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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 1505
HOUSE OF COMMONS
TAKEN BEFORE THE
Eurozone Crisis: Impact on the UK
Wednesday 14 September 2011
Professor Charles GoodharT and Professor William Perraudin
Simon Hayes, Jan Randolph and Simon Tilford
Evidence heard in Public Questions 1 - 99
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Taken before the Treasury Committee
on Wednesday 14 September 2011
Mr Andrew Tyrie (Chair)
Mr David Ruffley
Examination of Witnesses
Witnesses: Professor Charles Goodhart CBE, FRA, London School of Economics and Political Science, and Professor William Perraudin, Imperial College, London, gave evidence.
Q1 Chair: The Committee is in a very lively mood this afternoon, as you probably noticed as you walked in. This is a very big, very important, very topical subject and I am particularly grateful to both of you for coming in at such short notice and for being prepared to give evidence to us today. I would like to begin with a question to Professor Charles Goodhart, which is to ask what he sees as the key transmission mechanisms by which the Eurozone crisis could have an impact on the UK.
Professor Goodhart: I think that the main effect would come through our net external trade, because if there is a crisis I would have thought that the Eurozone is likely to go into a period in which output will fall. Something near to 50% of our exports go to the Eurozone and if the Eurozone was to go into a severe recession it would adversely affect our exports and, since the forecasts for our growth next year-such as it is-depend very heavily on net exports, that would be a major transmission route.
The other issue that could arise would be the declines in wealth, because the banks hold claims on a range of these European countries. Incidentally, I think we are most at risk to Ireland rather than to any of the other countries, and it is not necessarily clear that Ireland would get caught up at all if the problem was primarily in the southern Mediterranean countries. But generally, if the Eurozone goes into difficulties, confidence will go, asset prices will decline, wealth will decline around the country and confidence will be considerably weakened, both by the asset value effect and by the effect of no credit.
Q2 Chair: Do you have anything you want to add, Professor Perraudin?
Professor Perraudin : Your question doesn’t differentiate between different possible outcomes with the Eurozone. I think there would be radically different implications for us if Greece and Portugal defaulted, on the one hand, compared with problems with Italy and Spain, and I think that-
Q3 Chair: Just on that, you feel that there will be a default by Greece? You are in the majority camp, are you?
Professor Perraudin : It seems highly likely. It seems difficult to conceive of how they can dig themselves out of the fiscal problems that they have. I think that countries can repay extraordinary levels of debt, if they have the administrative facilities and arrangements and if they have the will to do so. Historically, if you look back, there have been cases where countries had debt for a much larger fraction of GDP than Greece currently has but I don’t think from all the-
Q4 Chair: Can you give us a few examples, just for the record?
Professor Perraudin : The UK, after the Napoleonic War, paid off an extraordinarily high debt and did so in a period of deflation. I don’t think that is relevant at all for the current Greek situation, because they have severe difficulties in their tax administration and they apparently don’t have the political will to tackle the financial problems they face.
Professor Goodhart : Romania is a recent example under Ceausescu, who drove the standard of living of the Romanian public into the ground in order to pay off his debts to the West.
Chair: Yes. He physically sent the police force round knocking on every door in the country, stealing property and then selling it off at a discount, including taking away light bulbs to prevent people from using electricity, so I think that-
Professor Goodhart : I hope it doesn’t come to that but that is a modern example that, if you have the power and the control, you really can pay off a huge amount of debt.
Q5 Jesse Norman: Could I ask either of you to describe how Greece might be able to default within the Eurozone? People understand what defaulting outside the Eurozone is, because they can see that it would mean issuing-however much trouble-a currency, a Drachma perhaps, and then trying to take the case and recapitalise in some way. How would it work inside the Eurozone though, or how might it work inside the Eurozone? Because this is being considered as a real possibility. I just want to know is it a real possibility or is the reality that-
Professor Goodhart: The difficulty that I see is that if the default is primarily a default of not paying the interest or the principal on their bonds, then the Greek banking system holds so much of their own country’s bonds that effectively those banks would be bankrupt. You can run a country in which the Government’s abilities to make payments is very heavily restricted, but in my view it is almost impossible to run a country in which the banking system doesn’t exist and the payment system doesn’t exist. The difficulty, therefore, is that if the default takes the form of not paying out on bonds, and the Greek banking system then all goes belly up, the Greek Government, in order to support the standard of living of its population, would have to somehow support its banks. At the moment it can’t because it has no money, and that is the main reason why, if the default is to take the form of not paying out on bonds, I think they would have to leave the euro in order, effectively, to provide finance through the printing press in order to recapitalise its own banking system.
Q6 Jesse Norman: What you are effectively saying is that the glib line that was, for example, advanced on the Today programme this morning by Roland Rudd, that you can default within the euro, is probably nonsense?
Professor Goodhart: It depends what you mean by default. There are, for example, states in the United States that say that in the case of failure to make payments actually the bond holder is the last person to get hit. So you can have a default in which the form of the default is you simply don’t make payments to your own public sector workers, for example, which is a form in a sense of requiring, really very rapidly, the Greeks to run a balanced primary budget because they simply don’t have any money to make any payments except those for which they have tax receipts.
Q7 Jesse Norman: That is very helpful. Would you agree with the thought-again this is a question to either of you gentlemen-that it is very easy to run together what are fundamentally two different but connected things: one is a crisis of sovereign debt and the second is a crisis in the money markets? There are connections between these two, but whereas one might understand that a sovereign debt crisis has a certain pre-determined process of resolution or non-resolution-it can be affected by politicians-a crisis in the money markets may obey no such timetable. Is that a thought that has any persuasiveness with you?
Professor Perraudin : I think that confidence and risk premiums are crucial elements in all of this. Before we were talking about the transmission mechanisms of the crisis through trade, as Charles was mentioning, but I think there are significant additional dangers with transmission mechanisms through the banking system and through a further collapse of confidence there. I don’t think that sovereign debt crises in general are ever divorced from what is going on in banking. If you think back to the Asian crisis, the problems of the sovereigns there and of their banks were completely connected.
Q8 Jesse Norman: The opposite might be true, might it not, which is that there is some progress on the sovereign debt issue and yet the money markets continue to freeze up and bank funding becomes extraordinarily difficult?
Professor Perraudin : Yes.
Q9 Jesse Norman: Is it your view at the moment that bank funding is pushing us towards a renewal of the crisis we had?
Professor Goodhart: Clearly so, particularly dollar funding, foreign currency funding, which it is harder for the Central Bank, either the national Central Bank or the ECB, to deal with where there are still outstanding Federal Reserve Bank swap lines that can be utilised, but nevertheless the funding through the wholesale markets, in particular in dollar form, has become much harder.
Professor Perraudin : Yes, I think the complexity of what is going on makes it harder for people to have confidence in their counterparties. If it were just a question of Greece, as a standalone entity with its own currency, defaulting then you could expect that, since this has been flagged for months or years, people would adjust their portfolios, they would hedge; everything would gradually come to a position that vulnerable levered financial institutions were reasonably protected against it. But because we have both possibilities of insolvency and possibilities of breakup of a currency, it is very difficult to know how institutions would be affected. So we are again back in the same position that we were with the subprime crisis where nobody knew how anyone else was exposed to what was happening. So I think that the dangers of financial contagion are exacerbated by the fact that it is both solvency and currency going on at the same time, and there are all sorts of different possibilities with a set of countries that could be caught up in it. Just like the subprime crisis, there are issues about whether people have made provisions. With some of these sovereigns they continue to have relatively high ratings. If you look at Italy, you wouldn’t really think that the probability of Italy defaulting was the same as the historical probability of an AA-rated entity defaulting, so there is a kind of disconnect between current ratings that may be used by banks in doing their provisioning and what the real risks are.
All of that means that it is hard for people to be confident what their counterparties are exposed to and hard for them to believe that, after the accounting that has been done by the banks or other financial institutions’ accountants, whether we really know their exposures. I was talking to a corporate treasurer recently and they had adjusted their exposure, or they had systematically reduced their exposure to local banks in some countries, but their customers were all highly exposed to the local banks. So the dimensions of financial contagion are quite complex and there is plenty of potential for that to cause further trouble.
Q10 Jesse Norman: Just to be clear, you have said some incredibly interesting things. We are talking about a situation in which there is political and economic threat to the markets; there is an effect from sheer complexity; there is an effect from cheating and non-transparency on the rules; and there is a bank contagion route and a corporate contagion route. That seems remarkably helpful and interesting.
Could I just ask a final question? Bracket out the question of the sovereign debt crisis we are in-just imagine that in some sense the can is kicked down the road or there is some solution to that, or nothing happens for the time being-and we nevertheless are facing a money market bank funding crisis. What are the kinds of mechanisms in an emergency, given what we have known from the last three or four years, that you would now expect to see put in place and are the current mechanisms we have in place already sufficient? You will recall that the Bank Governor has taken a very benign view in front of this Committee on the lessons to be faced in the event of crisis in the markets.
Professor Goodhart: A huge amount has already been done. The ECB has provided an enormous amount of liquidity and through its six months’ refinancing banks can get as much liquidity as they want. The difficulty is not so much euro liquidity. The difficulty is more in their foreign currency financing, again because of concerns about their ultimate solvency.
Q11 Jesse Norman: On the dollar account in particular?
Professor Goodhart: Yes, the dollar account in particular, which again was a real problem in Europe with the subprime and it very nearly knocked out quite a number of banks around Europe in 2008. It involved a huge utilisation of the Federal Reserve Board swap lines, which again will have to come into operation. In these kind of circumstances, in a global system where banks borrow in dollar-based wholesale markets, in some respects the Fed actually acts as the lender of last resort to the banking systems around the world.
Professor Perraudin : I agree with Charles that a lot has been done by Central Banks but also a lot has been done by the banks themselves, so they are much more clued up about liquidity management over significantly more prolonged periods of crisis than they were before the last crisis.
Q12 Chair: Just to be clear, a moment ago you were saying, weren’t you, that broadly speaking you don’t believe the returns that these banks are putting in? You were saying that these may be made up; you don’t believe the stress tests.
Professor Goodhart: The banks gave sufficient information to allow people to adjust insofar as they wanted to. The point is not that the banks are in a sense being illegal. The banks are following the legal requirements of the accounting arrangements as they stand at the moment.
Q13 Chair: We are talking about the continental banks?
Professor Goodhart: Certainly the continental banks, which enable you to value the bonds in your banking book at a very low discount indeed. If they were in your trading book you have to mark them to market but if they are in the banking book you can value them pretty much at face value and, of course, many of these bonds are nowhere near the face value. So they are not acting illegally, in no sense are they acting in any-
Chair: I just wanted to clarify that.
Professor Perraudin : But they might not be acting prudently. Through the last couple of years people have had choices about how they accounted for losses in exposures where they were very difficult to mark to market, so they were marking them to model because it wasn’t very easy to get direct quotes. As markets dried up there were a lot of different approaches used for valuation and, as Charles mentioned, in the banking book they are not necessarily directly responsive to what is happening in market values, so you may be looking at provisions based on what you think is happening to the default probability. If you were using ratings, which are somewhat smoothed-the rating agencies adjust them-sovereign ratings are not a completely direct reflection of the true quality of the pot.
Chair: You are sounding like a bureaucrat, "not a completely direct reflection". What you are talking about is ropy ratings.
Professor Perraudin : Yes. There is quite a lot of variation. I remember I did some work for one of the rating agencies and helped them look at how they did valuations of illiquid securities, and at some point I gathered that they had one way of doing it, which was what I was looking at, and then they had another approach, which was also-
Chair: Maybe we will have you back at another time because we are thinking about taking a look at risk rating agencies, sooner or later: they deserve it.
Professor Perraudin : Yes, but just-
Chair: I am sorry to cut you short but I know Michael Fallon is eager to get in.
Q14 Michael Fallon: Just a very quick question. We are seeing growing distrust between the banks at the moment but do the monetary authorities, the finance ministries, have any greater visibility of these exposures and default probabilities than they did three years ago, last time?
