UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 261-i

House of COMMONS

MINUTES OF EVIDENCE

TAKEN BEFORE

TREASURY COMMITTEE

 

 

FINANCIAL INSTITUTIONS - TOO IMPORTANT TO FAIL ?

 

 

Tuesday 19 January 2010

PROFESSOR CHARLES GOODHART and PROFESSOR JOHN KAY

Evidence heard in Public Questions 1 - 74

 

 

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Oral Evidence

Taken before the Treasury Committee

on Tuesday 19 January 2010

Members present

John McFall, in the Chair

Nick Ainger

Mr Graham Brady

Mr Colin Breed

Jim Cousins

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

John Mann

Mr James Plaskitt

John Thurso

Mr Mark Todd

Mr Andrew Tyrie

Sir Peter Viggers

________________

Witnesses: Professor Charles Goodhart, Programme Director, Regulation & Financial Stability, Financial Markets Group, and London School of Economics Professor Emeritus of Banking and Finance, and Professor John Kay, Visiting Professor of Economics at the London School of Economics and a Fellow of St John's College Oxford, gave evidence.

Q1 Chairman: Welcome to our first evidence session on Financial Institutions - Too Important to Fail. I am delighted that you have been able to kick this off for us. Can you formally introduce yourselves for the shorthand writer, please?

Professor Goodhart: I am Professor Charles Goodhart, retired professor from the London School of Economics.

Professor Kay: I am John Kay, visiting professor at the London School of Economics and various other things.

Q2 Chairman: Good, and we read you every week.

Professor Kay: Thank you, Chairman.

Q3 Chairman: Today we will be discussing several potential root and branch reforms of the financial system. Do you believe there is a choice to be made between potential economic growth and the need to ensure a more stable financial system? Has the boom been worth the bust?

Professor Goodhart: If you are talking about a really constrained communist-type system, the answer is yes. There are countries where the financial institutions are so constrained that certainly they do not have any financial crises. If you look at a map of countries without financial crises, you will discover that North Korea, Sudan and one or two others of that ilk are on it. Under those circumstances, a shift from that kind of constrained financial system to a much more free-market system, which undoubtedly carries with it risks, is without any question and without any doubt, desirable. If you are asking whether greater constraints within our market system might reduce the rate of growth, the answer is that it is possible but we do not have enough evidence at this time to be able to say whether there would be much, if any, reduction.

Professor Kay: I agree with Charles. We could have an aggressively state-controlled financial system that would be an inhibition on economic growth. From where we are now, constraints on the way the financial system operates that achieve more stability, done properly, could enhance rather than reduce possibilities for economic growth, partly because I am quite sceptical as to whether most of the so-called innovation in financial markets over the last two decades has any great social or economic value and, even more, because I believe there are opportunities to make retail financial services serve the consumer a lot better than they have done over that period. We can have the best of both worlds if we get it right.

Q4 Chairman: Do you agree with Paul Volcker that the only decent financial innovation in the financial services industry in the past 30 years has been the ATM machine?

Professor Kay: There is a bit of an exaggeration there, but it focuses on what is an absolute key element, which is that the test of any innovation or other development in the financial services industry is how it either improves the efficiency of non-financial businesses or how it serves customers, and we need to apply absolutely rigorously these tests to any proposals we are talking about. The interests of the financial services industry are not an end in themselves. The financial services industry is a servant of business and the personal sector, not a master - or should be.

Q5 Chairman: Is it going to be possible to quantify the costs and benefits of any of the new potential systems, such as narrow banking, living wills or greater capital requirements?

Professor Goodhart: You can try but you will not get very far. It is a nice idea but in practice it is so difficult. When you are changing the structure it is very hard to work out exactly what is likely to happen. The unexpected consequences of a structural change can be fairly profound.

Q6 Chairman: Professor Kay, your head is in the air with narrow banking.

Professor Kay: Pretty much. I can invent bogus numbers - indeed, I have spent part of my life inventing bogus numbers in order to justify particular policies, because there is a huge demand for these bogus numbers out there - but in the end we have to make these decisions on the basis of our own judgment and knowledge and your judgment and knowledge.

Q7 Chairman: If others do not do it, should we just go alone and do this change?

Professor Goodhart: That is one of the key issues. If you are looking at the important financial intermediaries, the ones that are systemic, the ones that we particularly care about, you will find that almost all of them are cross-border, they are international in operation. One of the great difficulties in this field is that the really serious problems arise when you get a cross-border failure. Lehman's was a particular example of that, where the failure of Lehman Brothers International Europe (which I always think of as Lehman's London) resulted in a chaotic mess. But the difficulty is that, when you get a failure, you find that your international financial institutions which were international in life become national in death, and all the national laws are very different. If one could assume that we were in a closed economy and all with just one legal regulatory system and one fiscal system, operating or changing the laws could be a great deal easier. The difficulty is that we are not. The great problem is that if you try to make a change in one country, it affects the competitive position of all the financial intermediaries which are cross-border and you always get the problem about the level playing field, which means that it is quite difficult to move ahead without international agreement, and because national conditions and laws are so different, it is actually very hard to get international agreement on many issues.

Q8 Mr Tyrie: This does seem to be one of the key questions, because quite a lot of people like to say they support these proposals in principle, but only if there is international agreement to move forward - which is a good cover for not doing anything or for not doing enough. When the Governor was asked this question in the House of Lords, he replied, more or less, that the UK could not afford not to go it alone because of the concentration of financial services in the UK economy. He said that if we did not, we would end up paying a premium in terms of higher bond yields, because people who buy government bonds around the world will say that there is a big risk that the UK Government and the UK taxpayer might once again have to pick up a massive fiscal burden, and, therefore, they will place our country at a higher risk. Do you agree with the Governor on that point? Do you agree that we cannot afford not to go it alone and do this anyway?

Professor Goodhart: There is the issue about too big to save, in the sense that the Icelandic banks were far too big relative to the Icelandic economy. The same is true of UBS and Switzerland. The same could be argued as being true of RBS and even HSBC and the UK. Their overall liabilities are very large relative to our GDP. There were two answers to that one. The first answer is to try to get some kind of international agreement on burden sharing if you need to resolve a really large bank getting into difficulties. If you cannot do that, then there is a question - which the Swiss and others have considered, the Icelandics should have but did not consider - whether there should be a limit on the size of a bank if it becomes, in a sense, too big for the country to save it.

Professor Kay: Instead of talking internationally about burden sharing, we should make very sure that there are not going to be these kinds of burdens in future. The Icelandic issue poses for us, in a very obvious way, the question: why on earth should the typical Icelandic taxpayer be landed with a very large bill for international activities of Icelandic banks over which he had no control, no influence and negligible benefit if the risks they were taking overseas succeeded? Adair Turner posed this issue very well when he said that in the European context we need either more Europe or less. Either these things need to be dealt with at a complete and comprehensive European level, with a single regulator and a single agreement on how bills are going to be met - which is not going to happen - or we have to protect the UK taxpayer. If we were to be in an Icelandic position, I cannot see why I should pick up bills for the international activities of Barclays, HSBC or RBS or any other British-based institution.

Q9 Mr Tyrie: Just to be clear, is the advice of both of you that the UK should go it alone with a narrow banking reform, even if they cannot secure international support?

Professor Kay: That is my view.

Professor Goodhart: No. I think the main aim should be to try to get international agreements. You are talking about a very second-best world in which you get no international agreement at all on how to deal with cross-border failures for very large banks. If you live in that second-best world, there are questions about trying to limit the size of a bank overall, relative to, if you like, the capacity of the country, and I would not do that via a narrow banking system. There is a whole range of ways you can make banks safer. For one thing, I would do it primarily through a leverage ratio.

Q10 Mr Tyrie: Are we not now discussing the absolute epicentre of the policy issue? Everyone has agreed we have to do something. There is a wide range of arguments about what we should do. Narrow banking or something akin to it, perhaps along the lines that Paul Volcker is proposing, carries a lot of intellectual credibility. Very few countries - and the key countries - seem reluctant to do this unilaterally, and without taking unilateral action, it is unlikely to happen.

