Treasury Committee
Oral evidence: The Appointment of Dr Nemat Shafik as Deputy Governor of the Bank of England, HC 492
Wednesday 9 July 2014
Ordered by the House of Commons to be published on 9 July 2014
Mr Andrew Tyrie (Chair); Steve Baker, Mark Garnier, Stewart Hosie, Mr Pat McFadden, Jesse Norman, Mr David Ruffley.
Questions 1-82
Witness: Dr Nemat Shafik, gave evidence.
Q1 Chair: Welcome, and thank you for coming to give evidence in this confirmation hearing. Could I begin by asking you what experience you have of the conduct of monetary policy that makes you fitted for this job?
Dr Shafik: I have spent the last three years at the International Monetary Fund, working on a range of macroeconomic issues for the 48 countries that I oversaw in my role as Deputy Managing Director. That included providing those countries advice on monetary policy, including things like the monetary policy framework they had, the way interest rates were set, the governance around monetary policy, as well as our views on the existence of an output gap or slack in those economies and what we believed should happen on interest rates. That was a routine part of the surveillance that was done over the countries that I was responsible for and those included some of the most difficult cases in the eurozone in which a very close co-ordination with the ECB, under the context of the troika, was a key part of those programmes.
Q2 Chair: How many of those countries had advanced, highly developed approaches to monetary policy and were larger economies such as our own?
Dr Shafik: In my portfolio I had Switzerland, Sweden, quite a few countries that were outside the ECB framework that had not quite the same size as the UK but quite respected central banks.
Q3 Chair: What else were you doing when you were at the IMF in those three years?
Dr Shafik: What other areas were in my portfolio?
Chair: Those were your primary responsibilities?
Dr Shafik: Yes. I was mainly responsible for countries in Europe and the Middle East. I also—
Chair: Mainly working in the Middle East?
Dr Shafik: No, mainly in Europe actually. Most of the eurozone crisis countries—so Greece, Portugal, Spain, Cyprus, Iceland—were the countries that I led on for the management team of the IMF, as well as a total of about 30 countries in Europe and about 14 in the Middle East. I also was responsible for the IMF’s budget and its human resources policies. I ran the IMF’s training arm that provided a great deal of training for government officials around the world on monetary policies, macroprudential policies, fiscal policies, statistics; the complete gamut of macroeconomic issues.
Q4 Chair: If I may say so, that sounds quite broad, and indeed the last description you have just given is extremely broad, whereas what we are looking at here is something that is quite specific and complex and in many respects technical. We are really looking too at a subset of three years’ experience. Do you feel, nonetheless, that you have the skills needed to do the job, or are you going to learn on the job?
Dr Shafik: I am not being hired to exclusively focus on monetary policy. As you know from the role, I will be sitting on all three committees—on the Monetary Policy Committee, the Financial Policy Committee and the board of PRA—in addition to the more operational responsibilities I will have in the Bank on banking, markets and international. It is a significant part of the role, but it is not the only part of the role. A huge part of what one does at a more senior level is play a vital role in connecting the dots between those three key policy areas, and I think that is where my comparative advantage will be.
Chair: I think many people would consider it a very significant part indeed of your role. Not least at this time, but at any time, monetary policy is so central to overall economic policy. I think you would agree with that.
Dr Shafik: Of course.
Chair: The system we have places a particular burden on those nine people to show independence in how they operate. We might come on to independence in a moment, but I will pass the questions on to Mark Garnier.
Q5 Mark Garnier: Can I stick on the monetary policy side of things? What is your estimate of spare capacity in the British economy?
Dr Shafik: The last estimates that were published by the Bank, and which are the ones out there, range between 1% to 1.5% of GDP. I think the next time those estimates are made they will probably be lower, because we have seen that both output and employment have improved far better than we had expected—than anyone had expected, frankly, any of the forecasters out there. Spare capacity in firms seems to have closed, and in the labour market there are two elements of spare capacity: one is unemployment, which has come down quite quickly, and the other is the number of people who are currently working part-time who would like to work more hours. That has not changed so much, and if you look at the numbers of those who would like to work more hours, that has not improved. That seems to be where the bulk of spare capacity is at the moment.
Q6 Mark Garnier: I am trying to work out what indicators you would be looking at in terms of seeing whether we are running out of spare capacity. One of them would be a drop in the number of people in part-time jobs who want to be in full-time jobs.