Professor Perraudin : I am sure that the FSA, and all the various banking regulators, have been crawling over people’s internal rating systems and approaches to evaluating credit quality in their books, so I am sure there is an intensified effort around all of that-
Q15 Michael Fallon: Do they know more than they knew during the last crisis?
Professor Goodhart: Well, we don’t know very much even now. What is the probability of default in, shall we say, Italy? No one can put a number on it. It is not a sort of probability distribution that is known. It really comes much more under Knightian uncertainty, in part because it is so influenced by political decisions and it is very hard to put you politicians into a sort of Gaussian distribution; you don’t fit very easily.
Professor Perraudin : There is almost no data of AA ratings being defaulted, so it is very difficult to measure statistically. In fact, it is almost impossible to measure statistically, so ultimately decisions have to be made that are judgements.
Chair: We have already gone as far as Knightian uncertainty and Gaussian distribution, so I am sure we are taking most of the public with us at the moment.
Q16 John Mann: I will attempt to simplify with an initial question. I am sure I am reading too much into what you are saying, but in your view is there any comparison with the risk to the UK economy that we had in 2008 to the current situation?
Professor Perraudin : If there is a kind of narrow insolvency problem with Greece and possibly Portugal defaulting, then I don’t think it is at all the same scale. It is difficult because if there is a default by them then there would be a crisis of confidence affecting other countries. The question really is if the defaults could be limited, then I think we are looking at a relatively small economic impact over a horizon of six months or a year, but if the problems spread over into major economies then obviously this could easily exceed the problems we had in 2008.
Professor Goodhart: I think there is an additional problem, which was that in 2008 the fiscal positions of most Governments were considerably stronger than they are now and, as of the beginning of October 2008, interest rates were considerably higher than they are now. That means that we had in 2008 a lot of instruments, official Government instruments, which could be used and were used to offset the bad effects of 2008. These have been very largely used up and the potential available additional space, either fiscally or in monetary policy, is much more limited now than it was in 2008. So you have the potentiality for another severe shock with less in the way of Government instruments to offset it and protect the communities against it.
Q17 John Mann: We already have a liability with existing Eurozone bailouts. Can you advise how much the UK’s liability is at the moment?
Professor Perraudin : I don’t know the figures.
Professor Goodhart: I don’t have the figures in my mind. I am rather hoping that in your next session they will provide those kinds of figures for you. It is a considerable amount. The amount that has been already spent in the SMP, the ECB bond purchases, and the amount of money that has already been spent in both phase 1 and phase 2 of the bailout of Greece and in the support of Portugal, Ireland and Spain is considerable. A lot of money has been spent, yes.
Q18 John Mann: Would you expect us to be asked for more and if we were how much more would you expect us to put forward?
Professor Goodhart: Who is "us"? Are you talking about the Eurozone Governments?
John Mann: Yes, within the Eurozone.
Professor Goodhart: The kind of figures that get put around in market circles are that the EFSM should have a capacity of something of the order of €2 trillion, I think it is, in order to deal with this.
Q19 John Mann: Is there any danger to our credit rating through the consequences of this, in your view?
Professor Goodhart: If the Eurozone goes really into severe recession and if America is also, shall we say, sluggish, it is going to be difficult for this country to maintain its growth. If this country finds it difficult to maintain its growth, the tax revenues will not be as buoyant as in the present forecasts, for example like from the OBR. Under those circumstances, we will fall behind the programme of deficit reduction that is currently in place. Then the credit rating agencies might look at our worsened deficit and debt projections under those circumstances and say, "In those circumstances, it is difficult to see why the UK should have AAA while the US has gone down a notch".
Professor Perraudin : We would presumably appreciate against the euro. It depends quite how the euro splits up, but the turmoil within the Eurozone, unless a core currency emerges that would presumably be strong, we would probably find ourselves appreciating against the euro. So what would happen to our cost of financing the national debt, whether that would go up or down, I am not quite sure.
Professor Goodhart: The Americans got downgraded and their interest rates have gone down and I know there has been a flight to safety. Under these circumstances we are still regarded as relatively safe.
Q20 John Mann: One final question and that is a question in relation to the behaviour of politicians in this country. In your view is there a danger that we have become overly distracted by the structure of UK banking, as opposed to concentrating on the bigger imminent problems of the consequences of Eurozone turmoil?
Professor Goodhart: In a sense, we are not in command of Eurozone turmoil. It is not for us to tell countries such as Germany, France, Italy, Portugal and Greece what they should do to maintain their system, while it is for us to take a view about our own banking system. I think one has to look to one’s own area where one has a responsibility, and we do have the responsibility for looking after our own system. We don’t have the responsibility-you don’t have the responsibility-for looking after the Eurozone system.
John Mann: You make it sound a bit like we are a bunch of England cricketers going in to face the West Indian fast bowling attack without any pads on, "Let’s just wait and see what hits us and hope that we might be able to catch the ball as it comes towards us".
Professor Goodhart: I very much hope that the Bank of England and the Treasury are undertaking a fair degree of contingency planning, but they can’t do much more than that because it is a contingency over which they have no control.
Chair: It is good to know you think they are padded up ready to face these bowlers.
Professor Perraudin : Yes. Picking up a couple of the things that you said, just slightly going back to your previous question about how we compare with the earlier crisis. I think our baseline forecast is obviously much worse for the UK economy. We are in a situation where our banks are struggling to meet higher capital requirements and a whole raft of new changes to do with liquidity, so there is a lot of rebuilding of bank balance sheets. On top of that there is the reorganisation of the banks, which could have very long-term benefits over decades but the timing of it is a bit regrettable. So I think that is all background to where we are. It is important to consider the extent to which the banks will be able to continue lending over the next few years. I would be worried, looking at the euro crisis, that it is yet another issue that will reduce confidence in banks, put more pressure on banks. However unpopular bankers may be, it is nevertheless the case that the economy requires continued intermediation and volume of lending. So I see all of these things as coming together and exacerbating the economic weakness that we have currently.
Q21 Andrea Leadsom: That all seems to me to be a little bit depressing. I feel we are slightly perhaps talking ourselves into a long dark tunnel from which there is no exit. On the one hand you are saying we have used up all our "get out of jail cards" in 2008. On the other hand you are saying that we have no influence over Europe and all we can do is look to our own issues. You are saying that we have the accounting completely wrong. I would just like to push back a bit. Surely we are a member of the EU; we do have a say, in fact, certainly over things like the FSM, as to whether that is used or expanded; and we would have to have a say if the ECB was going to try and issue Eurobonds. Presumably, there is also a potential contingency proposal that the ECB starts doing asset purchases of impaired debt from the banks, like they did in the US. There are all sorts of possibilities that Britain should and could have a view on. There is also the possibility that we change the accounting rules and say that banks and sovereigns now need to mark to markets the debt that is on their portfolios, and indeed make provisions for it. We could even start playing hardball with the rating agencies and start looking realistically at whether the ratings agencies are getting these things wrong. We have already discussed the fact that it is ludicrous to think that America is anything other than AAA, since it continues to have the means and the desire to repay its debts, and to rank it the same as Italy is utterly ludicrous in anyone’s book.
You are effectively throwing up your hands in despair. Is there no scope for any of these possibilities? Should we not be doing something with our Eurozone partners?
Professor Goodhart: We can certainly try and advise them. I think that what should have happened is what the Chairman of the IMF, Madame Lagarde, proposed, which was that there should be recapitalisation of the banks. If the banks, particularly on the continent, were recapitalised to a degree that would protect them against the kind of revaluation of sovereign bonds that you are suggesting, then I think that the likely dangers from a potential default in Greece, or even more widely, would be much reduced. The real problem is this interaction between sovereign debt and the banking debt that William was talking about.
Q22 Andrea Leadsom: Just to interrupt you, Professor Goodhart, should we, as a Treasury Select Committee with all the influence that we have, be saying to the ECB that it should be requiring all banks henceforth to mark to market their sovereign debt as a strong recommendation from this Committee, for example?
Professor Goodhart: You cannot properly and helpfully do that, unless that is accompanied-and indeed I would argue preceded-by an appropriate recapitalisation of the continental banks, so that when there is this revaluation they are still in a good, strong, solvent state. The problem about revaluation, through a mark to market of all sovereign debt at this moment, is that-I have no idea what the figures would be-I would not be confident that there would be a sufficient overall majority of European banks that would now be in a position to stand that.
Professor Perraudin : We are where we are, so the ability for banks to get out from under the rubble to escape things is severely limited. It is almost impossible to hedge exposure. The volume of some of these exposures is so major that people-
Q23 Andrea Leadsom: Would you not agree that actually knowing where the problems are-because we are all talking about how it is terribly interconnected, nobody quite knows how much and banks are very nervous-and more transparency is the answer? Isn’t knowing what the problem is part way towards solving the problem?
Professor Perraudin : I don’t think total transparency introduced in the middle of the crisis would necessarily be a good thing.
Q24 Andrea Leadsom: Okay, but can I just challenge you on that? A long time ago Margaret Thatcher said, "You can’t buck the markets". Just recently Angela Merkel said the European Union politicians will not follow the markets. It seems to me like there is a fundamental disagreement there and I think Margaret Thatcher was proved right. Surely now for politicians to be saying, "We are just not going to do what the markets want" is a challenge to the markets that we simply cannot afford to meet. So to say that to change tack now and go for transparency is not going to solve anything, what is going to solve anything then? What can we recommend? What steps could we take to try and prevent the crisis that is almost certainly going to hit us within the next few months?
Professor Goodhart: A major recapitalisation of those European banks that need it.
Q25 Andrea Leadsom: How do we identify that without the required transparency to know exactly what their mark to market position is?
Professor Goodhart: The internal regulators will have sufficient information on that. They do know the information. They know what each bank holds; they can apply mark to market accounting for themselves. They are in a perfectly good position to do that.
Chair: Anything to add, Professor Perraudin?
Professor Perraudin : Yes, I broadly agree that if the German and the French banks have not made adequate provisions or if they have not been cautious enough, then certainly what they are doing is understood by their own regulators. The regulators will see what the practices are and they can easily investigate that.
Chair: Well, we have that point on board.
Q26 Andrea Leadsom: Can I just make another point on a slightly different tack which is, what do you think the impact is of Britain holding back from the fiscal problems in the Eurozone and not jumping in and bailing out? What impact do you think that will have on the Eurozone’s approach to Britain in the future?
Professor Perraudin : The UK has made contributions in helping Ireland and it makes contributions through the IMF, so it would be surprising for the UK to be assuming substantial fiscal burdens to rescue the Eurozone.
Q27 Stewart Hosie: Professor Goodhart, in among all of this there is an argument that says the ECB should be issuing Eurobonds to cover all of the Eurozone’s debt, but in addition to that there is a simplistic argument that says that as the Eurozone has ever closer monetary union, it should therefore have ever closer fiscal policy. What is your view on that?
Professor Goodhart: I am already on record because, although it is not very widely known, in the early 1990s the European Commission introduced an exercise to consider what fiscal measures ought to be introduced to back up and support monetary union. There was a report that came out in the European Union. We came to the view that with a centralised EU budget of I think it was 2.5% of EU GDP, you could introduce an appropriate contra-cyclical stabilisation mechanism, and that you could adjust the budget in a way that would enable monetary union to have much greater strength.
This report was pigeonholed by Jacques Delors because at the time he was trying to raise the EU centralised budget, I think, from 1.5% to 1.8%, and when we came out with the suggestion it should be 2.5% or 2.6% he thought it would frighten the horses. Anyhow, when he got his 1.8% through, this then was put forward and it was very rapidly sat upon by the richer countries of the EU, including the UK, Netherlands, Germany and Sweden. It did not have support. There was very little support at that time-and until now-for any greater centralisation of fiscal competencies. It is really only with the crisis that we have had in the last year and a half that there has been an appreciation that, under strain, a monetary union without fiscal support is in great difficulties.