Professor Goodhart: I think you underestimate the degree to which there is real international agreement. The Basel Committee proposals that were circulated in December are a very good first step. They took some useful measures on shifting capital requirements. They are still studying whether these could be made countercyclical. They are also introducing a leverage ratio and the kind of proposals, the American latest tax suggestion, have a certain merit, though they could be considerably improved, in the sense that the levies related to all non-insured deposits and non-equity capital but they ought to have been levied according to the systemic riskiness, which is related to the maturity, so that there should have been a much higher rate of tax on very short-dated wholesale liabilities, and a much smaller one, tapered, as the term of the liability lengthens.

Professor Kay: We are talking here about devoting more resources and elaboration to measures that have plainly not worked in the past.

Q11 Mr Tyrie: You are talking about the capital requirements and the Basel regime.

Professor Kay: There are two areas. One is the capital requirements and the Basel regime. Over the last 20 years that regime has been essentially negative in its effect. It has made banks riskier, not safer. Its worst effect probably has been that it has encouraged banks to believe that, as it were, they were managing risk if they were complying with these kinds of regulations. I have heard, several times in the last two or three years, very senior executives in banks saying, "The regulators ought to have imposed higher capital requirements on us." My rather strongly felt view is that what capital you need is a business decision - perhaps the most important of business decisions, and certainly the most important of business decisions for banks - and it is a commercial decision, not a regulator's decision. That is the only way it will be made well. The other area that has not worked has been, as we have been ascribing, the arrangements for dealing with cross-border failures. The Icelandic story ought to have been a kind of wake-up call for us because, in world terms, these were relatively small institutions. It is an indication of the problems that can arise if there is a major failure of an institution, most of whose operations are outside its home base. The measures which we have to deal with that situation did not work in that particular case. What are we doing to resolve that in future? The answer is: essentially nothing.

Q12 Mr Tyrie: Your policy prescription is: go it alone. We cannot afford not to. You are agreeing with the Government.

Professor Kay: We have to go it alone, and we have to go it alone in two ways. One is, essentially, if British financial institutions are to operate overseas, we make it clear that we want them to do that but we do not want, as the British taxpayer, to give people any impression that we are underwriting these activities.

Q13 Mr Tyrie: This is subsidiaries, not branches.

Professor Kay: They must operate as subsidiaries and we will let these subsidiaries go, as the UK Government, if need be. Conversely, we do want banks from other countries to operate in the UK but, if they do so, as the world is now they are going to have to maintain assets in the UK which we could seize in the event of a failure of that institution, because there is no other mechanism by which we can ensure that UK depositors get paid if that happened. These are the things that are essential to safeguard the interests of UK customers and UK taxpayers. Just to repeat what I have said several times earlier: these are the things that matter, and the interests of UK financial institutions are secondary.

Q14 Chairman: I wonder if you would clear something up for us, John, in terms of financial stability. You are reported to have said that "no public agency should have financial stability as its goal" and yet consumers, governments and businesses do not like financial instability. Surely someone must be responsible for financial stability?

Professor Kay: I have said that a public agency should not have financial stability as its goal because we cannot achieve it and it is a mistake to adopt targets you cannot achieve. The important thing we should aim for is ensuring that the real economy (that is non-financial businesses and personal customers) are protected from the worst consequences of financial instability, because it is the nature of modern financial markets that people are going to speculate, gamble in these markets and get things wrong. I do not want to shut all that down. If I had to, I would, in order to create a greater degree of financial stability than we have enjoyed, but we want to allow people as much freedom as we can consistent with protecting customers and taxpayers for the consequences.

Q15 Mr Plaskitt: At the root of this lies the issue of the mismatch between the scale of banking on the one hand and the scale of regulation on the other hand. We have talked this morning already about global banks. Are we in a situation where we effectively have global banks but national regulators?

Professor Goodhart: Yes.

Q16 Mr Plaskitt: Part of the analysis is to say that you have to get equalisation between these two things. That causes one side of the argument to focus on reducing the scale of the banks and leads towards a narrow bank type solution. How much attention should we pay to an effort to try to rebalance it by getting towards more effective global regulation - not necessarily bigger or heavier regulation but all the regulators agreeing a set of common standards? Do we dismiss that as unattainable and therefore concentrate on the size of banking?

Professor Goodhart: John and I disagree on this. I am on record as having said that Basel II plus mark-to-market as an account mechanism was a Doomsday machine. I entirely agree with John that the international regulatory system that we have had over the last ten years or so has been procyclical and has been damaging. The fact that it was wrong does not mean to say that it cannot be greatly improved and made right. John dismisses regulation as impossible or always going to fail; I do not. I think that regulation can be made better. I think that the Basel Committee is taking steps in the right direction and that the situation can be improved. The distinction between the national and international is correct. Absent a European fiscal authority which can help to deal with European cross-border resolutions, it is more or less inevitable that the tendency will be towards less Europe and a greater national control. I agree with John on that front. But it is better to try to control through regulatory mechanisms, maybe including some various kinds of fiscal controls or premium for risky activities, rather than, if you like, outright bans: you cannot do this and you cannot do that. My regulatory proposals are rather more flexible than John's requirement that you can only have narrow banking. It would be very difficult to introduce that.

Professor Kay: Charles is right in saying that there is a nub of disagreement there. My belief - and I derive this belief partly from having spent quite a lot of time on the regulation of other industry, so for the last 20 years I have looked quite a lot at the whole process of regulation, deregulation, privatisation in British utilities and transport - is that one very clear conclusion from regulatory history is that if you can regulate structure it is almost always better to try to regulate structure than behaviour; that is, to put in place structures that give firms roughly the incentives to do the kinds of things you want, rather than engage in detailed monitoring of the activities they engage in. That has been true across the utility sector. Almost all the industries where we think regulation is going wrong are those where we have ended up trying to regulate behaviour, and there we end up, as we do in financial services, with a regulation that is at once extensive and intrusive and yet not very effective, and subject to what people call regulatory capture. It is not so much that it operates for the benefit of the industries, as that it sees the industry through the eyes of industry. That is what I think the financial services regulation both in Britain and elsewhere does. I am sceptical about the capacity of this behavioural regulation. That is why the regulation I want is more structural, but I also agree that we should pursue both the routes of developing more effective regulation at a national level and pursuing regulation at an international level. I am frankly sceptical as to whether in any short-time horizon very much that is useful will come from pursuing better regulation at a global level.

Q17 Mr Plaskitt: That was my follow-up question. You are after a globally coherent form of structural regulation, but is the mechanism in place to achieve it or is it an ideal but just not deliverable?

Professor Kay: That is where we are at the moment, that it is an ideal - as other political ideals - that we should continue to work towards, but it is not an ideal which is well expressed in the Basel Committee, and, frankly, in saying we need better rules from Basel is just the familiar story, that when the snake oil does not work, people tell you that what you need is more snake oil and there ought to come a point at which we say, " Well, I think we'll try something else instead."

Professor Goodhart: You need to ask yourself: what is the financial system supposed to deliver? Back in the 19th century we had a mechanism of controlling risk which actually worked quite well. That was unlimited liability for the shareholders and of course the managers were shareholders. We got rid of it. Why did we get rid of it? We got rid of it because what resulted were relatively small institutions which were not able or prepared to take on very large risk in supporting industry. The UK looked at France and Germany and the countries in the Continent which were developing universal banks which were much bigger, and they saw themselves and their banking system falling behind. They said to themselves, effectively, "What we have to do is to provide a condition in which our banking system provides the support for growing industry and is prepared to take up much larger positions much riskier positions, much longer term positions." In order to get sufficient capitalisation to do that, you needed to move from unlimited liability to limited liability, which everybody recognised was going to make the financial system much, much riskier, and there were attempts to offset that by increasing accountancy and transparency and all that sort of thing. And of course it did make the world a bit riskier. There are a myriad of ways in which anyone can make the banking system safer. The question is: exactly how safe do you want it to be? One of the considerations that you have to have is actually what you want your banking system to do. One way or another, whether it be through John's route or greater capital and liquidity requirements or one way or another, we are likely to make our banking system safer and smaller. The question is: will that be a good idea? How safe and how small do you want the banking system to be? If you make your banking system safer and smaller, what happens to the financing of your companies? You are going to push all the financial intermediation probably back on to the market. Will that make the world safer or will it make it more dangerous? For example, a lot of mortgage origination you can do through the market rather than through banks. Will that necessarily be safer?

