential producers could not sell forward their oil made it harder
for new entrants into the market, for example Canadian tar sands, to be
entirely confident that if they were to invest heavily in the production of new
sources of oil the price would still be high 10 years down the road when their
production came onto the market. A deeper and more extensive futures market
might help in that respect. There are some good reasons why it is difficult to
create that kind of futures market and it may be that government has a role to
play. It would be valuable for the G20 to talk that through. All countries in
the G20 recognise that this problem affects everyone. This is not a zero sum game;
there are real benefits in reducing some of the volatility in the oil market.
In terms of a world carry trade the argument for thinking that there could be a
carry trade must rely on the fact that some countries do not allow exchange
rates to move in a way they would otherwise do. The idea that countries have
different levels of interest rates is a very natural one and that is why we
have different national central banks. You set monetary policy to suit your own
conditions which naturally means that interest rates will sometimes be high in
one country and low in another. That does not generate a carry trade in the
normal sense of the word because exchange rates are flexible and if there are
unexpected movements in relative interest rates, the exchange rate will respond
to it, thus eliminating an arbitrage profit. But where governments prevent
exchange rates from moving it is possible for a period for a carry trade to
appear to be profitable while people are basically speculating against future
decisions by governments about moving exchange rate pegs or changing exchange
rate regimes. That is the problem which lies behind the generalised question of
world imbalances if we do not have macroeconomic frameworks in the G20 that are
compatible with each other. It is not a question of the individual policies
being pursued now, but if the framework for macroeconomic policies within the
G20 means it is possible for a carry trade to develop within it, with borrowing
in the currency of one country and lending in the currency of another, there is
an inconsistency in those domestic policy frameworks which will eventually
create difficulty at international level. The G20 has now committed itself - it
was explicit at St Andrews - to invite the IMF to work with it to examine the
domestic monetary and macroeconomic policy frameworks of each G20 member
country to see whether when the IMF puts the results on the table there are any
apparent inconsistencies and to talk to each other about steps that need to be
taken to remove them. One would have to be an optimist to think this process
will necessarily work but the G20 has committed to it and thinks it is
important to recognise that if this process leads to failure it will be a big
blow to the G20 as a group. The G20 has now put its reputation on the line to
make progress on this front. That is beneficial because it means there is
something to lose if these talks go nowhere.
Ainger: If there is no immediate solution to
this apparent asset price bubble, or certainly a substantial increase in asset
prices, oil being among them, is there not a serious risk that the recovery
will be delayed, damped down and so on with unrealistically high energy levels?
Mr King: I do not think it is an immediate threat to recovery. If you go
back to energy prices I do not think the current level prevents a recovery.
What we do not know is what will happen to oil prices if, say, there is a
fairly rapid recovery. It may be that oil prices start to rise again to past
levels of well over $100 a barrel. In itself that would undoubtedly have a
dampening effect on recovery. We shall see this as matters evolve. To my mind
the bigger problem rather than that is that recovery takes place but the
imbalances in the world economy start to re‑emerge and the fundamental
issues about incompatibility and policy frameworks among the major economies of
the world are seen not to have been resolved at that point. Unless they are
resolved the tensions and underlying causes of the financial crisis will take
place all over again. The crisis will be different next time; I cannot work out
in what way, but we shall return to tensions and sharp breaks in financial
Keeble: I want to ask about the growth
forecast again. Your projection of 4% in 2011 has been described by some
commentators as optimistic. Have you included factors in particular QE which
have not been so strongly factored into the other models?
Mr King: We believe our asset purchases will have an impact and will
stimulate the economy. To the extent that other people have not taken any of
that into account that is one reason to explain the differences. You quoted 4%
for 2011. That is a rough figure for the most likely outcome but it is not the
expected growth rate. We have significant downside risk resulting from the
state of the banking sector and a drag on the supply of credit, which means
that 3% is a better guess for what we expect to be the growth rate in 2011 over
2010 and only 1.5% in 2010 over 2009. They are closer to the consensus forecast
although they are still a little on the high side, but given the scale of the
existing spare capacity I do not regard this as excessively optimistic. There
is scope for recovery. The world economy is beginning to recover. We see signs
of recovery in our own economy and from business surveys. I think it is not
unreasonable. Who knows what the precise number will be? There does not seem to
me to be much value in putting weight on any given number rather than the
general picture we have described. I stress that even if we see growth rates of
that order of magnitude we will be left with levels of activity and employment
well below the levels we would otherwise have expected to see.