Q28 Stewart Hosie: The contrary argument presumably would be if there was monetary loosening, as we have in the UK, they might want fiscal tightening to counterbalance that to meet other Government objectives. I suppose the reverse would be true if you were embarked on a process of monetary tightening: if inflation grew, the countries would want the flexibility to have fiscal loosening, would they not? Would the ability to manoeuvre like that not be gobbled up or eroded because of fiscal policy?
Professor Goodhart: Having some degree of fiscal centralisation-and remember 2.5% is tiny. In most overall federal countries, like the USA or Brazil or Australia or Canada, for example, the amount of funding that goes through the federal centre usually is of the order of about 35% to 40%, so 2.5% is really tiny-
Professor Perraudin : Yes, but that is in countries where people are voting for decisions in a centralised way.
Professor Goodhart: That again goes back to the question of, if you were going to require somewhat more fiscal centralisation to support your monetary unification, do you need-as I think William was rightly implying-a greater degree of political centralisation? My own feeling, and it is a purely personal one, is that one of the great weaknesses of the EU as a whole is that the EU authorities, like Barroso and Van Rompuy, are not elected. You and I have no role in this. They are actually appointed in a smoke-filled backroom-except that prime ministers are no longer allowed to smoke in these rooms-by prime ministers in a sort of national haggling.
Stewart Hosie: Indeed, and I would love to get into the politics of democratising Europe but that is not what we are doing today.
Professor Perraudin : I would not really agree that one has to have fiscal co-ordination that involves support from one country to another in an ongoing way. A much simpler type of fiscal co-ordination would just be debt ceilings or balanced budget requirements on countries that are in a common currency area. The issue then is that you give up a major economic lever for affecting your economy. So that is why I think that some of the ideas that people have been discussing of using macro-prudential policy to affect the level of economic activity, by adjusting capital requirements for banks through the cycle, is an interesting alternative way of bringing some control at a local level.
Q29 Stewart Hosie: I was counting that in my head as one of those fiscal mechanisms, because it is not pure monetary policy but it has the same impact of loosening or tightening availability of cash in an economy. So you are not convinced about going down this fiscal uniformity route?
Professor Perraudin : I think it just sort of ups the bidding each time, doesn’t it? As Charles was saying, one can do that but then you need changes in the political arrangements, so I think it is all too far to go. A much simpler approach is constraints on fiscal policies, but then you have these other issues of how do you affect the level of activity.
Q30 Stewart Hosie: I will ask both of you, in which case, whether you would agree fundamentally with Christine Lagarde. She didn’t use the word "cap" specifically but she said, "Fiscal adjustment is critical for the long-term sustainability of public finances in many economies"-not just certain countries, but many economies. She was effectively arguing for the use of fiscal policy in that way, but not asking for it to be uniform, certainly across the Eurozone.
Professor Perraudin : It would be difficult to have rules that were not uniform across the various countries, I would have thought.
Q31 Stewart Hosie: Would you like to expand on that? How would that work? Give me an example of a uniform rule that might apply both to Italy and Germany, say.
Professor Perraudin : I think it would be difficult for countries in negotiation to accept different levels on deficit as a percentage of GDP. I guess that one could have constraints that had more than one dimension. So obviously, if you have no debt whatsoever-if you have a zero stock of debt-presumably you can sustain a larger deficit over a short period. It might be that constraints would have to take into account the debt level and the deficit together. There are complexities there because you can have a zero deficit and yet you have to roll over your debt, so you can actually have a run against a sovereign borrower that has a zero deficit. This phenomenon that we see with sovereign defaults is very similar to banks, so you could have a run. Even though you have a profitable solvent bank, you could have a run.
Q32 Stewart Hosie: Indeed, but when one adds a national savings ratio into that equation, in addition to whether the country is profitable, whether there is a debt or whether there is a zero deficit, it does rather make a single uniform target quite difficult to achieve, does it not?
Professor Perraudin : Sure. I am a simple finance person, not a macroeconomist. Often people say, "Well, there are imbalances here and there", but I would have thought the simplest thing is just to regard the sovereign countries as borrowers and then you have the outstanding debt and the deficit, because you can pitch those at different levels in the accounts, but I would not see the need to bring in vague notions of current account imbalance or-I don’t know-all sorts of other things.
Professor Goodhart: I would disagree with you strongly there.
Professor Perraudin : The danger is you would get some sort of really complicated formula so you need something transparent and simple.
Q33 Stewart Hosie: Professor Goodhart, let’s say we call the 2.5% a stability fund for the Eurozone, which is how it would work. Would that always be enough? Would there be a ratchet effect? Would we ever have to use 2.5% of wealth in that way?
Professor Goodhart: I don’t know. It seemed good at the time, in 1993. Just reverting to what William was saying, I don’t think this balanced budget lark is either necessary or sufficient. It is not sufficient because you can have a situation, like Ireland and Spain, where their budget balance was extremely under control. They had a national construction boom, and when that went sour it effectively landed on the Government. It is also the case I understand-although I don’t know this for sure myself- that Japan has had a balanced budget requirement and every year the Diet says, "Well, it’s crisis time so we’ll ignore it". One Government cannot commit the next Government, and the next Government can always find a loophole. So these balanced budget constraints are not what they are written up to be.
What is more, the European Commission has now developed what I think is a much better approach than the old Maastricht 3% and 60% approach, which is the Excessive Imbalance Procedures, known as EIP-if you are interested in this, lots of stuff has been written on it. The excessive imbalance is to look to see where a country overall appears to be in an unsustainable position, and this may be on the current account side; it may be on the construction side; it may be on the public sector side. Then the EC is going to try and examine the country in much greater depth and bring forward measures or suggestions about how it can improve itself. I think that this is a very considerable step forward and to be applauded. What I think is still a huge weakness in what they call the EIP is the sanctions about what happens to you if you do not meet it. The problem is that the sanctions that they are suggesting are still these old ideas about just fining the country that does not meet the target. Now if the problem is a public sector weakness, imposing huge fines does not really help anybody.
Q34 Mr Ruffley: Could I ask both of you some questions about UK bank exposures? You have already indicated the limitations on estimating some of the figures. What is the order of magnitude, do you think, of potential losses to UK banks that have unhedged exposure to core countries in the Eurozone, and to non-core countries should they enter severe crisis?
Professor Perraudin : Well, I don’t know.
Mr Ruffley: I know it is a relatively difficult question but, in terms of the order of magnitude, would you have any feel for the exposure of UK banks to uncovered sovereign debt holdings of both the core Eurozone countries and the periphery?
Professor Perraudin : I do not have reliable information on that.
Mr Ruffley: What would your educated estimate be? Put it another way, do you think it is potentially a problem for UK banks or unlikely to be a problem for UK banks?
Professor Goodhart: What are you describing as core? Are you including Germany as core?
Mr Ruffley: Yes. On the one hand, what is the answer to the question if we are just looking at: first, a banking crisis with the peripheral countries; and then secondly, if it is the whole of Europe, including France and Germany?
Professor Goodhart: I think if it is the whole of Europe the number of policy changes would have to be so great that the world would just look totally different. If you are talking about core Europe and widespread defaults, either at the sovereign or at the banking level, I just don’t think that this is the kind of exercise that can be usefully done. You can do it, perhaps, with what would happen if there were problems in Italy. I think to-
Q35 Mr Ruffley: Let’s take that then. What would be the exposure of UK banks to a sovereign debt crisis in Italy? Is the exposure such that UK banks would have a real problem or would it be an inconvenience? I am trying to get a sense of the order of magnitude. I am not asking you to give a specific numerical representation, but what would be the exposure, say, in the case of Italy?
Professor Goodhart: I am desperately trying to remember some sort of matrices on all this, which I once saw, but my memory is slipping. I am afraid this is a factual point and if you want a factual answer I think you should make a written request to those people who would know that answer, and I don’t.
Professor Perraudin : I think there are BIS statistics on inter-country lending, so you could look up that.
Q36 Mr Ruffley: Yes, but I am asking you from your knowledge, and you are the experts in banking: is your sense that it might be a difficulty for UK banks, yes or no?
Professor Goodhart: I think we are most on the hook to Ireland, because the UK banks did a great deal of mortgage lending into Ireland, and I think that there are also considerable interbank links with the Irish banks, or at any rate there were. Certainly of the peripheral countries, I think that real difficulties in Ireland would be the greatest problem for us.
Q37 Mr Ruffley: What about in terms of holdings by UK banks of EU sovereign debt, whether it is the core countries or the periphery-Greece, Portugal, Ireland?
Professor Goodhart: Everybody holds a great deal of German debt and everybody holds a great deal of French debt. I don’t know the figures on Italian debt.
Q38 Mr Ruffley: Could I ask about the stress tests? I think you have touched on this in your earlier answers. UK banks have been pretty much given the all clear, as have European banks, and you have indicated what the limitations are on the results of those stress tests. Could you just indicate in straightforward terms what factors you think may trigger a crisis in the periphery or in the core countries, such that would make the all clears on the stress tests a nonsense? What do you think is going to make the stress tests look a bit sicker than they are at the moment?
Professor Goodhart: Sovereign debt failure.
Q39 Mr Ruffley: Anything else?
Professor Goodhart: The extent to which that might become contagious and that, of course, would be worsened, insofar as the economies in Europe should now fall into negative output growth.
Professor Perraudin : I think our banks would only be significantly affected by failures of Spain or Italy or Ireland. I don’t think that we would be substantially affected by smaller countries. So it is really a question of whether one can find ways in which to limit contagion and spreading of sovereign defaults to major countries. That is the key question for our banks.
Q40 Mr Ruffley: Where do you think the answer might lie? You talk about measures being taken.
Professor Goodhart: It would depend how the default, if there was to be one, would be handled. The great danger is that you might find that a default of, shall we say, Greece was forced, but that might lead to sufficient losses that there could be banking runs in other countries and the contagion could spread incrementally from one country to another. A contagious spread could mean one default leading to defaults of both sovereigns and banks elsewhere. The question is how a forced default of one country could be contained. I would hope that is something that the authorities in the Eurozone-because it would be primarily for them-are now thinking about very seriously.
Q41 Mr Ruffley: One final question arising from answers you have given to my other colleagues is, is there any way of making the cheating more explicit?
Professor Perraudin : Cheating by whom?
Mr Ruffley: Well, the mark to market question, the difference between the banking book and the trading book, is there anything that usefully can be done to clean all that up? You articulated it very clearly-while there may be full value in the banking book, if they are marking to market in the trading book it might look very different.
Professor Perraudin : I do not regard it as cheating. I think that having a non-mark to market approach in the banking book is not dishonest or shocking. It is simply a way of accounting for values gradually over time for things that banks intend to hold to their final maturity.
Mr Ruffley: But does it matter?
Professor Perraudin : The key thing is whether proper provisions are made against deterioration in credit quality and that really ought to be visible to supervisors. So it is a question of making sure that supervisory practices by different countries are satisfactory.
Q42 Mr Ruffley: You were implying in your earlier answers that the provisioning was maybe not as realistic as it should be, or you implied that the provisioning was questionable.
Professor Perraudin : There are certainly concerns about that.
Mr Ruffley: A final question, is there a debate going on in relation to the countries where there is questionable provisioning?
Professor Perraudin : They are seeing the problem of taking that approach right now because it is adding to concerns about their banks. This is one of the reasons why the French banks have been downgraded today.
Q43 Mr Ruffley: So it is being exposed, slowly but surely?
Professor Perraudin : Yes.
Q44 Andrea Leadsom: I just want to challenge you on that, Professor Perraudin, because you say they are not cheating, they are not doing anything wrong, and so on, but if we roll the clock forward a couple of years are we going to be sitting here saying, "Right, so is no chief executive of a bank going to go to prison for the fact that they were falsely accounting during the latest crisis?" Surely there is the playing by the book of, "Well, we don’t have to mark to market" and there is the stating the bleeding obvious, which is that if we have a crisis that is very real and could be tomorrow-it could be next week for all we know-would it not be the prudent position of a senior executive in a bank to say, "Right. We need to start marking to market and making provisions against sovereign default"? Would that not be the prudent position? If we get two years down the line and they didn’t and we do have another banking crisis, are they still going to walk away scot-free for not making that prudent decision?