Professor Kay: I hesitate to add to Charles's lecture on banking history because he is our country's leading expert in that, but I want to say that the banking system moved on as financial innovation came in, particularly in the 1970s and 1980s. While we had to have big banks in the past in order to deal with the problems of pooling risk and the basic banking problem of matching the maturity of deposits with the maturity of loans, what happened as financial innovation took place was that you could deal with these things through markets rather than have to deal with them in single big institutions. People wrote then that what would happen would be that banks would become smaller - and there is a compelling logic to that - but what happened was quite strange: the retail side of banks did use markets to reduce their risk. If one takes the Royal Bank of Scotland or other failed banks, in the retail side they had used these markets for securitisation and swaps to reduce the problems of pooling risk and matching maturities. But the wholesale parts of the same banks took on more and different risks - the ones the retail departments of the banks had got rid of. That is how you got this absurd situation where Halifax was in effect selling mortgages in the UK which it had underwritten and knew a lot about, and directly and indirectly buying mortgages in the United States about which it knew absolutely nothing. That is a large part of what in the end went wrong. In essence, that is a substantial part of the argument for saying separate these things out, and then we can get the benefits of financial innovation without the disadvantages we have seen.

Professor Goodhart: But the separation is actually quite difficult. It is easy enough if you are dealing with people/persons and if you are dealing with small enterprises, but when you are dealing with large financial intermediaries, and when you are dealing with manufacturing companies, and the range of activities that is required and the kind of treasury activities that are required, the range of operations is very large and it will incorporate a lot of activities which are, if you like, of a wholesale characteristic. I would entirely agree with you, John, that the retail side and the innovations there and the securitisations there were done well. It is the wholesale side which was the problem.

Q18 Mr Todd: I would like to explore one of the apparently consensual areas of public policy purpose for this, which is depositor protection. An unalloyed good? Something that you both feel is absolute and that the taxpayer should guarantee in all circumstances?

Professor Kay: I do not think it is an unalloyed good. Ordinary people and ordinary businesses have to be able to place deposits and use the payment system and be confident that these things will work. That is why I have kept going round calling it a utility. A utility, for me, is the ability to make deposits and make payments.

Q19 Mr Todd: No element of co-insurance at all? It is just simply that you put your money in, you must always expect it to be paid out, and if there is a difficulty the taxpayer will guarantee it 10% in all circumstances. Is that your goal of public policy in this area?

Professor Kay: I do not find the way you have expressed it a very appealing outcome.

Q20 Mr Todd: I deliberately put it in that way.

Professor Kay: I want to limit as far as I can the area in which that is true. The structure which I would like to see would be one in which people have deposits which were the deposits they needed to make the payment system function. That is essentially the utility and the bit of the financial services system we need every day. For deposits in excess of that amount, I would like to see rather more development in the UK than there has been so far of the kind of money market funds that exist in the United States, where people would be investing in a diversified portfolio of short-term obligations and would be taking a little bit of risk and would either have to judge that risk themselves or employ the fund managers to assess the risks for them.

Q21 Mr Todd: That is a rather more complicated model than the one we have seen operate during this crisis, in which virtually everyone has had their money back, no questions asked.

Professor Kay: Yes, and we have to escape from that as soon as possible.

Q22 Mr Todd: You will appreciate the moral hazard argument that is developed at various times.

Professor Goodhart: That was the reason why the original deposit insurance fund had a lot of co-insurance. It was set up in the aftermath of the S&L crisis, when people used to go around trying to find the most crooked S&L they could because it usually offered 0.25% more, and the moral hazard was clear. On the other hand, if you have such a lot of co-insurance, it means that it is worthwhile running if you think your bank is in difficulties and, also, if you think your money market mutual fund is in difficulties. Remember that these money market mutual funds are, in a sense, a bank with upside but no downside, because the money market mutual funds promised never to break the buck, and when the reserve primary fund did break the buck, after Lehman's, there was an immediate run on the money market mutual funds and effectively the Fed and the US Government had to go in and guarantee the lot. Beware of money market mutual funds, in the sense that if they appear to have, as many do, a downside commitment, then they are, in a sense, risky banks just as much as the banking system is.

Professor Kay: My view is that a money market fund of the kind we are describing cannot guarantee not to break the buck. What has happened in the United States has happened because they had regulation of current accounts for far too long. Money market funds came into being that were, in reality, current accounts, where people placed transactions/deposits. Money market funds in the US are too large and became a substitute for bank deposits. A money market fund should not guarantee not to break the buck, but it will not break the buck by very much. Even the reserve primary fund went to 97 before the US Government intervened. That is very different from the traditional bank deposit, where the story was that the people who were at the front of the queue got 100% of their money back and the people who were at the end of the queue did not get any. That is what creates the instability of bank runs. But that is something, once again, making use of financial innovation, you can get rid of.

Q23 Mr Todd: Implicit in your argument for narrow banking is that you define very clearly these deposit-taking institutions and precisely how they work: the level of risk that a depositor actually carries in that process. I think you have accepted there should be some and that the taxpayer cannot simply be the guarantor in all circumstances, as they have been in this instance. Presumably there are other implications from that, because we have a number of effectively narrow bank institutions that have run into trouble during this crisis - some building societies; Northern Rock, arguably. One of the areas of your argument I have found hardest to work through is this definitional aspect and the issue of quite how one ties up the public policy good to which you obviously are strongly committed and how you narrow that area of risk, because there will be some risk retained by the public purse and there will be some risk shared with depositors. I am not clear of the mechanisms on either side of that.

Professor Kay: Could I elaborate on that. It seems to me that if we are going to have deposit protection we need to minimise the taxpayer risk from deposit protection. That means ensuring that deposits are backed by safe assets - and not just partly backed by safe assets but wholly backed by safe assets. The blunt fact is that in the world we have got into over the last 20 years, where the rating agencies would attach triple-A ratings to anything, the only thing we can be sure are safe assets are government securities of various kinds. I see narrow banking and deposits that go with narrow banking being backed by genuinely safe assets of that kind. That is also the only protection I can see against the kind of thing that happened.

Q24 Mr Todd: Pushing you a little harder, I think you are saying that the model of banking we have in this country is going to alter fundamentally to one where the margins are going to be so tight for the bank you have designed that we are going to have charging systems and a rather unfamiliar institution to most of us. Is that your view?

Professor Kay: I think that is right. We have been giving deposit protection for free, in effect, and we are going to stop.

Q25 Mr Todd: By some sort risk sharing between customers.

Professor Kay: Yes.

Q26 Mr Todd: But not transparently.

Professor Kay: That is right.

Professor Goodhart: We have had narrow banks many times. Indeed, Parliament arranged for two narrow banks going back to the 19th century - the Post Office Savings Bank was one, the Trustee Savings Bank was another - which operated exactly along the lines that John wanted. Neither of them was very successful. In competition with other banks which could take more risk and therefore offer a higher rate of deposit, the Post Office Savings Bank and the Trustees Savings Bank had a role.

Q27 Mr Todd: I put some money into them at one time. I was very young!

Professor Goodhart: At one stage in his very interesting paper John says that in a free market the narrow banks would win. He says that the market is being constrained by deposit insurance. But deposit insurance only came in in the 1990s, after BCCI. There was none before then. The narrow banks were able to compete and effectively lost out. The problem is that if you required narrow banks to hold entirely riskless assets, those assets would have very low rates of return. Also, the services that narrow banks like the Post Office Savings Bank could offer were relatively limited. In competition with the other commercial banks, effectively they lost. Possibly because they are myopic - and remember these financial crises only come around about once every 50 or 60 years and most of the time people think their money is going to be safe - if you have a narrow banking system and you tie it up with a commercial banking system, in ordinary times people will shift all their money to the commercial banking system and narrow banks will lose out - as has happened in history time and time again - and then if there is a crisis people will rush the other way, actually making the crisis worse. I remember that John wanted to divide the utility from the casino. What was the greatest failure that occurred in the recent crisis, the greatest failure of policy? Most people think it was letting Lehman's go. If ever there was a casino, it was Lehman's. No deposits, no relationship with the payment system and that sort of thing, and yet letting Lehman's go, most people think, and I tend to agree with them, was a total disaster. Simply having a set of narrow banks - and I am not against having the odd narrow bank: why not? - I do not think deals with the kind of situation that a more complex financial system, of the kind we have now, is set up to handle.