Keeble: I appreciate that the fine-tuning
will depend considerably on circumstances. However, if you downgrade your
growth assumptions from 4% to 3% that brings them in lower than the treasury
forecast which then has a significant impact on projections for the structural deficit
and fiscal squeeze. Can you comment on that? The treasury assumptions for 2011 are
3% to 3.5% which have also been regarded as quite optimistic.
Mr King: It is a big mistake to place all one's weight on one number. The
whole point about our forecast and the fan chart is that we say we believe the
single most likely modal outcome is higher in the range, but taking into
account the downside risks the average growth rate embodied in our fan chart in
2011 is closer to 3%. Who knows what the number will be? It is very unlikely to
be any of those numbers. The key point is to have an appreciation of the
balance of risks, what the general picture of recovery or failure of recovery
looks like and why that is the case. We have to recognise that if things turn
out to be different from our central view, as it almost certainly will be, we
shall adapt the policy accordingly. The only point I make about fiscal policy
is that whatever precise measure are implemented will need to take into account
the state of the economy at the time. We just do not know that in advance.
Keeble: I appreciate all of that. However,
the knock-on effect of all of this in terms of the public perception, public
services and so on is profound and some percentage differences can have a big
impact. You said that you would expect the deficit to be dealt with over the
lifetime of a parliament. Therefore, it is quite helpful to know what shape it
will be. You expect growth to be between 2% and 3% or so and the deficit to be
dealt with on the basis of those kinds of growth figures.
Mr King: There must be a plan saying what will happen to the deficit over
the lifetime of a parliament for which any government elected at the next
election will be in power, so that is five years from next spring/summer. I think
it is sensible to have a plan over that period which says what actions we will
take in the eventuality that the economy performs in a certain way, that if it
grows faster other actions will be taken and if it grows less rapidly there are
things that at that point will not be put into effect because the economy will
be unable to sustain them. My point is that to have a plan which says we will
genuinely try to get rid of the deficit if the economy really does recover makes
some sense, but it must be contingent on the state of the economy and a
credible plan that spells out what will actually be done.
Keeble: That sounds far too calm and
measured perhaps for the debate we are having at present.
Mr King: I am sure you could lead a calm and measured debate now.
Keeble: Dealing with the 5% to 10% loss of
output referred to by the IMF, about which Mr Fallon asked you, there have
been some sharp comments about what happens to unemployment. Increases in
employment rates are likely to lag behind growth and therefore unemployment can
remain higher than we have been used to. You said that 8% was higher than we
had been used to. How real a threat do you think that is?
Mr King: It is very hard to judge. Given the scale of the fall in output it
is quite striking that unemployment has not risen more than it has. Given past
relationships between changes in output and unemployment one might have
expected unemployment to have risen by more than it has.
Keeble: You have referred to part-time
employment, people taking pay cuts and such like.
Mr King: Indeed. The puzzle in all this is that you can point to pay as
being extraordinarily flexible at present, much more so than perhaps we saw in
recessions in the past. That is one explanation of why unemployment may not have
risen as much as it might have done in the past. However, in the United States
which we think of as being very flexible in terms of pay and the labour market
unemployment has risen by much more than expected. I do not believe we have an
explanation for that. There are real puzzles in the behaviour of the labour
market in looking across Europe, the United
Kingdom and the United States. That is what makes
it particularly difficult at this juncture to know whether the fact that so far
unemployment has not risen by as much as it might have done is either
encouraging in the sense that greater flexibility means unemployment will not
rise to the levels we might have feared or there are further rises in
unemployment to come next year as companies catch up with the need to reduce
their costs. I honestly do not know which of those two paths we will follow, in
part because we do not have a story to explain differences in labour markets
across the US, UK and Europe, but
it is something we should watch very closely over the next few months.
Keeble: You have probably seen the
discussion on the Committee's inquiry into women in the City. What is your view
of any risks to the bank generally, given comments by Professor Goodhart for
example, because of lack of diversity? How do you believe it is best tackled?