Chair: Let’s just have an answer to the first of those two questions because we might be able to-
Professor Perraudin : I think they are taking advice from their accountants and then their policies should all be visible to their supervisors. I don’t think that if somebody does that in a way that their supervisors sign off on they are then guilty of some offence.
Chair: One quick further rejoinder.
Q45 Andrea Leadsom: Yes, but as I say, there is the doing it by the book, "This is what my regulator told me to do", and there is the prudent director’s competence requirement that says to you, "Transparency in marking to market in this market environment is absolutely essential", isn’t there? There are those two things and it seems to me that what you are arguing for is, "Well, rules is rules and we just did what the rules said". What I am saying to you is, is it not the case that senior people-don’t forget paid a huge amount of money, an awful lot of it being paid at the moment by the taxpayer-ought to be seriously looking for prudent reasons at what they should be doing with marking to market on their portfolios?
Professor Goodhart: The regulators ought to be requiring them to do the prudent thing. Let me try and put it in more colourful language. If you want the banker to go to jail in two years’ time, I hope you will ask that the regulator goes with him.
Chair: And all those academics who were busy commenting on it as well, perhaps.
Can I just end by asking you, Professor Goodhart, whether you agree with Nigel Lawson who on the radio today said that the Eurozone was doomed and that what we had to do was prepare for the post-Eurozone world, that it was so fundamentally flawed that it would have to be replaced, against the Chancellor of the Exchequer’s view, which is that we must do whatever we can and we must hope that the Eurozone holds itself together?
Professor Goodhart: I think that the Eurozone will continue in some form. Whether it continues in exactly the form that it has today is at the moment very uncertain.
Q46 Chair: Is it easier to solve these problems as you suggested, or ameliorate these problems by shovelling some recapitalisation into these troubled banks in northern tier countries, than it would be to kick Greece out of the Eurozone, go for the stress as a re-creation of a separate currency and accept their bad debts into a bad bank or a bad institution funded by northern tier countries?
Professor Goodhart: I think that there is a serious question whether you can kick Greece out and have-
Q47 Chair: But they did cheat, didn’t they? I am sorry to interrupt. I mean there isn’t any doubt there, is there? They got Goldman Sachs in to do the job, didn’t they? I think that has been widely reported and accepted, so there are plenty of grounds for a sharp exit.
Professor Goodhart: I understand that there was nothing that Goldman Sachs did that wasn’t legal. There are various accounting mechanisms for shifting income between periods that are perfectly legal but are not, shall we say, entirely transparent.
Chair: I am very sorry that I interrupted your reply to my question about whether we might be better off going down that route, enabling a devaluation of the currency and the Greek economy to recover.
Professor Goodhart: I think if you had said in May 2010 that it would probably be easier to have Greece excluded and then go on before, that was very doable. I think that the crisis has got beyond that kind of stage. We now have a number of countries that are perceived as being in severe difficulties; in some of them there are worries about whether they are sustainable. What worries me is, if you were to have Greece excluded from the EU and some kind of rescue finance arrangement, whether this would necessarily bring the whole exercise to an end. I rather doubt it. It could have been done earlier. I think it may be too late for that now.
Chair: I am very grateful to you both for giving evidence today. If there are further thoughts that have been triggered by these exchanges we would be very grateful to receive them. If you do find the time, or if you have already done it perhaps, Professor Goodhart, we would be appreciative of a very short note on this question of the shortcomings of balanced budgets and their successor, the EIP, on which there was considerable interest around this table. Thank you very much. We will adjourn for five minutes and then resume with the second session. Thank you both for coming in.
Examination of Witnesses
Witnesses: Simon Hayes, Chief Economist, Barclays Capital, Jan Randolph, Director, Sovereign Risk, IHS Global Capital, and Simon Tilford, Chief Economist, Centre for European Reform, gave evidence.
Q48 Chair: Thank you very much for coming before us this afternoon, at short notice, to give evidence. Of course, as you can imagine, most of the things we want to hear about are pretty much answers to the same kind of questions that I think all three of you, or perhaps only two of you-I certainly noticed two of you in the room-have heard over the previous hour. Perhaps I can begin pretty much where we left off. What is the most intelligent solution to this crisis in your view? Let’s go through each in turn, starting from my left to right. Mr Randolph?
Jan Randolph: That is the €14 trillion question, I think. First of all, the solution requires the two most powerful institutions in Europe to get together and work out a short, medium and long-term plan. By the two most powerful institutions, I mean the ECB, European Central Bank, and the predominant Government and lead creditor nation, which is the Berlin Government, representing the monetary side on the one hand and the fiscal side on the other. I think part of the reason why this drama has gone on so long, and will continue to go on, is they have not actually worked out a strategy that involves tactics and a proper plan.
I think, first of all, in the short term, tactically, the ECB has to change. It can no longer be "son of Bundesbank", as the Germans would want it as a condition of exchanging the Deutschmark for the euro. It has to rise to the new challenges of being a central bank for the Eurozone as a whole. That is very difficult, but the Germans cannot have it both ways-being hard line on Germanic monetary policy and at the same time expect the euro to exist in its current form. That obviously has raised tensions within the European Central Bank board, and so on, with the loss of German members, although they will be replaced. It is important because I think in some ways the investors, the longer term investors-I am not talking about the short-term investors, the speculators-have lost some sort of confidence in their investments, particularly the peripheral sovereign bond markets of the Eurozone, and as a consequence have lowered their exposures, which has directly raised new borrowing costs. We are seeing that play out.
In part there are fundamentally good reasons for that. Relative credit risks were ignored in the boom years. When interest rates came down-every time a new country joined the Eurozone EU interest rates came down-asset prices went up, with sovereign bonds at the top of the Christmas tree and all the other asset classes and property at the bottom went up. It was great, and markets were making money every time this happened and they were encouraging the process and ignoring the fundamental credit risks. At points, Dublin and Madrid were borrowing less than the German Government. What does that say about relative credit risks or lurking problems in banking systems and property, and so on?
We have a partial reversal of that now, since the last quarter of 2009, and that is extremely painful because the implication is higher interest rates, which means that asset prices have to come down, which raises questions about book value and what is the fair value of these bonds that we hold.
I have argued that ECB has to change. It can no longer be "son of Bundesbank" and the Bundesbank rulebook has to be put aside, even if just temporarily. That will mean being much more activist and providing liquidity in every single market that requires it, including sovereign bond markets, in the same way the US Fed would act, because in some respects investors-and they are predominantly domestic investors to the country concerned or elsewhere in the rest of Europe, because very little sovereign debt in Europe is held outside Europe, in complete contrast to the US, for example-in a sense, see Spanish Government debt as somehow borrowing in a foreign currency still, rather than a local currency. That opens a question about whose Central Bank is this? The ECB, if it wants to snap the psychology at the moment, has to make it clear to the markets that it is prepared to defend each and every central bank, like the Three Musketeers would, in response to it.
Q49 Chair: Just to be clear on the legal position, though, it can only do that up to what its balance sheet can bear-is that not correct in EU law? Therefore, what you are proposing actually would require a treaty change if it was very large sums.
Jan Randolph: If need be. The current strategy has been, basically, muddle along, pressed on-a full stretch, if you like-with essentially risk burden sharing games being played out between the European Central Bank and the Berlin Government. No one wants to carry the can for the risks if greater liability is extended out to Greece or whoever, and they need to agree on the burden sharing and how that is to play out. For example, if the Eurozone Governments insist that the EFSF, which the way I see it is essentially a baby mini IMF-although it is learning to grow up very rapidly and quickly to learn all the best lessons of the IMF, including contingency lines of credit and so on-be made more flexible, if there is going to be a cap on that, that pushes more onus of responsibility on to the ECB. If that means expanding its boundary, so be it.
Q50 Chair: Very interesting. Simon Tilford?
Simon Tilford: I agree with much of that but I will come at it from a slightly different perspective. I think the immediate thing they need to do is stop obsessing about long-term problems, such as the long-term position of public finances, in particular Member States and their so-called competitiveness, because this crisis was not caused really by fiscal ill discipline, with the exception of Greece, and countries are not indebted because they lack competitiveness. If by competitiveness people are talking about productivity, well, low productivity might explain why a country is relatively poor, but it does not explain why it has lots of debt. We are living through the aftermath of the financial crisis. We saw excessive capital flows; for various reasons they froze; various economies were thrown into deep recessions; public finances ballooned as a result of that.
The core to the problem is now the banking sector. They have to get on top of the banking sector and to eschew uncoordinated, excessive fiscal austerity, because at the moment we are in a vicious circle whereby everyone is tightening fiscal policy simultaneously. The fiscal tightening we see in some indebted Member States is totally counterproductive. If we take Greece, for example: despite all the cabbages that have been thrown at the country, at the moment Greece is tightening fiscal policy by more than any developed country ever. What has happened is that that fiscal tightening has pushed that economy into a deep, deep slump-a far deeper slump than the EU or the IMF said would happen as a result of a fiscal tightening of that order. At this point, investors are not worried about the degree of fiscal tightening in Greece. If Greece announced tomorrow that it is going to tighten fiscal policy by another eight percentage points of GDP over the next three weeks, investors would just think, "Oh well, this is no more credible than the current fiscal programme." The only thing that would restore confidence in Greece-not that I think it is possible at this stage-would be a credible route back to growth and hence debt sustainability. That is not going to happen by forcing them into a deep slump and depression, which I think actually threatens democratic accountability in Greece.
They need to stop this moralistic posturing about the virtuous and the profligate and get over it. The responsibility for this crisis lies on both sides. It lies on the side of those who lent imprudently and those who borrowed imprudently. It is an argument about money, essentially: who pays for capital that was misallocated to various Eurozone economies, the lenders or the borrowers? At the moment, the lenders, the creditors, are in the driving seat and they are determined that the taxpayer in the debtor countries foots the whole bill. What they are essentially saying is that, "We can lend imprudently without any real recourse to proper risk analysis, and you are going to make us whole, irrespective of what it does to your economy and your society."
To make it work, they have to come clean about what they have done. A single currency comprising a very heterogeneous group of economies has to have some degree of fiscal integration; you have to have some degree of debt mutualisation. Unfortunately-well, not unfortunately-that can only happen democratically. You can’t push through a debt union under the radar. This has profound implications for democratic accountability, for national sovereignty. Unfortunately, they have made it very hard to win any democratic argument in favour of such debt mutualisation because the countries that are in the driver’s seat at present-the Germans, the Dutch, etcetera-have cast this crisis in a thoroughly unhelpful fashion, i.e. about, "We have lived within our means. We have been responsible. We have been virtuous. They have taken the mick, essentially. They have lived beyond their means. They have broken the rules," and so on. That is making it very, very hard to win any argument in Germany and elsewhere in favour of the kind of fiscal integration that most people, most economists, most outsiders, believe must form some component of any lasting solution to the crisis. Of course, that has to be democratic and that has to be won, and they have made it almost impossible to win those arguments.
Jan Randolph has already talked at length about the need for a Central Bank that performs the full range of lender of last resort functions. They have to have that. That is as important, obviously, as some kind of debt mutualisation. In the previous session, we heard at length about the need to recapitalise. Of course, it is an interwoven sovereign debt banking crisis but, to all intents and purposes, Eurozone policymakers are treating it as a sovereign debt crisis. They have done virtually nothing to address the banking sector issues.
Finally they need to face basic economics-the belief that we can all slash public spending simultaneously and the confidence fairy will suddenly persuade households to go out and buy new cars and companies to go out and invest, because it is not going to happen like that. The IMF came out with some great research yesterday expounding, laying out quite how grave the risks are of everyone cutting by this much simultaneously at a time when there is no scope to cut interest rates. Basically, there is nothing to offset that. What is essentially happening is that a strategy that would be sustainable for a small open economy with its own currency is being wheeled out as a strategy for a large closed economy. A small trade-dependent economy with its own currency can devalue and cut public spending and still grow because it can generate net exports and that offsets the contractionary impact of big cuts in public spending on demand. It is not as if the Eurozone as a whole can do that. That is a zero sum game.