Professor Kay: There are several points there, if you will allow me to pick them up. Let me begin by saying that we had narrow banks, which were called building societies. Not only did they compete, they were steadily winning market share at the expense of other banks. We mistakenly, in retrospect - and I say mistakenly having supported it at the time, but mistakenly, in retrospect - allowed them to diversify their activities, which they did - unsuccessfully in every single case - and failed. That is a large part of the problem which we have in the UK financial services sector today. This kind of solution is perfectly feasible. Charles quotes me accurately in saying that if we had a free market today we would have narrow banks immediately, but the reason for that is that, if there was no government underwriting of Barclays, I would today take all my money out of Barclays and put it in an organisation which was transparent and where I knew what activities it was engaging in. Ten or fifteen years ago, I would never have imagined that the Royal Bank of Scotland or Barclays would pose any problems. Now I know what these organisations were doing and I am worried, both as a potential depositor and as a taxpayer. We have had narrow banks, they have worked in this sense, and this kind of proposal can work in the future. It is going back to a world which worked perfectly well in the past. We did not have these kinds of problems.

Q28 Mr Breed: Professor Kay, you said just now that you would regulate structure, not behaviour. You think the FSA's policy of treating customers fairly is a bit of a waste of time because it rather depends upon the integrity of those people who are operating the system.

Professor Kay: I do not think it is a waste of time. We should have a consumer protection objective, either in the FSA or whatever other set up we might put in place for it; but in the end, the consumer protection objective is going to be best achieved by a world in which people develop deserved reputations for treating customers fairly. Unfortunately, when we took the building societies out of the picture, that was one of the positive elements in the British financial services scene we lost there as well.

Q29 Mr Breed: Essentially, if you do not regulate behaviour, you are depending upon them behaving properly. If they do not, we come into what we call the moral hazard argument. To what extent do you think the recent bail-outs have increased moral hazard within the financial system? When the Government decided to bail out Northern Rock, all the share prices of the other banks rose on the basis that if they were prepared to bail out Northern Rock then of course they were absolutely prepared to bail out the RBSs of this world.

Professor Kay: There are two groups of issues there. One is that I believe the Government absolutely has to extricate itself from the position it is in at the moment, where it is perceived as underwriting essentially all the liabilities of the UK banks. We have to have - and this, it seems to me, is a central issue for you in this inquiry - a clear programme for extricating ourselves from that situation and becoming clear about exactly what it is we guarantee, which I hope will be quite limited and what we do not guarantee.

Q30 Mr Breed: Can that be done through regulating the structure, rather than regulating behaviour?

Professor Kay: I think it can. There are two key structural elements. One is to say: what are the deposits we guarantee, what liabilities of banks do we guarantee? Conversely: which is it clear we do not guarantee? Either consumers or wholesale financial markets have to make their own decisions about the quality of these counterparties. One of the reasons for talking about a role for money market funds is to enable people to employ professionals, if they want, to deal with that for them.

Professor Goodhart: You have to go wider within institutions. You have to guarantee market structures as well. One of the issues relating to the centralisation of dealing in derivatives through central clearing houses, centralised clearing parties (CCPs), is that that then becomes a sort of focus, because all the deals then get made with the central clearing party. If that central clearing party went down, there would be chaos. One of the lessons of the recent crisis has been that it is not just the safety of the depositors and the safety of the payment system that needs to be assured. Indeed, virtually no depositor and no payment system actually went down at any stage to any degree during the crisis. One of the reasons why the crisis has been so severe is because it has impaired the mechanism of credit flows through the system. One has to think about the form and structure of credit flows through the system. That was one of the reasons why the failure of Lehman's, although it had no deposits and no relationship with the payment system, caused such a major problem. I have a lot of sympathy with what John says, but I do not think he appreciates sufficiently that it is not just about deposits, it is not just the liability side, it is the asset side. It is the provision of credit for our companies and mortgages for our people that are so important. You can have a development whereby the system is unable to provide sufficient credit and the economy will go down, whatever happens to the deposits and whatever happens to the payment system.

Q31 Mr Breed: We are going to move on. When we allowed unlimited partnerships, which were mainly engaged in investment banking activities, to be conjoined with limited liability narrow banks or joint stock banks, we seemed to have ended up with the best of all worlds for them and the worst of all worlds for us, in the sense that the bonus culture and such was then allied to the banking business and the personal liability of those who were able to risk their own capital was then transferred on to the taxpayer.

Professor Goodhart: I have a great deal of sympathy for that point of view.

Q32 Mr Breed: Is the reintroduction of more unlimited liability partnerships part of the way in which we tackle this moral hazard argument?

Professor Goodhart: I have a great deal of sympathy for that point of view. There was a very interesting piece by Record in one of the FTs in which he was arguing that you could have unlimited liability if it accumulated bonus payments to bankers. Also, there are many who feel that the shift in the major American investment house from partnerships to limited liability companies was not a step in the right direction with regard to risk-taking. When John was talking about the building society changes, I was waiting for him to say that the step that we took which was wrong was shifting from mutual arrangements to limited liability incorporation, and he did not say that, but I expect him to think it!

Q33 Mr Breed: That sounds like some encouragement there.

Professor Kay: Interestingly, nor do I think it. The key shift in the building societies was not so much the loss of mutuality because they were not behaving much like mutual institutions anyway by the end of their time as mutuals. The key shift I observed in building societies was when they moved to the idea that the treasury operation was a profit centre in its own right rather than a service operation for the business of taking deposits and providing mortgages.

Q34 Mr Breed: Do you agree with this potential for reintroducing unlimited partnerships as part of the way in which moral hazard might be ameliorated?

Professor Kay: It is one way. The key issue is that the trading operations ought to be undertaken in hedge funds, which can be undertaken by people providing substantial amounts of equity capital which they know is at high risk. That is the bit of these banks, or, indeed, in the case we were talking about, building societies, which ought to be out of them. It is a different culture, a different risk profile, a different reward structure - different in every way.

Q35 Mr Breed: In respect of cross-border regulation, have we learned nothing following BCCI?

Professor Kay: I do not know what the lessons of BCCI were.

Q36 Mr Breed: They were operating in a variety of different countries, none of which the host regulator was looking at. That was a pretty bad example. Twenty-five years later, we have Iceland and everything else. We have learned nothing, essentially, and if we are not careful we are not going to learn anything out of this one either.

Professor Kay: Once again, if BCCI had had to back its UK deposit-taking operations with safe assets in the UK, we would have had a very different picture. We would not have had BCCI in the UK.

Professor Goodhart: Not necessarily. There were bits of BCCI, including BCCI Hong Kong, which were profitable and which had assets to support their liabilities, but BCCI Hong Kong could not continue because once a significant part of a bank structure goes down, the reputational effect is such that the rest almost always cannot operate on its own and will fail. If you want to ensure that your part will continue, you have to go down the New Zealand road. The New Zealand road requires the New Zealand subsidiaries, which are primarily the Australian banks, not only to have assets to back their liabilities but to have their own IT system, and if the Australian Head Office should fail, the New Zealand part of the bank would be able to be up and running the very next day. The New Zealand approach is more or less making subsidiaries into completely stand-alone banks.

Professor Kay: And we have experience of this in other industries. To go back to my analogies earlier of other utilities, in these utilities we have provisions that make the central distinction between continuing the activity and continuing the corporate vehicle. Railtrack went bust, Metronet went bust, the trains and the tubes kept running. Enron went bust, the water kept flowing in Wessex and its electricity subsidiaries continued to operate as well. That is because in these industries we have set up structures and firewalls that mean that if a parent goes bust you could step in and continue the essential activity the following day. That is what happened in these cases and that is what we need to do in this industry.