Dr Shafik: Correct.
Mark Garnier: What about wage growth?
Dr Shafik: That is clearly a key issue. I think the key things to look at are what is happening to inflation, which has remained low at 1.5%, what has happened to wages, unemployment and other indicators of the labour market; not just unemployment but also the type of survey evidence on the desire to work more hours. Wage growth, as I am sure you know, has been flat, as have prices, and that has been the paradox of this recovery. Growth and employment have done better than we expected; wage growth and productivity and inflation have done less well than we expected.
Q7 Mark Garnier: What do you think explains that?
Dr Shafik: I think part of it might be that clearly employers are able to hire more people without having to offer higher wages, which is consistent with the fact that there is still slack there and perhaps slack around willingness to work more hours.
Q8 Mark Garnier: The productivity puzzle is quite a problem for people, and certainly for a number of people who have come before this Committee when we talk about the productivity puzzle and what is behind it. What do you think is behind the productivity puzzle?
Dr Shafik: I am afraid it is still a puzzle. I have read the rather large academic research that is out there on the productivity issue in the UK. There is no clear consensus. For a while people thought it was labour hoarding, and then with what happened with the employment numbers that is clearly not the explanation. The Bank of England itself has done a piece of analysis that looks at the 16% drop in productivity; 4% of it is because of measurement error but if you look at the remaining 12%, cyclical factors don’t seem to be the issue anymore. Structural factors are still an issue and they explain between 6% to 9% of the productivity gap, but there is still a significant part of the productivity shortfall that we just cannot explain econometrically, and I think that is an important area for continuing research at the Bank.
Q9 Mark Garnier: What is your gut feeling?
Dr Shafik: My gut feeling? I don’t like to rely on my gut for those kind of more empirical questions, so I would rather look at the data.
Mark Garnier: Sure, but you have suggested there is error in data. Ian McCafferty has come up with an explanation that is talking about, for example, the fact that in the banking industry or the financial services industry a greater burden of compliance is costing, so that is explaining some of the reduction in productivity. Some people are suggesting that forbearance by the banks is hiding quite a lot of misallocation of capital and labour, and that may come out when the interest rate starts to go up, and the grey economy. You might answer that and say, “Well, all of the above”, but is there anything in particular that you are worrying about? Ultimately it is a very important question. At some point we are going to start seeing other factors coming through and interest rates are going to start to go up. If they go up and we—when I say “we” I mean you—have misread the indicators, you could cause quite a significant problem. This is why it is very important for us to try to understand what your thoughts are and what you are particularly worried about, and where you think you might make errors in assessing what is going on in the economy. So perhaps if I can press you again—gut feeling might help.
Dr Shafik: I think continuing to look at firm behaviour. There is something clearly going on with delays in restructuring and efficiency, and that is probably enabled partly by low interest rates, which mean that the survival rates of firms has been quite high. Continuing to look at that data will be key. The other thing that we have to keep using to the extent we can is the work of the Bank’s agents around the country, whose guts I frankly trust more than my gut because they are closer to the coalface. I would hope to draw very extensively on that work in the period ahead to make a judgment about productivity. I fully agree with you; it is the central question for the solidity of this recovery. If we can start to see an improvement in productivity numbers, rates can stay lower for longer. If we don’t, we will be facing supply pressures and price pressures and rates will have to go up. I wish I could give you a clearer answer.
Q10 Mark Garnier: Let me try to ask this question differently, if I may keep pressing a little bit on it. Let’s say hypothetically we are sitting in the MPC meeting right now and you are about to take a vote. What are the key factors that you would have been looking at? With all the information you know now, what are the key factors that would make you decide to vote for an increase in interest rates or not?
Dr Shafik: I would look at inflation, wages, productivity trends and the labour markets.
Q11 Mark Garnier: But inflation can be driven by a number of different other factors. Inflation can be driven by the currency level, energy costs, all those kind of weird things that don’t necessarily reflect rising wages.
Dr Shafik: That is true, and that is why one has to look at inflation in a kind of decomposed way. This Committee has seen inflation rates above the target during the crisis and seen through them, because it was clear that they were being driven by the exchange rate, changes in VAT, food and fuel shocks. There will be similarly such one-off effects going forward, and I think the Monetary Policy Committee and this Committee has rightly seen through and looked at the fundamentals in terms of prices. I think looking at prices in that disaggregated way would be key for that decision.