So I think on four crucial points there is a long way to go. As we heard in the previous session, the problem is that we are approaching the endgame, really, and it is quite possible to imagine this crisis spiralling out of control in a matter of weeks, rather than months and years. I think it is difficult at this stage to be that optimistic.
Q51 Chair: Extremely interesting as well. Are you able to add much to both of those two, Simon?
Simon Hayes: I think so. There is no shortage of angles to this, I’m afraid. My starting point would be that the most important near-term objective is to prevent contagion to Spain and Italy because, in terms of thinking about how this could go really horribly wrong versus just being unpleasant, that is the line that I would not want to cross.
There was a discussion earlier about exposures to the various countries. I have some figures on that. UK banks have exposures of about £660 billion to the euro area as a whole, which is about 15% of their overall assets. About half of that is to France and Germany, very little to Greece and Portugal. As someone mentioned, I think Ireland is the biggest direct exposure but still, that is only around 2% of UK banks’ total assets. So really, the direct exposure to the crisis countries isn’t that big. What you would be worried about much more is a much broader crisis across the euro areas as a whole. Also, UK banks’ exposure to sovereign debt isn’t that great, but their lending to the non-bank private sector across Europe is quite substantial. Again, it is not a direct exposure but what you would be concerned about is if there were broader problems across the European economy. One of the things, one of the most direct ways where you could be affected there, is if there were a break-up of the euro, inasmuch as if any country leaves the euro, presumably they redenominate the debts in the new currency; it falls against the euro and you have taken a hit on that already. There are various ways that could play out; who knows who ends up holding the euro as their currency? Obviously, if some of the larger countries were to leave the euro, then you could see UK banks taking a hit through that channel. That almost seems like the unthinkable thing; that is the line that you don’t want to cross.
Spain and Italy I think do need supporting because on our calculation-
Q52 Chair: Just to be clear, how do you intend to differentiate in order to provide that support? You are basically saying support those and cut the rest adrift, aren’t you?
Simon Hayes: No, what I am saying is it really is a matter of priority. The financial markets are clearly sceptical.
Chair: If you prioritise them you will be cutting the others adrift. At the moment, we are prioritising Greece, Portugal and Ireland, aren’t we?
Simon Hayes: I think in the near term this comes down to the ECB’s bond purchases for Italy and Spain, because the financial markets are clearly sceptical about Italy and Spain’s ability and willingness to-
Chair: It has worked fairly well with Italy. The long bond market has improved a lot.
Simon Hayes: With the purchases.
Simon Hayes: What I am saying is that that needs to continue and that there needs to be some official sector support to those markets. Because fundamentally, I think Spain and Italy, the amount of adjustment that they need to do to remain solvent is manageable. It is not an outrageous or unreasonable amount of adjustment, but the financial markets are not convinced and that matters because, obviously, if the yields go up they can’t keep borrowing at 5.5% or 6% and be sustainable on that basis. So there needs to be an official sector structure in place to keep bond yields down and there is at the moment; it is the ECB. By the end of the month, maybe into next month, it should be the EFSF. I think that that channel of support needs to be kept open and will be there for some time.
Then the second thing that needs to happen if you are going to convince markets that actually Spain and Italy are going to adjust, they need to be able to see evidence that they are adjusting. At the moment, we have this problem where financial markets react so rapidly that countries come out over the weekend with some new proposals about fiscal tightening, and then by the end of the week it turns out that the particular proposals are not that acceptable and they may prove difficult to get through. You can’t really make these sorts of adjustments politically on the timetable that the markets demand, so you have to buy yourself some time on that, and I think maintaining bond purchase programmes for Spain and Italy is one way of doing that.
In the longer term, you do need to introduce credible fiscal management arrangements across the euro area. As the discussion went on earlier, that could be applying the same rules to each individual country and saying that, "If we all meet these individually, overall, the euro area will be solvent", or it could be an overall fiscal authority where you have some flexibility and somebody who is allowing certain countries to run larger deficits and others smaller, if that were politically feasible. Some seem to like that proposal; personally, I find it difficult to imagine that that would really work. In either case, the euro area as a whole is solvent and you need to have measures in place that each Government signs up to convince markets that that is the way it is going to be in the future.
Chair: Those were very interesting replies to what I thought was a reasonably simple initial question.
Q53 Stewart Hosie: That was fascinating, more for being a little more prosaic or parochial in terms of where the UK’s liability is at the moment from your various perspectives. What is the UK’s liability to various Eurozone bailouts at the moment through the EFSM and bilaterals? Where are we as a whole with that just now?
Jan Randolph: The Bank for International Settlements have a unique perch in terms of reporting from the banking system. National banks within the nation state, reporting goes normally to the Central Bank and then goes up a layer again to Basel. They have a unique perch, even the IMF and OECD don’t have, which is they can look at what goes cross border on an asset and a liability basis. In that position, and it is a helicopter position, they can see 360 degrees who owes what to whom, which banking system owes what to which banking system. It is a unique perch. It is one that individual commercial banks don’t have because they only have a side-on view, but they are better able to look at concentrations. To the extent that banks actually report all their activities-and we had a big problem in the financial crisis where they didn’t, the emergence of the shadow banking system, assuming that a lot of that has now disappeared, particularly in the States, that which is in the sunlight of reporting-then the numbers are quite clear where our exposures are, our direct exposures in terms of the normal breakdown of the level of assets that a bank might have. Separating the core, for the moment, and the peripheries, clearly Ireland and also, to a certain extent, Spain.
Q54 Stewart Hosie: In addition to the banks’ liabilities, there is also the issue of the state’s liability. I think the UK through its EU contributions and the EFSM is a maximum of 12.5% of £60 billion or something-£7.5 billion. Looking at the banks’ exposure, RBS exposure to Italy and France is about £7 billion; HSBC to the same countries is about £6 billion; Barclays to the same countries is about £11 billion; Lloyds, next to zero. These are big numbers but they don’t strike me as catastrophic, even if there was to be total default, which is highly, highly unlikely. So what is the general view about the real scale of the potential contingent difficulty to the banks and to the economy here generally?
Jan Randolph: We are trying to feel out perspective here, aren’t we, really?
Stewart Hosie: Yes.
Jan Randolph: It is a good starting point-where your perspective is before you can move on in terms of an analysis. If we look at the big debt markets, Italy for example, I believe it is nearly as big as the German Government debt market, although with a much smaller economy. Half of that debt is held by domestic banks-that is not unusual; that is actually typical. There are countries on the periphery that have a little bit more cross-border into the Eurozone banking, mainly into the core, and I include the UK here now in the core from the banking perspective. Like Ireland and Greece, over half is with other Eurozone banks and the UK. By the figures there, from the top of my head I believe we are still the largest of the core countries in Europe with $118 billion-something, slightly more, slightly less, followed by Germany.
Germany had a lot of investment in the financial sector in Dublin, because they liked the regulatory environment there compared to back home and the development of the financial sector there. It is followed by Spain. But if you take these numbers and look at what the total sovereign debt of that country is, it is relatively small. It is true. If you look at the size of the balance sheet, I remember as a rough rule of thumb our four high street banks, roughly, had on the asset side the equivalent to UK GDP. Some would say that is horrendous, we should never get us into that position where total banking system liabilities is four times GDP. It is GDP. If something goes wrong it is what we call contingent sovereign risk from the banking system. We saw how that played out in Iceland and Ireland. If banks can get too big to fail, so can banking systems.
Q55 Stewart Hosie: Given what you have just said-it is big numbers but it is not catastrophic numbers-should we get into a new crisis, either core or non-core, in the Eurozone area, what would the likely impact be on the UK balance sheet? What would the impact be on UK credit rating, just to try and get a picture of where this might go if it does begin to unravel?
Simon Tilford: I think it is worth looking at Lehman, just to get a handle on what looks like a manageable winding down and the impact that can have. When they looked at Lehman they thought, "Okay, the financial system can cope with this," and then we saw what happened. I don’t think it is just a question of looking at liabilities. It is what happens if, in the eventuality of a default or a series of defaults, the interbank market freezes and disrupts wholesale funding operations, etcetera. Then you see an implosion of trust between financial institutions-who is sitting on what-and you get liquidity-type problems. It is not just a question of just the raw numbers; it is all about confidence and trust.
In terms of the impact on the UK and its credit rating, it really depends on how far it went. If it was just Greece and Portugal defaulting-I mean, I think the best thing to happen at this point would be for them to say, "Okay, Greece’s debts are unsustainable, they have to be restructured," probably the same for Portugal, and then they have to make a decision on Ireland. Then they throw everything at the rest. So they restructure their debts and accept, yes, under no realistic forecasts for economic growth are they going to be able to service debt burdens of that order. But then, when it comes to the rest-that is, Italy, Spain-yes, the adjustments are big but if only they had a central bank behaving like a regular central bank and if they had more realistic fiscal targets, etcetera, they weren’t having to tighten fiscal policy by quite as much as this in the teeth of a downturn, so fiscal policy was not quite so close, etcetera-if things were being handled rather more competently, then it would be possible to demonstrate to the markets that they were solvent. Investors need to be confident that the necessary provision, the necessary support, is going to be for them come what may.
Q56 Stewart Hosie: Given your view about the central bank acting as a central bank, and given the view that the ECB should be providing liquidity to all markets, including the sovereign market, would your view generally be-and tell me if there is a disagreement-that the UK, because of the risk of contagion and the huge export market we have to the EU and to the Eurozone, should continue to offer the support that it possibly can in order to provide that liquidity where it is necessary?
Jan Randolph: I think certainly, but it would be an additional problem. We have to remember London is the international financial market for most markets still in Europe, so what happens in Europe does affect us here in the City. That is our local economy.
Yes, liquidity provision is important. We can look at different transmission channels of contagion. We can see clearly that banks hold debt, including sovereign debt; they may also hold debt of other banks. We forget how much banks actually do business with each other. We normally think of them lending to corporates and to Governments and households. When I was working for one British bank, our biggest customer was another British bank-these were two big British banks. That is also the problem of the viral nature of financial crises and the way you are roped up: climbing up a mountain, if one starts wobbling, you all start getting worried, and you can’t see those roped up behind the mountain and so you assume most caution and that is where we are now.
We have contagion on direct hits-who holds what? We have contagion working through sentiment and psychology-we don’t know who is roped up behind the mountain that we could be linked to, the secondary knock on effects. Then there is the liquidity funding side-some banks are structured where they are hugely dependent on wholesale markets for liquidity; others are deemed safer because they have a retail base of depositors. All these things come into play. Basically, we have a tightening of credit conditions and the general financial conditions separate from interest rate policy setting, the general tightening of financial conditions, which isn’t good for the supply of credit should there be a demand for credit, because we need these two working together if we want some fuel for recovery. Without those two going together we are stuck in this anaemic crawling growth path.
Q57 Stewart Hosie: I am not going to go too far on this. This is my last question just now. Simon, given what you said earlier about protecting the countries most at risk just now, would your view be the same that the UK should continue to contribute, whether it is bilateral or through the IMF or through any other funding, to make sure that that is done?
Simon Hayes: Yes, it would on that. We have reached the stage now where this applies not just in Europe, but also in China and the US and more globally. The debt problem built up and there are two sides to that. There was excessive borrowing but it is also excessive lending. The first stage is always to make the borrower adjust and that is what we have been going through. In some cases, making the borrower adjust is too extreme a requirement and it becomes apparent that the lender has to take some of the hit as well, because they also lent on unrealistic expectations about what the outcomes of investments were going to be. I think that is the stage that we are getting to now, where there is a certain amount of pain that has to be gone through. We are realising that maybe it is unreasonable to expect all of the burden to rest on the borrowers, so the lenders, in their own interests, are going to have to come in and take some of the hit. I think the UK contributing to these sorts of packages is part of that process.
Q58 Andrea Leadsom: Just a very straight answer from each of you, if you could. Are we beyond the stage of being able to prevent a crisis, yes or no?