Q37 Nick Ainger: The customers of those utilities could not go anywhere else. The problem with the banking system is that, as soon as there is reputational damage, customers go elsewhere. That is what was happening with Northern Rock. You cannot draw a direct parallel between the financial services sector and the utilities sector.

Professor Kay: Yes, but what created the problem with Northern Rock was partly because of the inadequacies of our deposit protection scheme. It was not possible for the Chancellor or the Governor of the Bank of England immediately to go and say, as it were, "We have taken over your deposits and they are safe." When the Chancellor finally did, that ended the problem. You need to have the capacity for the Government to be able to do that in these situations.

Professor Goodhart: You say it would have ended the problem. In one sense, yes, and there would not have been the run, but in another sense no. Northern Rock's run really occurred well before, because the run was by the wholesale funders, who simply knew that if you were making loan-to-value loans of over 100% in an economy where the housing market was quite likely to go down because there had been a bubble, effectively Northern Rock was likely to be insolvent. Northern Rock was in grave difficulties before the run occurred. The run occurred because the realisation that the Bank had to step in revealed to all and sundry, including to the retail deposits, what a right old mess Northern Rock was in.

Professor Kay: What could and should have happened in the Northern Rock case was that Northern Rock plc would have become insolvent over that critical time, and at that time the regulatory authorities would have taken over both the mortgage origination operation of Northern Rock, which is a rather efficient business, and the retail deposit activities, both of which could at that point have been sold quite easily to another financial institution. It was because we did not have the provisions in place - which now to a fair degree we do, but did not at that time - for a resolution procedure and for proper assurances about asset protection. The Northern Rock crisis is in that sense rather untypical of the set of financial problems which we have been talking about in this session. Northern Rock in this sense was not a "too big to fail" problem.

Q38 John Thurso: I was going to start by saying I would like to talk about narrow banking, but since absolutely everybody has, perhaps I can continue with that discussion. First of all, is there an agreement on a definition of what we mean? We have heard some people talking about utility versus casino, some people talking about Glass Steagall. All of these are a sort of shorthand. What precisely, Professor Kay, is it that you would like to see, and what precisely, Professor Goodhart, is it that you do not want to see?

Professor Kay: There are several possible models of narrow banking, to confuse the issue a bit.

Q39 John Thurso: That is a good start.

Professor Kay: In my pamphlet, which I imagine you will have seen, I have indicated one which I would prefer, which would be a rather rigorous model of narrow banking which would require insured deposits (that is, deposits which the UK taxpayer guarantees) to be wholly matched by safe assets (that is, government securities).

Professor Goodhart: John is absolutely right that there are several more versions of narrow banking. It is better to try and adjust regulation to make the banking system safer rather than to do it by absolute constraints: you cannot do this and you cannot do that. For example, one of the areas in John's paper which I would be most upset by was saying that only narrow banks could access the payment system. You have loads of financial institutions, stockbrokers for example, who would undoubtedly stick with the commercial banking. You are going to have your financial market operators without access to the payment system; you are going to have your major manufactures without access to the payment system. As I say, I do not think narrow banking would emerge naturally in a free system. I do not think it ever has emerged naturally, because it is relatively unprofitable, and I do not think that forcing the financial system into that mould would be desirable.

Q40 John Thurso: If I could take those two answers. For Professor Kay, some form of narrow banking is highly desirable but, within bounds, you are not too worried about how it is. For Professor Goodhart, no form of narrow banking is really desirable.

Professor Goodhart: The nub of the arguments that John and Paul Volcker and others have been putting forward is a concern about financial institutions taking what appear to be speculative positions for themselves, in what are usually known as "prop desks" and that these speculative positions should be supported by the taxpayer if things go wrong. I see that problem and I think that there is a problem there. My preferred solution would be to ensure that the regulatory requirements on such activities were greatly increased. I would have considerable interest in trying to see whether the governance mechanisms - by which I mean, for example, the proposals that Record put forward to the FT of making accumulated bonuses unlimited liability - could help to deal with that situation without simply straightforwardly banning it. The line of division between taking, if you like, positions on behalf of your customers - which you frequently need to do if you are a major financial institution - and taking a position simply on your own behalf is frequently quite difficult to define exactly, and you might have to have really quite an intrusive situation to be able to make that distinction.

Professor Kay: Charles has absolutely expressed the nub of the issue. It is how we stop people who are taking deposits from the public engaging in speculative transactions on their own account - what we can loosely call "prop desks" in this sense. I describe the nemesis at Halifax. It was blurry. It was the point at which that became blurred that was the start of the downhill path.

Q41 John Thurso: That goes to the heart of what irritates the public, and, indeed, most of the small business and medium businesses: the cross-subsidy issue, that we have pumped billions into the banks in order to protect the healthy credit flows into commerce/industry and we have seen over the last year the other end of the bank making vast sums of money by speculating with it. Is there anything we can do to stop that cross-subsidy or is that just an inevitable consequence of what is happening?

Professor Kay: Separate the institutions.

Professor Goodhart: That goes too far. I do not want to separate the institutions. It is entirely valid to impose much tougher requirements on, if you like, gambling/prop desk activities within the financial institution and I would look for various mechanisms of trying to adjust the governance mechanisms alongside that.

Q42 John Thurso: My colleague Colin Breed raised a matter that I raised with the Governor when he was before us, which is, without going into too much of a history lesson, that in the late 1970s/early 1980s we had a number of merchant banks which largely had the capital of the people involved, the partners, at stake, and the tradition of taking a large reward was because it was directly in relation to a large amount of capital and the culture of large reward for that activity began with that relationship with capital which has now been pretty well entirely lost. But there is another point. There are two types of funding required by industry. There is, if you like, the relatively safe commercial debt, where there are covenants on both interest and capital, but there is also the need for riskier investment which was more likely to come from within the merchant banking arm. We had some cross-pollination of the two which has been to the detriment of commerce. Surely not separating makes funding for industry much worse?

Professor Goodhart: I am not sure why it makes funding for industry worse. I am not sure why it makes, say, the commercial paper market or lending to industry worse. If you are going to have a company with involvement on the merchant banking activities and perhaps on the overseas activities, there are certainly economies of scope that can mean that any company will want to have a range of its activities with a particular financial intermediary rather than going to two. I do not think that I accept your premise that it has made financing for industry worse.

Professor Kay: This is a key issue. Until the 1980s, essentially, we had functional separation in financial services in Britain, in the sense that there were different kinds of institutions performing different roles, and we removed the restrictions on that, some of which were implicit, some of which were explicit. I believe that we can substitute for that wider behavioural regulation. We have learned over the last 20 years that the disadvantages of that approach have substantially outweighed the advantages. There are both advantages and disadvantages, but we are in the mess we are in today because the disadvantages were dominant.

Q43 John Thurso: Would it be possible to reconcile the objective of separating activity with the desirability of having integrated banking if one had a licensing system where each unit was a brand in the way that, for example, Coutts is a separate licensed brand of RBS and could at any time have been taken out? Could one license the different activities in such a way that they were discrete and therefore separate fruits, as it were, so that in the event of a crisis they could be dealt with separately, whereas the holding company could retain the advantages of the whole?

Professor Goodhart: It is a problem of reputational risk. I remember, almost, how this particular exercise started, which was when Bear Stearns had a couple of hedge funds which were effectively separated and the hedge funds had gone quite largely into these sub-prime mortgages and got into difficulties. Bear Stearns felt for reputational risk reasons that it had to support these hedge funds, which both denuded Bear Stearns of quite a lot of capital and, in a sense, just underlined the problem that Bear Stearns was getting into. This idea that you can separate the reputational risk without worrying about reputational risk, I do not think flies. In an institution with a lot of subsidiaries, people know that they are all of a part, and if one goes down it infects the other.