Q12 Mark Garnier: Come the time when interest rates do start going up, what expectation do you have that this forbearance will start tightening up and there will be what economists talk about as a reallocation of capital away from ineffective use but many other people talk about as companies going bust, and unemployment or people losing their jobs? As politicians, we look at individuals and what effect it has on them and not necessarily how it reacts to the economy or the economic picture. What is your estimate, if you have made any, of rising interest rates having that effect on people’s lives?
Dr Shafik: I think we will be able to answer that question quite specifically with the stress tests that are currently being done and which we will have the results of in 2014. That will tell us the extent to which forbearance will result in increased bankruptcies going forward with higher rates or not and the pace at which that risk might manifest itself. So I think we really do need to wait for the stress tests. The forbearance issue, as you imply, is certainly part of the productivity problem. Some studies seem to indicate that firms are holding on to labour, not investing in capital because wages are low, and that is resulting in some of the decline that we have seen in productivity in the recent period. The months ahead will provide us with key data that we can look at to try to better understand what is going on.
Q13 Mark Garnier: Do you think it will ever happen that UK productivity will get back to its pre-crisis levels, or do you think there has been a fundamental shift, as perhaps Ian McCafferty is suggesting?
Dr Shafik: I think it is possible that it goes up to pre-crisis levels. There are a whole array of policies that would determine that. Up until now the strategy has been to use monetary policy to get output back to potential, but the next challenge is to increase potential. That would involve seeing a recovery in investment in both labour and capital but also an increase in productivity. It will depend on whether that actually happens, along with the third key pillar, which is to see a rebalancing in the economy. If that happened, I would imagine that productivity could go back to higher levels.
Q14 Mark Garnier: It has been suggested that when interest rates do start to rise the MPC will use baby steps. What do you see as baby steps?
Dr Shafik: I think we are entering a period in all the advanced economies when what economists call the natural rate of interest, which is the interest rate that is consistent with a zero output gap, is actually lower than it was before. That phenomenon is why the Monetary Policy Committee has been saying that the equilibrium rate going forward, the long-term rate, is probably going to be lower than the 5%, which is what bank rate has been historically. So I do think we have seen a structural change in the natural rate of interest. I don’t know whether I would use the term baby steps, but the step we end up at is going to be a lower step than where we were used to.
Q15 Mark Garnier: I agree with that, but I am more worried about the moment interest rates start to rise. People talk about a 25 basis point rise at each step or, to put it another way, a 50% increase in funding costs overnight, which is the other way of looking at it. This is not the same as going from 5% to 5.5%; this is the equivalent of going from 10% to 15% in terms of funding costs, which is really what I was thinking about. No matter how much of a baby step you use, the forbearance costs for a bank, even if it is only 75 basis points, is still a 50% increase in their costs. What troubles me is that the reaction by the banks may be sharper because of the significant relative increase rather than necessarily the fact that it is still only 75 basis points, and that is that key point that I am—
Dr Shafik: Are you worried about bank health or are you worried about the consequences for borrowers?
Mark Garnier: I am worried about the consequences for borrowers, for businesses, and in particular for those individuals who are in trouble. If a bank is offering forbearance now, because of course the argument goes that if you are paying 3% on your mortgage and the base rate goes from 0.5% to 75 basis points, then there is going to be very little difference on the monthly costs of your mortgage, particularly when a lot of the cost of your mortgage is repayment, so that is fine. But if you are a household that is troubled at the moment so that you are not paying your mortgage, you are having trouble with your mortgage, or alternatively you are a business that is troubled at the moment, the cost to the bank internally is at the moment 50 basis points, because they are funding that on an overnight basis and they are keeping it funding over. If interest rates go to 75 basis points now there is a 50% increase, so the resolve of the bank might dramatically decrease to try to sit with a business or a household that is in forbearance, and that is the point that troubles me the most.
Dr Shafik: Part of that process, though, is part of the necessary reallocation that we need to see to restore productivity. It is a delicate balance that we are trying to manage. I think from the perspective of financial stability, the stress tests will tell us, both for firms and households, what the risks are and where the vulnerabilities are of an interest rate rise. In terms of the overall economic consequences and the consequences for firms, one has to assume that as the recovery strengthens some of those firms will see new opportunities and increased demand and new investment opportunities that will enable them to move to a higher level and no longer depend on such low interest rates to survive. That is why, going back to your original question, the question about the recovery and productivity is central to whether this recovery will be not just a good one but a great one.