Jan Randolph: I would say that we are in a crisis already, so-
Andrea Leadsom: Yes, sorry, I should have been more specific. My definition of crisis is either a sovereign default or a massive change in the structure of the EU. That to me would be the crisis. We are in a crisis period now and what I want to know is whether there is anything, any combination of policies, that could avert the inevitable crisis do you think-yes or no?
Simon Hayes: Yes, I think there is. I accept that the most immediate one would be to do with Greek restructuring. You can have hard defaults and you can have soft restructurings, and the soft restructuring route is still open and still being explored.
Q59 Andrea Leadsom: Can Greece stay in the euro currency group under those circumstances?
Simon Hayes: Yes, I think so. On our assessment, if this second programme is successful, if the private sector involvement comes on as they hope, then it takes Greece from being clearly unsustainable to being borderline marginally unsustainable. So I think you have bought yourself some probability of getting through this, but still with a big risk that you don’t; a hard default is certainly still on the cards.
Andrea Leadsom: You are effectively saying that you might not be able to prevent it but there is more still to be done?
Simon Hayes: Yes.
Andrea Leadsom: Simon Tilford, what would you say?
Simon Tilford: Starting from where we are now, with the current policy mix or current strategy for dealing with the crisis that we have, I think it is unsustainable in its current form. That will not be just Greece and Portugal either. It will be more.
Andrea Leadsom: Jan Randolph?
Jan Randolph: I think essentially even though this crisis morphs and it has ricocheted from the origins back to 2008, it is essentially manageable. I think what is wanting is policy coordination, having the right institutions deal with the situation. Sometimes markets expect and demand certain things to happen, but politics works and policymakers work on a different, slower body clock, and sometimes things are not realised until they are very clear for everyone. I think, certainly in the Greek situation, default is more often than not a decision made by creditors, whether it is sovereign or corporate. They decide. They precipitate the default by not rolling over the money and they stop the financing. That could still yet happen to Greece, although I think Berlin and the others are fully aware of the consequences. If it was just Greece, they would probably do it sooner rather than later, but the problem is contagion. That is where the ECB needs to come in as a backstop. Greece is going to be given enough time because structural adjustment requires it before you see any kind of genuine results.
I think if the ECB is given greater powers to intervene, a full licence to act as a lender of last resort in all respects, for me that would defuse the bond market crisis, but it doesn’t defuse the underlying crisis to do with the Eurozone. They would have more time to deal with that, but that would be a separate challenge.
Q60 Andrea Leadsom: How do you see the ECB being given the powers-the technical powers-to act as lender of last resort? How is that going to happen from where we are today?
Jan Randolph: It has happened already. Jean-Claude Trichet reopened the bond buying programme on 8 August while politicians went off on holiday. To be fair, Angela Merkel and Sarkozy provided a signed letter to Trichet to handle all financial matters in full confidence while they were away.
Q61 Andrea Leadsom: But there is a ceiling, isn’t there? There is a ceiling and that ceiling isn’t high enough. If the markets want to test that ceiling then it will not be high enough, will it?
Jan Randolph: Yes. This is it.
Q62 Andrea Leadsom: So it is not really a lender of last resort, is it?
Jan Randolph: They know that the ECB is half-hearted about this and the ECB should be determined. It should show the nuclear button and say, "Look, we will" and convince the markets that they will.
Q63 Andrea Leadsom: How can the ECB be a lender of last resort if it does not have the power to be a lender of last resort? How will it get that power if that is what it takes to avert the crisis?
Jan Randolph: That is a good question. It is up to the owners of the Central Bank-the sovereign Governments, and the most important is Germany.
Q64 Andrea Leadsom: That presumably will require some sort of new treaty and that is certainly not going to work in the timeframe of the markets, is it? I am just trying to get to the bottom of whether that is realistic. You are saying that is the solution to prevent a crisis.
Jan Randolph: I am saying it is part of the solution. I see a Central Bank that is not up to the challenges that the Eurozone presents itself as. We are still seeing a Central Bank moulded in a ‘70s and ‘80s environment of West Germany. That was suitable then. Now it is obviously bigger but its mentality and thinking is still very much of a medium-sized efficient export engine-a powerhouse called Germany. The challenges of the Eurozone are much, much greater and I think it needs commensurate powers and policies to deal with that.
Q65 Andrea Leadsom: You are partly saying it is preventable but I am not getting any real handle on what this should Committee be recommending happens. Recommending that the ECB becomes a genuine lender of last resort with complete rights to obligate the entire EU membership is just so badly not going to happen in the timeframe, so short of that what else could be done to avert that crisis? In your view, is there anything that we as a Committee should be recommending that could be done now to avert a significant crisis?
Simon Tilford: The unfortunate truth is you can do relatively little. We are not in the currency union. We are not participating fully in the European Financial Stability Fund. I understand personally the political reasons for that, but we have limited say over these decisions. Clearly, we are going to suffer huge collateral damage if and when the Eurozone crisis really blows up-there is no doubt about that. Given that we can’t really influence policymaking within the Eurozone, we have to concentrate on trying to increase-
Q66 Andrea Leadsom: We can influence banking, though, can’t we? We can influence bank regulation to a decent extent. Is there anything we could do in banking?
Simon Tilford: In the timeframe necessary and in the ways necessary, I am not sure.
Q67 Andrea Leadsom: Recapitalising of banks, forcing them to mark to mark to market their sovereign debt and so on?
Simon Tilford: The Chancellor of the Exchequer has been quite outspoken on the need to recapitalise banks in particular Eurozone economies. He has also come out in favour of some kind of fiscal union. For a relatively Eurosceptic British Chancellor, that was quite a step. I don’t know what they can do beyond that-I mean that is quite a shift. He is basically saying, "Okay, we are not part of it, but in order for it to work you are going to have to become much more integrated." That isn’t something one would necessarily have expected from a relatively Eurosceptic Chancellor of the Exchequer. I am not sure what they can do beyond that. They can back IMF calls for the recapitalisation of banks.
What would be very useful, but of course the British Government is very poorly placed to argue it, is to highlight the risks of uncoordinated and excessive fiscal austerity. The UK position on that is it is a difficult one for us to argue. Of course, our position is different: we have had a big devaluation of the currency; we have our own central bank; we have very low interest rates; we have a central bank that can print. The risks of our tight fiscal policy are much, much, much less acute than the risk of such policy across the Eurozone in economies with similar imbalances to our own but, nevertheless, it is a tough argument to make.
Like it or not, I think all we can do is concentrate on trying to bolster our defences. Our banks are, as a whole, better capitalised, but we have to ensure that they do have sufficient buffers to absorb what is likely to be coming. We do need a strategy for economic growth. I think there needs to be a conversation about whether, for example, it makes sense to be slashing capital investment in this climate. When investors look at the sustainability of the country’s fiscal position, they are really not bothered about the next 18 months to 24 months. They are bothered about the long term, and one of the things that affects a country’s long-term fiscal position is its growth potential. Slashing investment in a country with very, very outdated and poor physical infrastructure from an already low proportion of GDP to next to nothing, I think, is unwise and does nothing to underpin confidence in our public finances. So these kinds of things, I mean I am afraid all we can do is concentrate on strengthening our own economy, making ourselves less vulnerable to this.
Q68 Andrea Leadsom: Simon Hayes, do you have anything to add to that?
Simon Hayes: Not materially. I think that in the near term the main thing that is required is that the markets see that there is sufficient firepower behind bond purchases, for instance, to ensure that Spain and Italy continue to be funded. I think that that is more likely to happen in an incremental way, in terms of there will be crises and that will force Euro area Governments into upping the size of the EFSF, for instance, but there is nothing that the UK really can do to influence that beforehand.
So no, I agree. I think the UK’s defences are about as bolstered as they can be in that the sorts of crises that really would have a very significant effect on the UK economy are things like break-up of the euro and, much more dramatic, a sovereign debt crisis to bigger countries, and I really don’t see what the UK Government can do to materially influence the likelihood of those things happening.
Q69 Andrea Leadsom: Just one last quick question, do you think that if there is a default or if there is some sort of break-up, some massive crisis in the Eurozone, do you think that that would affect Britain’s prospects, as in its own credit rating and the viability of its own banking system? Obviously, we all recognise there would be short-term massive pain, maybe another recession, but do you think it would actually undermine Britain’s longer-term prospects?
Simon Hayes: I think it would. Again, you can draw a line: there are more minor crises where the UK may benefit again from safe haven flows, and so on, because it reinforces the fact that the UK is in this more solid position fiscally; but the fact is the economic and financial interlinkages and banking interlinkages, between the UK and the euro area, are so strong that if something is fundamentally bad for the euro area, it is fundamentally bad for the UK. I am sure that would be reflected both in financial market movements and in the behaviour of the real economy over time. I think it is one of those things; it really is a very material risk because the hit to the UK could be very serious indeed.
Simon Tilford: I think without a shadow of a doubt even the modest forecasts for economic growth upon which our fiscal projections are predicated assume pretty strong growth in net exports, i.e. we are basically assuming that exports in one way or another-exports directly and also investment in export orientated risk to the economy-are going to account for a much bigger share of economic growth than has been the case for a very long period of time in the UK. A profound dislocation in the Eurozone, perhaps not even that, but just stagnant growth in the Eurozone and ongoing instability, is going to have a bad enough impact on the likelihood of us being able to pull that off, given that well over-
Q70 Andrea Leadsom: But that again is short term. I am talking about our rating, the future for our banking sector.
Simon Tilford: I will come to that, but basically given how much of our growth presupposes strong net exports, and given how important a market the Eurozone is, and given the likelihood that, even on the best scenario, they are going to stagnate for years but more likely we are going to have a full-blown crisis, then I think our forecasts for economic growth and hence the public finances look very rosy, very optimistic. If it transpires that growth is weaker and far less progress is made on consolidating the UK’s public finances, then I think a downgrade is a given. I don’t think Britain has much chance at all of retaining a AAA sovereign credit rating.
Q71 Stewart Hosie: Just one question on that. Simon, you mentioned the Chancellor effectively called for a fiscal union. This is the same question to all of you. Does it really make sense to have ever closer fiscal policy to mirror ever closer monetary union, or should the states in the Eurozone not have the largest possible degree of fiscal flexibility in order in some cases to be procyclical or countercyclical with what the ECB are doing in terms of monetary policy? Where is the balance on this?
Jan Randolph: I am not quite sure whether you are asking what is an ideal optimal currency area. Obviously, that has a lot to do with the various constituent parts-are they converging? Are they moving in the same direction? If they are not moving in the same direction economically, are there counterbalancing influences, fiscal transfers, other ways and means? For example, Greece in the longer term needs to regain some sort of competitiveness, viability, in this brave new economic world, not just within Eurozone but globally. That is true for us as well. We are seeking a new path out there as well. To a certain extent the Germans have achieved that exporting to the successful emerging markets.
What strikes me very much is, if you want to be a member of a single currency, it was a bit like being under the gold standard in the 1930s. It was one of Keynes’ great insights that if you have this situation-and there are similarities between currency union and gold standard-you have countries that are generating structural exports and others structural deficits. Over time, you will get a build up in debt, which could manifest either on the private side or the public side, or a mixture of both. At some point you have a solvency crisis. We had to wait until the end of the Second World War before we had the IMF popping out at the end of this. We are getting exactly the same replay now in Eurozone, the same sort of replay of a parallel story, new creation of a central fund, the EFSF.
On the fiscal flexibility side, I don’t know. It depends where the debt goes because all deficits have to be financed.
Q72 Stewart Hosie: Let me give an example. Ireland have just cut VAT in the tourist industry-they have effectively kept money in that sector to grow it as part of their attempt to increase growth in their overall economy. Were that to be impossible because of fiscal union, would that be a good thing or a bad thing?
Jan Randolph: Could you say that again, please? That was a bit too quick for my one ear.
Stewart Hosie: Sorry. Ireland have just cut VAT in the tourist sector, deliberately to stimulate growth in that part of the economy as part of the overall growth strategy. Fiscal union may have removed that lever tool from them. Would that be a good thing or a bad thing?