Professor Kay: I would favour the approach you describe. Indeed, from where we are now, it is where one would naturally go to create financial holding companies with largely separate subsidiaries. But I suspect that is not a structure that would last very long, partly for the reasons Charles describes, partly because if the people in Barclays Capital were firewalled from Barclays Retail Bank they would lose interest in Barclays Retail Bank fairly rapidly.

Q44 Mr Fallon: I would like to pursue this, not on the same definition but on the jurisdictional point that Professor Goodhart mentioned earlier about New Zealand, which I think has wider application than simply IT systems. There is a suggestion in Turner 2 that it might be possible to develop a better definition of legal entities. Is it not the case today that if HSBC's proprietary trading in Singapore gets into difficulty, that is not carried on the group balance sheet here that exposes the UK taxpayer; whereas if Barclays, Bob Diamond for example, makes a mistake in New York, then the British taxpayer is at risk - which is a reflection of the different jurisdictional structures of those two banks?

Professor Goodhart: There are these jurisdictional differences. Some banks have organised themselves as a kind of holding company with subsidiaries which really are separate and others have not. One of the difficulties is that a number of the really large universal banks would regard it as losing a great deal of the synergies and the advantages of global finance to be forced to separate all the parts. This is one of the areas where I think that the living will exercise will be particularly helpful, because it will enable people who understand the regulators and everyone else, including within the banks themselves, to understand much more clearly what the jurisdictional arrangements are, and to try to relate the jurisdictional arrangements to the way that the bank functions. Taking Lehman's, I believe that there was an enormous number of separate legal jurisdictions, many of which had no relationship whatsoever with the functions of the bank but were there purely for regulatory and, indeed, tax purposes. Under the living will proposals, I would hope that the regulators will get a grip at this and will enable this to be simplified and made both clearer and easier in such a way that the bank itself can move towards a greater appreciation of what should be done when it runs into difficulties, and if those difficulties become insuperable, to enable the various national regulators to be in a much better position to reserve the bank quickly and with as little impact on the taxpayers as possible.

Q45 Mr Fallon: You have not quite answered how valid you think the arguments are of the more integrated banks, like Barclays, who will always be the cause of activity and say this is what their clients demand; whereas an equally global bank like HSBC seems to have managed to operate in exactly the same climate with a very different structure.

Professor Goodhart: My personal preference, given the fact that laws are national and given the fact that fiscal powers are national as well: it seems to me that in that kind of world there is a great deal to be said for trying to make the structure of banks national rather than international; in other words, to use Adair Turner's phrase, that we go less Europe rather than more Europe, but I appreciate two things. First of all, this will run entirely counter to the desires and interests of many universal banks, who will fight it and who will argue that we are destroying the global financial system, and the other - which is in some senses much more important from the regulatory point of view - runs entirely counter to the desire of the European authorities to have a singe European financial system, because going down that road effectively means the end of the single European financial system, and that means that you have most continental countries in Europe absolutely and vociferously and very, very strongly against the line that you are suggesting.

Professor Kay: Picking up a point Charles had made somewhat lightly - that a large part of the synergies which we are talking about in these global banks are to do with tax, regulatory arbitrage and the kind of cross-subsidy we were talking about earlier, so from a public policy point of view we should not have very much sympathy with these synergies - the difference between the structure of HSBC and Barclays that you were describing is a lot more noticeable to Barclays than it is to the customers of either of these two banks. Going on from that, if one talks of other industries, people are endlessly talking in these industries about the desire of large corporations to buy from a single global supplier. I have heard that every year in telecoms, for example, since telecom privatisation began. Most of the evidence is that most of their customers do not: they want to pick and choose who are the best suppliers for particular goods. There are some synergies of that kind, but I do not think we should go overboard about that.

Q46 Mr Fallon: In telecoms and, indeed, in oil eventually, some of these huge corporations were split up. You do see some merit in working further on replicating the HSBC model rather than the Barclays model.

Professor Kay: Yes, I do. That is the line that functional separation, in the first instance, at least with global holding companies, takes us down. It may well be that that structure proves satisfactory and permanent.

Q47 Mr Fallon: Do you believe that because you think the price of all this connectivity and synergy is simply too high in exposure to national taxation, or because instinctively you feel that that kind of corporation is simply wrong in terms of size and spread? Or is it both?

Professor Kay: I think it is both. I am sceptical about how much we need these kinds of global institutions in banking or telecommunications.

Mr Fallon: Thank you.

Q48 Sir Peter Viggers: The theory of categorising banking and other financial institutions and applying to each category the appropriate gradation of risk is very attractive, but there are arguments I have heard that the practicality makes this really very difficult indeed, and it is brought to a head in the so-called boundary problem. Professor Goodhart, would you say a word about the boundary problem and how important you see it, and then, Professor Kay, would you comment on that.

Professor Goodhart: The boundary problem is very simple. If you impose constraints and/or various kinds of burdensome regulations and taxes on one sector, it means there is a tremendous incentive for people to do the same kind of business over the boundary in the unregulated sector so that there is always a tendency to shift business out of the regulated into the unregulated sector. When it is unregulated the results may be considerably worse. In a sense I have been making that comment throughout, that if you are going to regulate, control, or constrain the banking system so much, you will shift the business elsewhere, possibly into the market; possibly into various other kinds of hedge funds. The end result may be that you will have a nice little protected sector at one point, but you will have a potentially dangerous unregulated area at another. I think my concern is that we will never actually avoid crises in the financial system, but if we make the banking system a great deal safer, what we will do is we will have the next crisis occurring in a shadow banking system or in a part of the unregulated market. You have to look at the financial system as a whole rather than concentrating just on one small part of it because of the boundary problem.

Q49 Sir Peter Viggers: Does this hold your narrow banking theory below the water, Professor Kay?

Professor Kay: You will not be surprised to know that I do not think so. Charles has identified the boundary problem in a very general way, and it is true of any form of regulation, whatever form of regulation we have, that we will get regulatory arbitrage in which people seek to do the same kind of thing in a rather different and differently regulated way. In whatever kind of regulatory structure we set up we are going to get problems of that kind. We have had them in spades over the last two decades. Indeed, a very large part of what has set up the problems which we have encountered in the last two years has been regulatory arbitrage in which people reconfigured and restructured transactions in order to reduce what they perceived as the regulatory burdens. Whatever set-up we devise, we have to structure it with a view to minimising the impact of these problems. Charles has talked quite a lot about a specific boundary problem, which is the problem of the boundary between guaranteed and non-guaranteed liabilities of banks. I think you are bound to get that boundary problem unless you go down the routes of either guaranteeing nothing or guaranteeing everything, both of which seem to me unacceptable. What I think we have to do is to try and find a relatively narrow area that is guaranteed, be very clear about what that is and be clear also that everyone understands what is guaranteed and what is not. At the moment I think we are in a terrible position where we really think everything is guaranteed but we are not quite sure, and Fannie Mae, if any other lesson were needed, is a lesson of the enormous potential cost of that kind of action.

Q50 Sir Peter Viggers: Professor Goodhart, if you were asked by a government which said, "We have decided to split up the financial sector banking system", where would you draw the line and where would you advise them to draw the line?

Professor Goodhart: I think there is an issue of how you limit financial intermediaries taking speculative positions for their own gain upon the back of insurance from the taxpayer. I would do this both by much more intensive regulation on such activities and I would consider various changes in the Government's mechanisms. I think if these were introduced, I would allow the system otherwise to operate as it wanted, but I am concerned that there is not sufficient downside risk for those people who are taking speculative positions for their own and their shareholders' gain, where if you get a tail event, a really adverse effect, it falls to the taxpayer. I think that is wrong and we have to change that.

Q51 Sir Peter Viggers: Professor Kay referred to the argument that there need to be large financial institutions to deal with the global problems of fund raising, and Gerald Corrigan, the Managing Director of Goldman Sachs, and others have launched quite a vigorous defence of the very large financial institutions. I suppose you will say, he would, would he not? Professor Goodhart, do you share Professor Kay's view on the very large institutions and that there is no special need for them?