Q16 Mr McFadden: Good afternoon, Dr Shafik. I would like to change the subject a little bit and go back to what the Chairman was asking you about—what you have been working on recently in terms of the eurozone. You have written on the eurozone that the business cycles within it have become more closely co-ordinated, but obviously what the crisis exposed was that the risk judgments of the different members were very different. Your response to that has been to say there needs to be more integration of policy within the eurozone. You have talked about banking union, resolution mechanisms, more directives to remove internal barriers like the services directive and so on. What is your brief judgment on progress on that in terms of integration in the last year or two?
Dr Shafik: I think the last couple of years have been a period in which we have had to complete the architecture of a currency union that was incomplete. Mario Monti, the former Prime Minister of Italy, once said that Europe was never designed for bad times, so they never put in place the infrastructure to deal with financial crises, and that has had to be put in place. There has been quite good progress in the creation of the European stability mechanism, the ESM as it is called, and in the development of the banking union. The single supervisory mechanism—
Q17 Mr McFadden: What are your marks out of 10 for the banking union they have created?
Dr Shafik: I am afraid it is too early to tell, because there are three pillars to the banking union. There is the single supervisory mechanism, which will only be put in place this coming November; there is the common approach to deposit insurance, which has been pushed out further in time and is not yet complete—
Mr McFadden: That is nothing out of two.
Dr Shafik: It is important to remember that the first things that were put in place were the crisis resolution mechanisms, but the banking union has only started a year ago and it is arguably a huge project. The area where I have a bit of disagreement is on the resolution area, where I think the current setup in Europe still relies on national resolution mechanisms. The common resolution fund will be built up very slowly at the European level, based on fees paid by banks, and is currently, frankly, not large enough and is not sufficiently common or pooled to break the sovereign bank linkages that were at the core of the eurozone crisis.
Q18 Mr McFadden: If “more Europe”, which is the slightly sort of clunky phrase we use for all this, is a necessity, given what the eurozone crisis has been through, where does that leave countries like the UK and the other non-eurozone countries?
Dr Shafik: From the perspective of the financial sector, which is probably the most relevant one for me to respond to, from the Bank of England’s point of view having to deal with one major other supervisor, rather than 27 or 28 in Europe, simplifies many aspects of co-ordination and collaboration. The ECB will now be the regulator for the 18 eurozone members and a key counterpart to the Bank of England. But with that simplification, like with many things in the single market, it raises the premium on co-operating and collaborating to make sure that decisions are taken in mutual interest. I think it puts a premium on the relationship that we have with the ECB and making sure that we work very closely with them so that the regulations in Europe are in common interest.
Q19 Mr McFadden: Is it possible for you to say which other member states you think most closely share the UK’s general outlook on these financial market issues?
Dr Shafik: I think Sweden is a good example. Sweden has not chosen to participate in the banking union and they have left it open as to whether they might join later. There are broadly three camps: there are those who are in the banking union; there are those who have clearly stated they will not join, like the UK; and then there is a group, mainly the Nordics, who are in the middle who have reserved their position and said they will stay out for now but have left it open as to their medium-term plans.
Q20 Mr McFadden: Obviously you are not going to want to get drawn on the question of Britain in or out of the EU, and I would not expect you to, but is it your view that even those countries that are out of the EU but part of the trade agreements, like Norway, Switzerland, Iceland and so on, if they want that trading relationship, are going to have to comply with a lot of decisions taken as a result of this “more Europe” answer to the financial crisis? In other words, does being out mean less in terms of freedoms than it might have done before the crisis?
Dr Shafik: I would say a couple of things. First, the global financial markets are increasingly global, so taking your own approach is becoming less possible in many domains of finance. We see that in many aspects, particularly with London’s very special role as a global financial centre. Co-ordinating with other countries when one is dealing with financial institutions that have a global presence has become an essential aspect of this. It is not just with Europe; it is with most major economies. Secondly, I think it depends on the issue. If you take, for example, MiFID, the Markets in Financial Instruments Directive, that is an EU regulation that tries to protect investors and consumers and makes sure to provide transparency and so on for investor protection purposes. That applies to the European economic area. It includes Norway, Liechtenstein, Iceland, so it is quite widely drawn and those countries have opted in because they see advantages in participating in that for the purposes of the protection of their own investors and retail investors in particular.