Jan Randolph: I see what you mean. Yes, Ireland is probably one of those that will eventually recover and rehabilitate sooner than I think people expect, precisely because of its flexible economy and the tax structure is advantageous. Some of the advantages that Ireland had that made it attractive to foreign direct investment are still there. The externals sector is booming and when you look at the country you can see the export surplus. It includes the services side as well. It is booming and this is the external adjustment that some of us look at. It will spill over into the domestic economy.
On the tax structure issues, I can understand why Berlin, for example, have said, unlike the French, when it comes to corporation taxes, "This is not a red line for us." They are quite right, why should it be? We want to see a recovering Ireland. That is more important for us than fetishising tax rates. It should not be fetishised. If it is successful in delivering growth, that benefits everyone.
Simon Tilford: When people talk about fiscal union, when most people do, at least when most economists talk about fiscal union, they are not talking about a uniform sort of constraint on Governments. They are not saying that. Basically, it is actually the reverse. If you have a currency union whereby you have basically a group of countries sharing a currency, and if we see huge trade imbalances emerge between the participating economies, it is very hard for economies to adjust, for those imbalances to be unwound in the absence of a fiscal union. What they are attempting to do at the moment is that we have these huge trade imbalances within the Eurozone but the full burden of adjustment for correcting those trade imbalances, which lie behind many of the problems we have, are falling on the deficit countries. So deficit countries are going to cut their deficits by deflating their economies-basically by cutting wages and slashing public spending, so the 1930s, really.
Now what a fiscal union would do-basically, what the Germans and the Dutch are saying is that they can participate in a currency union, we can run huge trade surpluses indefinitely, but we do not need to participate in a currency union. The problem there is that if the private sector will not finance the deficits of the deficit countries, the public sector has to finance them in one way or another. If the public sector won’t and you won’t go to a fiscal union, basically the only route out is for the deficit countries to adjust. That basically means slashing wages. Anyone who thinks that is going to be politically sustainable in Italy by as much as they need to do it, or in any of these countries, is guilty of gross ignorance of economic history.
When people talk about fiscal union, this is not a way of imposing German procyclical, one-size-fits-all fiscal targets on everyone, which would be catastrophic, which is what they are trying to do. It is about actually providing a mechanism to transfer funds between participating economies. Of course, the problem is that there isn’t the necessary solidarity between the participating economies to underpin that kind of network and it has to be underpinned democratically. You can’t push that kind of thing through under the radar, although some people would very much like to do so. Clearly, that is a fundamental sovereign step and it can only be pushed through if it is sanctioned democratically. That is the problem because at the moment there are very, very considerable obstacles to that.
Stewart Hosie: That is helpful.
Q73 Jesse Norman: Mr Hayes, do you track Barclays’ own funding in the markets?
Simon Hayes: No.
Q74 Jesse Norman: Let me ask you all then a wider question, which is, on a scale of one to 10, how do you assess the ability of banks to fund themselves in Europe at the moment; with one being bad and 10 being good?
Simon Hayes: Could you just repeat the last bit, sorry?
Q75 Jesse Norman: Sure. On a scale of one to 10, one being bad and 10 being good, how do you assess the ability of banks to fund themselves in the money markets in Europe at the moment? I am just trying to get a handle on how serious the impending secondary banking crisis would look.
Jan Randolph: Again, a lot of banks fund themselves through a retail base and so they can ignore what market-
Jesse Norman: I would have said there are very few banks in Europe that are not reliant on the wholesale markets in some way or other.
Jan Randolph: I think liquidity funding is not really an issue. Obviously, you can measure stress, the LIBOR spread, for example. It is a gauge of fear, these mountaineers climbing a mountain. The banks fear each other in terms of what they might be thinking of doing. We saw that LIBOR risk spread, which was essentially a measure of the financial crisis. You can do the same for EURIBOR. You can also look at the dependence on the ECB balances for liquidity as a measure of liquidity stresses, how far we are being cold-shouldered or excluded from the basic liquidity markets, the funding markets, and therefore we have to depend on the sovereign, the Central Bank, for liquidity. There are different ways you can measure these things and then try and understand what do they actually mean? What is-
Q76 Jesse Norman: In one sentence, what is your assessment at the moment of those measures and what they mean?
Jan Randolph: Obviously, I think it is worse than it was before. I don’t personally think it is near a Lehman-type situation, mainly because we do have these new backstops from the ECB liquidity facilities, six months unlimited and so on. You do have a sovereign safety net.
Simon Hayes: I think its significance might be a bit of a red herring. You can look at this in two ways. One is the Central Bank facilities are there and are widely used and the ECB and the Bank of England have certainly been very clear that they will be willing to provide liquidity as required.
Q77 Jesse Norman: If everything is as rosy as you suggest, why are there hundreds of banks across Europe being directly funded by the ECB?
Simon Hayes: Because it would be a lot more expensive for them to get funded elsewhere, but so long as the-
Jesse Norman: It is vastly more than was ever contemplated when the ECB direct funded-
Simon Hayes: So long as the ECB is providing that liquidity, then you shouldn’t expect a crisis.
Q78 Jesse Norman: So why has the CDS spread on the Royal Bank exploded over the last month and a half?
Simon Hayes: The CDS markets don’t always behave similarly to the two interbank markets in other measures of stress. We don’t always pay a lot of attention to them because they are very thin markets indeed. I think in terms of funding costs, one thing is that on the spreads, even though the EURIBOR spread may have increased, the actual EURIBOR rate has not. All that has happened is it has not gone down. The actual funding-
Jesse Norman: If people are not actually able to fund through it you are not going to see much movement in the spread, so it is a matter of how much is actually done.
Simon Hayes: You don’t need to because the ECB and the Bank of England, and the Fed via the swap lines, will provide the liquidity. I think the concerns are much more to do with the sovereign debt issues and the ramifications of euro membership.
Q79 Jesse Norman: That is helpful. Tell me, you have talked about the importance of preventing the contagion from spreading to Spain and Italy. Which is more at risk? Which are we more worried about? Which should we be more worried about, Spain or Italy, from a UK perspective?
Simon Hayes: I don’t think that you could isolate them. If one ran into problems then it is hard to see how you could have a crisis in one that was not a broadly euro-area crisis, I think.
Q80 Jesse Norman: It was fairly obvious that Greece is the sickest of the PIGS. People could see certain factors. You are suggesting there is no qualitative difference at the moment that would allow us to say Spain is worse off than Italy, that we should be more worried about Spain from a Eurozone perspective, or is Italy more worrying?
Simon Hayes: They are both big, substantial economies.
Simon Tilford: I think Italy ultimately, if you wanted to choose between the two, is the bigger threat. It is the bigger economy. It is the one with a much less stable political system. I think it is perfectly possible to imagine in Italy that if they face the choice between years of deflation and fiscal austerity or the alternative, there is a greater risk; if the political constituency are in favour of staying the course, there is a much greater risk that that constituency could fracture in Greece than there is in Spain. Also, I think the spreading of the crisis to Italy really has raised the stakes, no doubt about it.
Q81 Jesse Norman: That is interesting. You have talked about the importance of complying with the new set of EU fiscal rules or the promulgation of something like that as part of a new regime. We heard from Professor Goodhart that you can’t fine people to get them to comply. That is counterproductive. How do you compel compliance with EU fiscal rules? What are the kinds of things we should be looking at? Or is there actually just rampant moral hazard in a situation like this where you can’t punish someone?
Jan Randolph: The Germans talk about sanctions and the question is, is it automatic or is it that you have to go to some court or committee to decide it? The Germans would prefer an automatic sanction, of course, but then if you look at it, that makes the situation worse.
Q82 Jesse Norman: What would those sanctions be? Just a fine? What would it be?
Jan Randolph: Yes, I mean this the reason why it didn’t work in the past, because it was sent to a committee to decide and it wasn’t automatic or enshrined in law, and so it did not pose much of a deterrent. It didn’t do so for France or Germany.
Q83 Jesse Norman: It is a piece of Euro fudge. We are going to get a massive moral hazard. These things come out again. No one can compel the compliance. The good guys do the right thing; the other folks do not. Then there is a huge crisis about who bails who out. That is what seems to be happening without a proper enforcement regime.
Simon Hayes: I think ultimately there are no effective sanctions because things can be fudged in the end and will be. What you have to do is to build a constituency within the euro area for close monitoring and adherence to public finance rules. I don’t think there is any alternative, so you have to get countries to sign up to these things and you have to do them in such a way that it becomes part of the system. I don’t think ultimately there is anything that you can do. Jean-Claude Trichet mentioned that countries could be ejected from the euro for not following the rules and that could be used as an ultimate punishment, but you can see that there are many circumstances in which you would not want to hardwire that into some rules so that it happened automatically. If it is not going to happen automatically, then there are whole myriads of circumstances in which you would not follow through with it.
Q84 Jesse Norman: Thank you. I am conscious of the passage of time. I will not keep you too much longer. Can the ECB in fact be given the powers that you think are necessary for it without a change in the treaty, without a treaty change of some kind?
Chair: It was the question I posed to you right at the beginning, Mr Randolph, when you said if the ECB would step up to the plate we would all be okay, to which I replied, "Well, they can only do that to the limit of their balance sheet".
Jan Randolph: Yes. I am not an expert on the legal constraints that the ECB is under or its room for manoeuvre. It is an animal defined by EU law. I assume it has a certain amount of flexibility and all I am arguing is that I see the way the ECB is behaving very much as if it were still "son of Bundesbank". That is not appropriate for the new times involving new Eurozone challenges when it has to face a number of different kinds of economies and their different financial positions and all the different markets that it is involved in. Yes, on one key issue, for example, quantitative easing, that is not countenanced under Germanic monetary philosophy. It has to be sterilised all the time.
If you look at the size of the asset, if we look at our Central Banks, Bank of England, ECB and the US, how have the assets side of this balance sheet ballooned by comparison since 2008? It is very interesting. Obviously the US has gone up quite a lot-threefold I believe. The Bank of England has gone up quite a bit, if you look on their balance sheets. It is not always easy to see what is on the balance sheet of banks. They are a bit like dirty windows, cracked windows and covered curtained windows sometimes. The European Central Bank has done very little by comparison I think, but again that is the way it was brought up by the Bundesbank. It needs to get real, basically, for the new challenges. If it does not have the powers, it should be given the powers.
Jesse Norman: Is this your view as well?
Simon Tilford: I think the constraints on the ECB are not so much on the legal side but the political side. It is quite unclear, really, what the ECB can and cannot do. It could do a lot more than it is doing just from a strictly legal perspective.
Jesse Norman: It already has powers and it is failing to-
Simon Tilford: Yes. The problem is that it is doing as much as it thinks it can do without prompting an open political rebellion in particular member states, not least Germany. It is worth bearing in mind we have now had both senior Germans at the ECB resigning over their strategy. There is no doubt that there is a profound split within the ECB. The ECB is in a difficult position because it can go ahead and do things, but that might prove counterproductive because it might just feed market fears that this split is doomed to come back out in the open and lead to an open argument about the ECB and its powers. It is not straightforward.
Simon Hayes: I think that the ECB is being used as a kind of quasi-fiscal transfer mechanism in a way that is undesirable, frankly, and that is what has caused the tensions. So I would not look to change things to allow it to do more of that. I would much rather it were a plain vanilla Central Bank, and things like the FSF and the central fiscal authority, and so on, have more transparent arrangements for the actual fiscal transfers that are going on rather than doing it indirectly by these balance sheets.
Q85 Jesse Norman: Thank you very much. A very quick question. Mr Tilford, you said, if I understood you, that as matters presently stood, you thought a downgrade in the UK’s credit rating was inevitable. Is that right?
Simon Tilford: No, I am not sure I would say "inevitable". I think if I had to bet one way or the other, I would say, "Yes".
Jesse Norman: Right; over a one to three-year period?
Simon Tilford: Yes.
Jesse Norman: That is because of the lack of growth?
Simon Tilford: Largely because our economic growth prospects are so poor-
Jesse Norman: Notwithstanding the austerity, such as it is, but the low interest rates we are currently being charged on our debt?