Mr King: I do not think it is for me to comment on what the banks should be
doing. I can say what we are doing. From our point of view, obviously we do not
pay well relative to the private sector. We need therefore to attract the very
best people we can get and in order to attract not only the best women but also
the best men we need to create an environment in which there are men and women
in reasonable proportions. It is a joint career; this is not a male environment.
We have gone to great lengths to see how far it is possible to make our careers
more attractive to women as they move through career paths. In studying it we
have found that the best way to do it is to put enormous weight on programmes
of flexible working not just for women but every member of staff. The bank
adopts the principle that no woman should be promoted to a job because she is a
woman. We take no account of that; it is purely based on merit, but we need to
ensure that everyone in the bank has the opportunity to find a pattern of
working that best suits them. We have put a lot of weight and effort into
devising and building up patterns of flexible working. I hope it will work. We
will see. Recently seven appointments were made at head of division level. Four
of those appointees were women. They are still under-represented at senior
level, less so at junior level. I do not think that time will solve that problem
on its own. In the past the belief that time will deal with the problem did not
work. There is a lot of self-selection going on in choice of career. We have to
create careers that all kinds of people in the bank want to pursue and
flexibility has been the mechanism chosen to do that. Whether that is for other
people to follow I leave to them.
Keeble: The view of the Equality and Human
Rights Commission is that the FSA as regulator has a role in monitoring,
championing, leading or however one wants to describe it. Do you agree with
that? If the bank was to be the regulator should the bank play a more active
role rather than dealing with just its own internal measures?
Mr King: My belief is that this is a matter of good management. A good
management team will want to ensure that it has a work environment that is
attractive to women. It is in their commercial interest to recruit and retain
better women and men. Therefore, one needs to think deeply about the way to do
it. I just do not believe a regulator can say it will raise a bank's capital
requirement unless more women are employed.
Keeble: That was why I said "leading" rather
Mr King: Certainly we would be supportive of the direction in which you
would like to go, but I am not sure regulation is the means to achieve it.
Q72 Chairman: Mr Fisher, from your contacts how has the loss of several
competitors changed the way markets are operating?
Mr Fisher: I am not sure they see it quite that way. At the moment each of
them has its own very distinct pressures which it is trying to deal with. If
anything, they see a great deal of competitive pressure at the moment. One of
the big debates going on out there is about competition coming from those firms
that have government support. I do not speak specifically about the UK but
across the international spectrum. I do not believe they see a reduction in
competition. What these sorts of circumstances do is open up competition to a
range of new entrants, so there are quite a lot of people out there who are
busy building up their business models and trying to get into markets.
Q73 Chairman: Do you agree with Dr Posen that half a dozen big banks is not
helping competition and at the end of the day we need to restructure so we
increase competition with an alternative channel?
Mr Fisher: That relates specifically to UK retail banking. I agree that we
need a wider group of banks. Some of the smaller banks may need to come
together to provide competition for the larger banks. One of the big problems
we have particularly with small business lending is the very high degree of
concentration with Lloyds and RBS in particular. That needs to be looked at.
Q74 Chairman: Dr Sentance, given your business experience do you agree with
Dr Posen that we need to reform the financial systems so that business is
less reliant on the banking system? If so, what reforms would you like to see?
Is there a case for government intervention to stimulate new sources of
Dr Sentance: This is a long-standing question. You can trace the issues around
access to finance by small and medium size firms back to the Macmillan
Committee in 1931. When I was in the CBI in the 1980s and early 1990s this kept
coming back. I believe that it returns at times of recession. It has been very
heavily spotlighted by the difficulties in the banking system. It appears that
larger companies are able to find their way round the banking system by
accessing the corporate bond markets. Dr Posen gave quite a long menu of
options. If we could find mechanisms to extend that access to corporate bond
markets to smaller companies - there are various ideas about how that
might be done - certainly it is a direction I would favour. I agree with Dr
Posen that it is not necessarily just one approach. At the moment when we talk
to companies given their caution about the state of demand and the impact of
the recession many of them do not want to borrow; they rein back on their
Q75 Chairman: They tell us that the big issue is the cost of credit.