There are other aspects in which the eurozone itself would need to co-ordinate, for example on common resolution. I think we have to accept that we will live in a world that some call variable geometry and, depending on the issue, we will need to choose, collectively with other countries, what the right geometry is for which countries will want to opt into certain aspects. There will be some where there will be flexibility; there will be others where it will be more difficult and we will need an international standard.
Q21 Mr Ruffley: Dr Shafik, welcome and thanks for coming to see us. Thinking of measures of spare capacity in the UK economy, what is your ballpark estimate of the medium-term equilibrium rate of unemployment?
Dr Shafik: The current thinking of about 6% is in that range, but these things can change depending on demographics, choices about labour force participation and so on.
Q22 Mr Ruffley: Most people, if not all, were surprised at the rapid fall in unemployment that we have experienced recently. What do you think that tells us about the UK labour market compared with other mature industrialised economies? What was going on there so that it fell so rapidly?
Dr Shafik: I think the sharp increase in part-time work in the recent period partly explains. There is a lot of evidence that for people staying in the labour market, even if part-time, they retain an affinity to the labour market and so it is easier to go back in full-time if necessary. I think that is a good thing and avoided the problem that we see in many countries, particularly in continental Europe, where you have long episodes of unemployment with people having a very hard time re-entering the labour market. So I think there was a bit of that going on during the crisis with the rise in part-time work. We also saw an increase in labour force participation, particularly of older workers, which again is a good sign and an example of where demographics change labour market dynamics. There were really a couple of issues at play.
Q23 Mr Ruffley: Drawing on your wide experience of international economies, do you think there is a problem of hysteresis evident in the UK economy now? Is that an issue that worries you?
Dr Shafik: The labour market was pretty flexible during the crisis. I know that many were writing about the concerns about hysteresis risks during the crisis but, frankly, I think most people were pleasantly surprised at how flexible the labour market proved to be. Part of the labour market dynamics contributed to this decline in productivity that we observed, and that was the downside of the fact that many stayed in the labour market even in unproductive or fairly low productivity activities, but the upside was that we did not see those kind of hysteresis effects.
Q24 Mr Ruffley: You have spoken in your replies about changing demographic considerations. There is quite a lot of concern among all parties, I think, about the level of youth unemployment. What consequences do you think you can predict for future labour supply when you look at the high levels of youth unemployment at the moment?
Dr Shafik: I come at this from having seen many other countries. I have to say that the levels of youth unemployment in the UK are not bad relative to what we see in many other countries in the world.
Mr Ruffley: But much higher than we would like.
Dr Shafik: Much higher than we would like it to be, exactly. I would come to it with that perspective, but it is a very important issue. The Bank of England has to set monetary policy and the financial stability concerns with the perspective of that being our priority target of looking at monetary and financial stability. We are not best equipped to deal with the youth unemployment problem.
Q25 Mr Ruffley: No, I understand that, but if we are seeking, as I hope we are all seeking, a sustained recovery built on sound foundations—and I think the Chancellor is committed to that and delivering on that so far—what kind of risk do you think this pool of youth unemployment poses five years out from now? Part of your remit will be to help participate in building a sustainable recovery.
Dr Shafik: I think there is a whole array of policies that are outside the Bank of England’s role in terms of education, vocational training and so on. The key variable in all the research that has been done on employment issues round the world, one of the few laws that works in economics, is what is called Okun’s law, the relationship between growth and employment. The biggest contribution that the Bank of England can make is to the overall recovery. Youth unemployment, just as is overall unemployment, is most affected by the pace of GDP growth and demand in the economy. That is where the ultimate solution lies, frankly.
Q26 Mr Ruffley: The MPC’s central view implies that whole-economy annual total pay growth will be approaching about 2.5% by the end of this year. How much weight will you be giving to private sector wage growth before you begin to think of tightening monetary policy? What would private sector wage growth have to be to get you worried?
Dr Shafik: I would not look at private sector wage growth in isolation. Obviously private sector wage growth is the key part of the labour market, because public sector wages are determined by a variety of other factors, so I would rather not give a number because I would not just look at that number in isolation. I would look at whether it was growing significantly faster than historical trends, and I would look at settlements going forward and what indicators those would give about supply conditions in the labour market, so I would be looking at wage agreements forward looking and what those imply for future wage growth.