Jan Randolph: What is clear is the biggest damage to the rating that could happen is a loss of tax revenues. That is the ability to pay back. That is the central pillar to the rating, any rating-my rating, the sovereign rating, corporate rating-your ability to pay it. If your tax revenues bleed away and dry up because of recession or because of financial crisis that can fundamentally undermine your rating.
Jesse Norman: That is extraordinary. If that was the case, you ought to be piling out of the markets because the markets are not discounting that kind of change-
Simon Tilford: No, but as we see from the US you can have downgrade and it can lead to an increase in bond prices and hence a fall in yield. Yes, it is only partly down to the extent of fiscal austerity. We have a lot of overly rich households. We have companies who are sitting on cash rather than investing. Okay, part of that is to do with perhaps excessive restrictive fiscal policy, but we are in the aftermath of a very serious financial crisis. Growth is normally very weak in the aftermath of a serious financial crisis. We are going into it with quite a lot of debt, having had an economy that was successfully driven by debt of one sort or another for a number of years. We have a painful rebalancing in front of us against a very unfavourable global backdrop, so there are all kinds of headwinds to UK growth and I don’t think it is a big call to say that we will struggle to hold on to AAA in that environment.
Q86 Mark Garnier: Can I just come back to something you said about the credit default swap market being particularly thin? Does that mean that it is effectively not much of a useful hedge against defaulting on sovereign debt?
Simon Hayes: I think it is. It is only just one for very specialist investors and presumably they find it useful, but really it is more about how one interprets movements in those spreads and whether one puts a lot of weight quantitatively on how far they move or what they are relative to other countries. Our approach is that we are pretty sceptical about that. It is never really very clear whether they tell you more information about concerns about default or other risk. It is the same information that you are getting from other markets, just magnified because of the lack of liquidity.
Q87 Mark Garnier: Where I am coming from on this is looking for the stability of banks and the financial system, but clearly obviously a lot of banks, including UK banks, hold sovereign debt around Europe and indeed debt on other banks. What I am trying to ascertain is whether there is a sensible way that you can hedge that position or, in reality, something like the CDS is not going to be able to do it to any extent that is going to be meaningful in the case of a country defaulting on its debt and possibly, subsequently, banks of that country also defaulting on their debt.
Simon Hayes: In terms of the default, the CDS are what they say they are and they do hedge against credit events, but I think-
Q88 Mark Garnier: I will tell you why I am slightly cautious about this. It is because if you have a sort of house of cards collapse, then eventually are the people who are writing the CDS in the first place ever going to be able to pay out on these? Simon Tilford, you look enthusiastic about answering that one.
Simon Tilford: No; I disagree with your analysis. I think there is a real likelihood that in such an eventuality, they would not pay out.
Q89 Mark Garnier: So the CDS market is, apart from a very, very loose guide as to what people think is going to happen, actually a pretty meaningless way of trying to defend the holders against defaults.
Jan Randolph: The way I see it is banks like to manage the risk profile of their exposures and these instruments are a way of fine tuning, pruning back, mitigating certain risks they believe in, but the value of CDS has conditions attached. They are only worth something if certain conditions are met, otherwise you are buying insurance for nothing. Quite often banks use them to manage their country limits. If they feel as though they have too much exposure to Italy, they will buy a few CDSs and they feel as though that mitigates a bit of exposure to that country. That is the way they are used. In terms of whether they are predictive, in terms of default probability, that should be the sovereign rating itself, but even then it is a private credit opinion. What matters at the end of the day are your borrowing costs. We saw the divergence there in the US, in terms of what actually happens in a crisis situation-borrowing costs fall, even though the credit rating has been downgraded.
Q90 Mark Garnier: Are credit rating agencies any good? I remember having a conversation with somebody about a year ago at one of these meetings, and they said, "Oh no, the credit ratings will mainly reflect what the market is telling them" which presumably is completely the opposite of what they are supposed to be doing. That sounds like the tail wagging the dog.
Chair: We are considering taking a deeper look at that issue at another time, so a brief answer would be appreciated. I am sure we will tap your knowledge on it more deeply later.
Jan Randolph: On sovereign ratings?
Mark Garnier: On the rating agencies.
Jan Randolph: Yes, black boxes.
Mark Garnier: So no good at all.
Chair: You are a black box yourself, aren’t you, Mr Randolph?
Jan Randolph: I am quite transparent. I take all my clothes off when I do a rating.
Q91 Mark Garnier: Again, I am concerned about the banking system, in particular the UK banking system. Is our exposure to the troubled countries and the banks in those countries significant enough to cause a real problem if they were all to collapse? That is the first part of my question. Secondly, if that had a knock-on effect on other countries, would the secondary crisis coming from the bigger countries be enough for our banks to have a serious problem?
Simon Hayes: My understanding would be no. First of all, UK banks’ exposures directly to the crisis countries-to public sector debt and bank debt-are very small. What is much larger is our exposure to, say, French and German banks. They are of many orders of magnitude larger. So then the channel would be that you would have a default in Greece or somewhere and then that affects French and German banks, but it would have to affect them to the extent that they then defaulted on some claim that UK banks have on them and I just see that as extremely unlikely. I think the banks would certainly be able to withstand these narrower crises, where you are talking about some of the small peripheral countries defaulting. The line would be drawn at the level of those banks and I don’t think they would back up into UK banks. As I have said, the bigger concern is if you had something that infected the much larger euro economies and some sort of breakup of the euro, then you are in much more serious circumstances.
Q92 Mark Garnier: Then you would think there was a very serious problem potentially for UK banks, the UK banking system?
Simon Hayes: Potentially-it depends on how things are played out but, as I said, one obvious mechanism is if you get countries that actually leave the euro and depreciate, then that is a de facto partial default on all your euro-denominated lending that you have done there. It is really the UK banks’ exposures to the non-bank private sector-households and businesses-that is the material element of their exposures to these economies. So it would have to be macro-channel or through the currency channel really to be of major concern.
Q93 Mark Garnier: If countries did start defaulting and there was a problem with the balance sheets of the banks that hold the sovereign debt, do you think there is an argument for a mechanism such as a TARP-a Troubled Asset Relief Programme-to be set up in Europe by the European authorities to enable them to go in and buy those troubled assets from the banks? Is that possible?
Simon Tilford: I think so, yes. I am not as sanguine about the outlook for either the Eurozone banking sector or the impact in the Eurozone banking sector on the UK. I think, yes, as we talked about earlier, the direct links look containable, but that ignores the impact that a freezing of the internet market would have and the impact on confidence, and so on. I think, yes, there is a huge volume of bad debt within the Eurozone as a whole concentrated in particular assets of particular countries and, one way or another, that is going to have to be addressed. Obviously there needs to be bank recapitalisation. There could well be an argument for a TARP-type scheme in addition to that or to augment that, yes.
Q94 Mark Garnier: Have you made any estimation as to how big it would need to be?
Simon Tilford: I am afraid not, no. It is kind of beyond-
Mark Garnier: Ballpark figure?
Simon Tilford: It is just one of those things. We are a small organisation; we just do not have that kind of manpower.
Mark Garnier: If somebody was to hold your feet to the fire, €1 trillion, €2 trillion?
Simon Tilford: Of bad assets? I have no idea. I really do not know the answer.
Q95 Mark Garnier: Just one last thing. I missed the bit leading up to this, but you saw the possibility of a write-down of the UK rating. Did you say it was going to definitely happen or it could happen?
Simon Tilford: I think we are entirely vulnerable. I mean, I am not saying it would be the end of the world if it happened, necessarily. I mean, people can fetishise these things, but given the headwinds facing our economy-and given the level of debt, both the absolute level of debt that we know about but also various contingent liabilities-it looks highly vulnerable. I think, of the AAA economies, only France probably looks more vulnerable.
Q96 Mark Garnier: Given the fact that there is this large implicit guarantee behind the UK banks because of the British problem, does that not necessarily mean that if we downgrade the UK as a country, then that implicit guarantee becomes less valuable so, therefore, there is a direct knock-on effect on the banks?
Jan Randolph: Yes. The importance of the sovereign rating acts like an anchor to the credit risk map in the entire country and everything important in that country; the politics, the finances, financial balances in the economy and all the players in it. So what tends to happen is that if the sovereign rating goes up, with or without direct links to equity in banks, it tends to lift all the other ratings with it, and then if the sovereign rating falls it tends to drag everything down with it. It is controversial whether to have a corporate bank rating superior to the sovereign level anyway, the sovereign circle-
Simon Tilford: That is in normal times though, isn’t it, and we are not looking at normal times. If we see what has happened in Japan over the last 15 years, there have been successive downgrades and look where yields are, and they are still-
Jan Randolph: Yes, that is very interesting, but if you watch the rating agencies long enough and look at the reasons why they change, upgrade or downgrade, you begin to learn things about their model, even if they don’t reveal it. You use a deductive process, if you like. The unwritten rule is that when net public debt goes above 100% of GDP, there have to be good reasons why you have still to play unless there are risk mitigation factors, like what the world global currency call "dollar", and we were approaching that level and that is why we were put on negative outlook. That was switched back off to stable because the new Government came in and took fright from the Greek crisis and said, "Yes, we have to join in the German austerity here, otherwise we might get bitten from behind in the bond markets with a country risk premium" by which time it is too late already or it is more difficult to get yourself out of the hole.
Simon Hayes: I think what has changed in the UK’s position over the last couple of months is-I agree with Simon-that the growth outlook for the UK is materially worse than the OBR has in their forecast. So, from that perspective, I would say it was going to be difficult for the Government to meet its deficit reduction plan. So I would expect some slippage there. However, to the extent that the problems in the UK economy are because internationally, they are similar within Europe and the US, there are additional problems that mean that demand is weakened. UK exports are not as strong as we would hope. The UK’s relative position is unchanged, if not improved, if you look at what has happened in the markets over the last couple of months. So, from that perspective, you could well actually see the UK retain the extraordinarily low funding costs that it currently has, because it is not in the bad bucket; it is in the good bucket. It is benefiting from safe haven flows.
Q97 Mark Garnier: Given the fact that we have £1.45 trillion worth of personal debt in this country, it does mean that we are much more susceptible to a rise in funding costs to the bank, which will then obviously be passed on to the consumer. Does that make us more risky in terms of the effect it could have on the population?
Simon Hayes: It is the sort of thing that ends up being a drag on growth, as it already is. The tighter the credit conditions are the more that is going to keep consumption weak.
Q98 Mark Garnier: I think my question is: are we more susceptible to that because of the position we are in than, say, Germany or America might be? They are different economies, but does our very high level of personal debt relative to the rest of Europe-for example, I believe that 50% of all personal debt in the whole of Europe is in the UK, which is nearly 10% of the population-make us much more susceptible as a country? It is a hindrance to growth, as you say, but what happens if we start seeing funding costs to banks going up and, therefore, the cost of borrowing on the high street going up as well?
Jan Randolph: Personally I think, it is like a lot of the Anglo-Saxon economies where housing is used as an asset-if prices are rising, the asset builds up. We then use additional debt to finance consumption. That model broke down basically, and there is no question that the financial crisis was a balance sheet crisis in a sense, and its impact was principally on the private sector in the UK, in the English-speaking economies as well as Spain. That debt levering process that is currently underway, it may be healthy in terms of restoring balance sheets by raising savings again but it is bad for growth, because there is very little consumption.
In terms of vulnerability, if high interest rates are in order or higher funding costs, then it makes the debt servicing a lot more expensive, so it is an additional drag, and by the time all this stuff is unwound it is going to take a lot longer, I imagine.
Q99 Chair: In a word, yes or no, will the Eurozone have the same membership in 12 months’ time that it has now? Simon Hayes.
Simon Hayes: In 12 months’ time, yes.
Simon Tilford: No.
Jan Randolph: Yes.
Chair: I think that summarises the sort of evidence we have been getting from all three of you, respectively, through the afternoon. Thank you very much for coming. It has been extremely illuminating and we appreciate it.