Dr Sentance: In some cases that is not helped by the cost of credit. In the fall
in lending at the moment we see a combination of supply and demand factors. There
are constraints on the supply side but also uncertainty about demand and
clearly the unwillingness to make big investments at the moment contributes to
that. I am not sure that in the next year or two we will find a magic bullet to
solve the issue facing small and medium size companies which has been around
for quite a long time, but I would encourage the Committee to continue its
inquiries in this area and come up with positive suggestions.
Q76 Chairman: Governor, about a year ago you said that lending was the big issue
in the British economy. We are still at it.
Mr King: We are still at it.
Q77 Chairman: You talked about a move by banks to operate as subsidiaries when
they are away from their home countries. How does that fit in with the European
Mr King: There are two aspects: the intra-European one and international
one. The point I made earlier was that a number of significant emerging market
economies had made the judgment that it would be sensible for them to require
subsidiarisation of overseas banks in their territories because they felt it
would be safer for them to apply to those banks separate capital and liquidity
requirements rather than be left exposed to the operations of a branch which
they could not regulate. One has enormous sympathy for that. We saw that in
part with Lehmans in this country. That is likely to be a development which
will gain greater traction. The difficulty in the European context is that, as
Lord Turner has said, you tend to be drawn towards either more centralised
European regulation in order to be able to regulate banks as if they belonged
to a single entity or recognition of the fact that national supervisors need
the ability to impose capital and liquidity requirements on institutions that
operate in their territory because they are responsible for what happens in
that territory. That is something we will have to confront.
Mr Tucker: On the narrow question of Europe,
it is not possible; there are passporting rights for authorised banks. The
broader debate internationally is about developing recovery and resolution
plans. There is an exercise involving about 25 of the world's largest banks and
dealers which will be undertaken over the next six to nine months. That will
throw up lots of issues, but we and everybody else will truly learn from it.
One of the most important things is not to have too many a priori thoughts now about whether subsidiarisation would be much
better than branch banking or cross-border lending. As it happens I am inclined
to that view, too, but we ought to hold that in suspense until we have gone
through the 25 exercises and seen what issues they throw up.
Q78 Chairman: Governor, when you appeared before us in June you expressed concern
that the European Systemic Risk Board could turn out to be "a mere talking
shop". We have looked at the issue in the report on macroprudential and microprudential
regulation. From your point of view has the commission's publication of more
detailed proposals allayed your concerns?
Mr King: I said in June that it could be a mere talking shop on the one hand
or a useful talking shop on the other. We were not in a position to know, and
still are not; it has not been set up yet and we are many months away from it.
Q79 Chairman: We are talking about a body of 61 members. If it is to deal with
emergencies do you believe that to be a big number?
Mr King: It will not be able to deal with emergencies, and I do not think it
is seen in that context. I would think of it as a good forum in which to raise
the "too important to fail" question and to start a proper debate on that
question right across Europe. That would be a
rather good forum in which to do it. Therefore, it might be useful for dealing
with the longer-term questions, but in all these things the proof of the
pudding will be in the eating.
Q80 Chairman: Maybe you can give us a list of the useful talking shops that you
attend round the world.
Mr King: That will be a very short one.
Q81 Chairman: Are you concerned that given ESRB's focus on market conditions
across Europe it could end up making recommendations or advocating policies
that are inappropriate given specific circumstances in individual Member
Mr King: It is possible. It will be able to issue recommendations only on a
"comply or explain" basis, so it will not have any authority to impose those
recommendations on individual countries. If a country felt that the
recommendations were inappropriate to its circumstances not only would it be
perfectly entitled to but it would find it rather straightforward to explain
why they were not appropriate in the case of country x and therefore they had no intention of adopting them.
Q82 Chairman: This Committee awaits a reply from the treasury on the potential
reforms to the international monetary system. Is this a time to be bold? Do we
need a Bretton Woods mark II?
Mr King: We certainly need something because of the fear that the imbalances
will re‑emerge and my two big concerns about how we got into this and why
we might end up with another crisis in future. We need radical reform of the
international monetary system. In large part this goes to politics at least as
much as to economics, so this is probably more in your domain than in mine. I
shall continue to argue for reform of the international monetary system, as I
have for many years in speeches. It is very important. If we ignore it and fail
to tackle it I fear that some of the concerns we thought we were about to
experience at the beginning of this year but fortunately did not will come back
to haunt us.
Chairman: On that sober note, I thank you and your colleagues. This session
has been very helpful and insightful.