Professor Goodhart: I think that the size of the financial institutions should be considered against the background of the size of the economy in which they are based. I think the Icelandic development was inappropriate, that Switzerland was put at risk by UBS and that we were put at some risk by allowing our biggest banks to become so large relative to the size of the UK economy. There need to be ways to ensure that that does not fall on the UK or, as John was rightly saying, on the Icelandic taxpayer, for whom, I agree with John entirely, I feel a great deal of sympathy; but if one does feel sympathy for the taxpayer under those circumstances, one must have a system which ensures that the taxpayer is not at risk for that kind of disastrous outcome.

Q52 Mr Brady: To follow that up, Gerald Corrigan's case, I think, made the point that large integrated financial groups are necessary to fund large corporations and sovereign governments. He said these are organisations with balance sheets ranging from the high hundreds of billions to $2 trillion or so. Professor Kay, do you completely reject the argument that size is important in that regard?

Professor Kay: One of the problems in this kind of debate is people have difficulty in visualising the world as being very different from what it currently is. I do not think in any world General Electric is going to have large problems tapping the world capital markets for very long. One way or another, institutions will emerge to ensure that a corporation of that size and clout can get the capital it needs, and I do not think, actually, the size of the balance sheet of either Goldman Sachs or Citibank today plays a very large role in ensuring that GE can get the capital it needs.

Q53 Mr Brady: You do not need institutions that have a balance sheet in the high hundreds of billions to do that job?

Professor Kay: No, I do not think that you do.

Q54 Mr Brady: Professor Goodhart, do you agree?

Professor Goodhart: I agree with John on that. I think that if the banking system were to be made smaller and safer, there would be problems for the small and medium enterprises, but I do not think there would be problems for the really large companies, nor for governments, because they can go straight to capital markets. In that sense I agree entirely with John and I do not actually see the basis for Gerald Corrigan's argument.

Q55 Mr Brady: They do not need to be large institutions. Do they need to be integrated institutions?

Professor Goodhart: I do not see why not. There can be advantages in integration. I think there can be advantages in doing a lot of activities and a lot of activities with these large manufacturing companies, and they have lot of requirements - for example hedging their positions, use of derivatives, and so on - which you need an integrated institution, I think, to help to deal with; so integration I see much more to be potentially advantageous than pure size.

Q56 Jim Cousins: I wanted to see how the discussion we have been having helps with some practical issues that we all have in front of us. Through the Asset Protection Scheme the Government has just guaranteed about 200 billion of RBS activities, most of which are outside Britain. That is a huge commitment to big banking. Was the Government wise to do that?

Professor Goodhart: Let me take the case of AIG where I can see it was even bigger. The American Government effectively supported AIG's commitments on CDS and derivatives to a range of banks, many of which were foreign, including many of the big British banks as well, and there were a lot of people in the US who said that the American authorities should not have done that, they should simply have provided guarantees to the Americans. I think that was entirely wrong, because if you were going to have a situation in which you discriminate between current parties on their nationality, that is a tendency towards protectionism. What we have seen in the recent crisis, which, I think, has been a considerable danger, has been financial protectionism where governments have said, in effect, to banks, though very rarely explicitly, "Please carry on lending at home, but because we also want you to make yourself safer and improve your capital ratios" - nod, wink - "cut down on banking abroad". For particularly the Eastern Europeans, where the banking system is almost entirely foreign owned, this was potentially disastrous. I really do not think that financial protectionism is any better than trade protectionism, and we must avoid it. There is, I think, a perfectly good question whether one should have got oneself into a position where the RBS assets had to be guaranteed, but distinguishing between domestic assets and foreign assets should never be done. You need to undertake an obligation whoever is the counter-party.

Professor Kay: I agree with Charles on that. I think that people were protecting RBS creditors. There is the question of why we should be doing that but, given that we are where we are, I do not think we had an alternative but to do it in the way we have done.

Q57 Jim Cousins: We are in a situation where over the next four or five years there is an immense refinancing and de-leveraging issue, about 1,000 billion strictly in banks, more in commercial property; the Bank of England has got to unwind quantitative easing and the Government has to finance itself. There is an enormous financing and de-leveraging issue. What structure of banking is going to help us to do that without ruining a lot of British people in the process?

Professor Goodhart: One of the areas has been an attempt to try and get the banks to increase their capital by going to capital markets and a great deal has been done. Those cases where the banks have not been able to go to capital market because they were in too difficult a condition, the Government has stepped in, as it did, in effect, in the autumn of 2008. I think what was done then, very largely under the leadership of this country and this Government, was absolutely right. It will be desirable to increase the safety of our banking system by increasing the liquid assets and its regulatory and, indeed, its overall capital, but, again, there is a problem, because while you want the banks to be safer and to have more capital and more liquidity, if you force them to do it too quickly, then you are going to get the banks continuing to de-lever and cut back on lending to ordinary people with spreads increasing. There is a problem, a trade-off, between the desire to get the banks to be in a better position and yet the desire to keep credit flowing to people in industry around the country. The way that everyone is dealing with this is trying to have a transitional period so that you say that you want the banks to reach a particular state by, shall we say, 2015 and move relatively steadily and slowly in the intervening period. I do not actually see a better way of doing it than that.

Professor Kay: The structure I would have put in place would be to have nationalised the failed UK banks.

Q58 Jim Cousins: Those being RBS and?

Professor Kay: And HBOS.

Q59 Jim Cousins: But you would not have allowed HBOS to merge with Lloyd's?

Professor Kay: It depends when I can start the clock on them, as it were. Yes, if you gave me the opportunity, I would not have allowed that merger to take place and I would then be restructuring these organisations, splitting them off into a variety of bits at both wholesale and retail level, directing public money and the public support to where we want it and not to where we want it. I am feeling at the moment that we are kind of pouring money into a conduit hoping that some of it will come out in the places we would like it to be, so we direct that public money more effectively and we would be selling off and floating the various bits of the institution as opportunities are seen to present themselves.

Q60 Chairman: A few weeks ago I attended a lecture by Jon Danielsson at the LSE. He is a regular at our Committee. He made the point that the crisis started in the most regulated part of the financial system, the banks, but the least regulated, the hedge funds, had little to do with it. He says that the problem left is that we did not regulate enough before the crisis or we did not know how to regulate. It depended on the future order. The new financial order will be quite different, and he says that the problem is we do not really know how to regulate rather than we did not regulate enough. Therefore, there is real danger in many of the proposals for how to regulate the banks in the future. We are agreed on that. He then went on to risk, and it was a fascinating point he made, saying that so much of how we think about the financial system relates to risk sensitivity and risk measurements are key, and we want to connect bank bonuses to risk, separate banks into more risk utility banks, high-risk casino banks, make banks capital risk centres and so on, but this depends on us being able to measure risk and the problem is we cannot measure risk with any accuracy. He went on to give a risk measurement exercise and evaluate risk for IBM, one of the biggest stocks in the world, he said, and it should have been easy but it was not easy. We really do not know how to measure risk. Is that correct?

Professor Goodhart: Yes.

Chairman: Charles, so what is my next question! We will maybe come back to that.

Q61 Mr Breed: Could we just talk about the effect of fair competition. We have received some written evidence from Richard Herring, of which I will briefly read a little: "After the crisis is over the expectation that an institution will be likely to receive a bail-out in the future provides an unwarranted competitive advantage to systemically important financial institutions that bears no relationship to their ability to allocate capital efficiently or serve their customers more effectively. Confidence in implicit government banking permits SIFIs to fund themselves more cheaply and collect revenues from issuing guarantees they are not prepared to honour. This distortion of competition favours the large and complex financial institutions relative to smaller simpler institutions that may serve their customers and society more efficiently." If you broadly agree with that, how would competition in that sense increase or decrease financial stability, in your view, if we could actually create that greater competition?

Professor Goodhart: I think there is a great need for additional competition and it is actually a very good time to start a bank at the moment because the competition has been reduced, the spreads are very large and you do not have any legacy of bad debts. A lot of people are trying to start banks in the UK, and good luck to them. On the Dick Herring point on the boundary, it is not necessarily the case that those who are described as systemic will have it easier, because they will be likely to be subject to considerably tougher regulation. The point is that, although it is not necessarily clear that it will be better to be described as systemic rather than described as not systemic, you will not get it right. There will always be a perceived advantage to be one side or other of the boundary, so it will distort competition even if you try and equalise the benefits and reputation being thought to be systemic and, therefore, likely to be saved as compared to the higher regulation that you are going to have. Again, there is an even worse difficulty, which is that what is systemic is not constant; it depends on the condition. So an institution that is likely to be systemic when conditions are normal and everyone is quite confident, that is not systemic under those conditions, may become systemic when everyone becomes jittery and there are a lot of fears about contagion. The idea that there is a constant set of systemic institutions is just not so, and any American or other proposals that you have a defined set of systemic institutions and you regulate them differently is subject to that difficulty that the set is time varying.

Q62 Mr Breed: I think actually Herring says exactly the same thing. It is a moving picture.

Professor Goodhart: Yes, and that makes the proposals in Barney Frank's bill and the Executive's proposals in America really quite complicated, because this idea that you separate systemic from non-systemic and regulate them differently will be much harder to do.

Q63 Mr Breed: You broadly agree that increased competition would decrease the problems of potential financial instability.

Professor Goodhart: I think the increased competition is a good idea on its own. I am not sure necessarily that it would decrease financial instability all that much. There are occasions in which the reduction of profit margins leads people to take riskier activities, so that you can have a nice comfortable rather static but quite safe oligopolistic system which jazzed up by additional competition becomes infinitely riskier.

Professor Kay: Indeed, that oligopoly is what we had for quite a large part of the 20th century, but that deal is off, as it were, and I think we will get more stability from greater diversity of institutions; so I am broadly in favour.

Q64 Mr Breed: In that case, is there a need to change some of the regulatory requirements to allow new entrants and to allow greater competition to actually happen? If so, what would that be?

Professor Kay: I think everything we can do to make entry easier would be better.

Q65 Mr Breed: Would you have disproportionate regulation to those that are currently important, not important but very large international conglomerates. Do we need a different set of regulatory requirements for that than we would do to perhaps, say, much lower types of regulation or requirement to encourage more entrants in at the lower end?

Professor Kay: No. I cannot think of a worse solution to this group of problems than saying we have a group of systemically important institutions which are government guaranteed.

Q66 Mr Breed: All existing players and any new players will have to play to the same rules?

Professor Kay: As far as possible, yes.

Q67 Sir Peter Viggers: There have been suggestions of some form of insurance levy on banks. Paul Tucker has put this idea forward and, of course, you also have the American proposal at the moment. Could I divide this into two halves, as it were. First, is this a sensible and fair way to pay to mop up the financial mess - that is looking backwards - and, secondly, and perhaps even more importantly, to what extent do you agree that, as Paul Tucker has said, a levy would give an incentive during peace time to monitor the threats which their peers posed to stability?

Professor Kay: If a levy is some kind of risk premium, which is the normal thing that is proposed, we are never going to get that at realistic levels. That exists in the US with the FDIC and their typical levies are two to four basis points. If you look at the CDS spreads that quite good banks are producing for the market at the moment, they are way, way higher than that and we would never be able to levy these at realistic levels. I think this is a fantasy, but actually I am in favour of getting back as much of the costs of what we have done in the public purse from the people who are responsible for it, but in relation to any of these kinds of levy proposals we have to ask who is actually going to pay the actual costs of these levies in the end. We need good answers to that.

Q68 Sir Peter Viggers: The US proposal would give an incentive for deposit taking, would it not, so it would help to shape the balance sheet of banks?

Professor Goodhart: Yes, undoubtedly. As I said before, I would have liked the levy to be more finely directed so that the levy goes to the short-dated wholesale liabilities rather than to the longer dated. Again, if you are going go down this kind of route, it ought to be ex ante rather than ex post. I was interested when John said you will never get this right because look how the FDIC requirements are so different from the CDS rates It crossed my mind at the moment, "Why do you not make the levy related to the CDS rates?", and then you have got a market measure of what the riskiness is. One of the problems here, though, is that the markets' measures of riskiness are not actually at all accurate. Adair Turner continually points to the fact that CDS rates generally were at their lowest just before all this blew up in 2007, so that if markets could measure risk properly, then it would be relatively easy to use market mechanisms to apply to the levies. The problem here is that it is not just we cannot assess risk accurately, the markets cannot either, and that is one of the key difficulties. That was one of the key lessons of the crisis, that the markets may be able to operate well in many circumstances but their assessment of risk and their efficiency generally is not all that great.

Professor Kay: I agree, although a CDS related levy would have put the Icelandic banks out of the business of collecting retail deposits in the UK.

Q69 Chairman: Yes. This issue of risk is really key, though, because a member of the FSA came here a year or two back and I said, given the complexity of the financial products that are there, should they only regulate what they understand, and they blanched at that, and then when the legendary JP Morgan chief executive, Dennis Weatherstone, said to his staff, "You have got 15 minutes to explain and persuade me, and if you cannot, your arse is out the door", something like that. At the end of the day this comes down to judgment, does it not, and we are really feeling our way along on this even at the best of times? Is that right?

Professor Goodhart: Absolutely, and, again, one of the difficulties, speaking as an economist, I do not think we economists have done very well in actually providing a proper measurement of risk or an analysis of the dangers of default and how the financial systems should be constructed. The theory and analysis in this field is not as good as it should be.

Q70 Chairman: Since measuring such risk is difficult, if not impossible, should we be over cautious and insist on a higher level of protection, however that may be achieved, in the system at all times despite the inefficiency that that may cause?

Professor Goodhart: I know you started by talking about costs and benefits. You do have a trade-off between being cautious, conservative and safe against the possibility that may cause spreads to rise, the cost of capital to increase and maybe the dynamism of our economies is somewhat less, and where you draw the line in that trade-off is undoubtedly a subjective issue.

Professor Kay: For me this is all an illustration of why, if you can regulate structure rather than behaviour, you should do so. All the discussion we are having at the moment is about the difficulties of behavioural regulation. Perhaps I might mention at this point that last week I gave a talk whose essential theme was that I no longer believed the theories of risk and risk measurement and management that I have been teaching for 20 years of my life.

Q71 Chairman: Charles, are you going to say something just as dramatic?

Professor Goodhart: No!

Q72 Mr Plaskitt: I want to pursue this risk question, because it is so fundamental. You have said that you have done a self-denying ordinance, you could not do it, we have said the markets cannot do it, but can I come back to the Basel system. Is it not the fact that the Basel system does not seem to be able to do risk either because it relies on the banks to do internal risk-based methodologies, yet I understand that some people are looking at Basel as a means of providing the new regulatory solution. Is it not fundamentally flawed in that?

Professor Goodhart: That is one of the reasons why I think it is very sensible for Basel to adopt a leverage ratio as well, because a leverage ratio effectively says we cannot measure risk very well but what we do know is that, if credit is expanding wildly, there are potential dangers around there; so I think there is advantage in a belt and braces approach where you do try and measure risk as best you can, which is, if you like, Basel II. Then you add to that a leverage ratio which says, "We are not very good at doing this but we know that if credit is expanding wildly there can be problems ahead", so you put the two together.

Q73 Mr Plaskitt: It is like saying, "We accept that we cannot manage the risk, so we just ramp up the insurance"?

Professor Goodhart: Yes; absolutely.

Professor Kay: This is the history of the Soviet Union that we cannot run these enterprises very well by these controls from Moscow, so we impose another lot of controls, and another lot of controls, and it goes on forever. It goes on forever because the basic approach of central direction cannot solve the underlying problem which you are trying to create, and the only way of solving that is to give the people on the ground the right kinds of incentives, and that is why I keep coming back to the point that, if you can regulate the structure rather than behaviour, you should always try to do so.

Q74 Chairman: In fact, in his lecture Jon Danielsson mentioned that, he said the trick is not to be as extreme as Joseph Stalin but not leave the finance system without any protection. It is not an easy problem and we do not really know how. Is that correct?

Professor Kay: Yes.

Chairman: Are there any other points? Could I thank both of you for a fascinating presentation. It was great for us and, like any gold-plated lecture, it demands a re-reading; so we will be doing that at the weekend. Thank you very much.