Q27 Chair: Can you expand a little bit on that? It is an absolutely crucial question, private sector wage growth. Do you have any further thoughts you want to chip in on that?
Dr Shafik: It is one of a range of key indicators that we would look at. The key thing from a macroeconomic perspective is the relationship between that wage growth and productivity. If that wage growth is being accompanied by recovery in productivity, it is sustainable. If it is not being accompanied by growth in productivity, one would start to worry, so I think that is the key thing I would look for.
Chair: That is a bit more of a view.
Q28 Stewart Hosie: In your questionnaire for us, you raised on a number of occasions the issue of quantitative easing. In question 3 you spoke of managing the eventual exit from unconventional monetary policy. You spoke also about the role you have in explaining the role of the Bank’s balance sheet, which is important in this regard. In question 12, in terms of unwinding QE, you spoke about the operational arrangements for gilt sales to achieve an orderly process. All of what you said about QE implied, as we all understood until some time ago, that the QE would be completely unwound and the Bank balance sheet would return to the pre-crisis position. Is that what you think should happen with quantitative easing, that the gilts should be sold or allowed to mature and then the new money withdrawn?
Dr Shafik: My view as to the unwinding of QE is that the decision to not act on the current stock of assets until bank rate is high enough—at a level high enough that the Bank of England could act to reduce it should it need to in future if stimulus were warranted—is correct. Once you start a programme of asset sales it is very important that it be a very orderly process and well co-ordinated with the Debt Management Office so as not to disrupt gilt markets. I think that would be the first key step.
As to what happens thereafter, I think that is ultimately a decision for the Monetary Policy Committee, guided by the objective of delivering the inflation target. The pace of asset sales will depend on many things and there are many options. If you let the gilts erode naturally you would reduce them by about a quarter by 2018, by about half by 2022, but you would have quite a long tail. I think the longest-held gilt is dated 2068, so you would have quite a long thin tail thereafter. That is one scenario, but there are many other scenarios. In fact, there is quite a nice little model on the Bank of England’s website that allows you to play with different scenarios, and I don’t think any decision has been taken.
Q29 Stewart Hosie: Indeed. Not doing anything quickly in terms of asset sales, for the reasons you gave about stimulus; using the base rate initially if some overheating is required to be corrected; and the pace of the sales—as you have described it, the long tail—all of this is fine for what technically can and can’t be done, but of course the Governor said to us two weeks ago, or certainly gave a very clear impression, that they may not now unwind all QE and keep the Bank’s balance sheet higher than it previously was for the purpose of dealing with the Bank’s liquidity requirements. It is the same scenario in the United States. All of the information you have given us and what you have said today still gives the impression that you would envisage the balance sheet being returned to pre-crisis levels and these gilts not being held for the purpose of increasing the balance sheet. Where are you on that particular issue?
Dr Shafik: I understand your question. I think there are two separate issues. One issue is exit from unconventional monetary policies and the other issue is the equilibrium size of the Bank’s balance sheet, and they are somewhat separate questions. They are obviously related, but one has to look at them as separate questions. The first one is about what do we do to deliver the inflation target, given what we have done on unconventional monetary policy. The second one is what do we think the Bank of England’s balance sheet should look like to meet its policy objectives of monetary and financial stability going forward. That question is a very open question still, and it is a very important focus of this new role that I hope to be taking on.
Q30 Stewart Hosie: Can I just interject there? You could envisage a situation where we unwind QE but repack the balance sheet in another way at the same time in order to meet the new equilibrium balance sheet requirements?
Dr Shafik: The balance sheet has many pieces to it, and the central bank’s financial strength is determined by many variables. The BIS did a very interesting paper last year that looked at central bank finances and noted that practices vary enormously across central banks. To give you a small example, the Federal Reserve keeps its seigniorage that it generates but the US quantitative easing programme is not indemnified by the US Government. The Bank of England does not keep its seigniorage but the asset purchase facility is indemnified by the Treasury. That is just one example of different practices.
Q31 Chair: You would rather have the indemnity, wouldn’t you?
Dr Shafik: I think it is rather nice, yes.
Chair: There is no contest there.
Dr Shafik: Exactly. No, I would certainly say that. But there are also different accounting practices; there are different agreements about profit and risk sharing between the central bank and the treasury across countries. One has to look at the balance sheet in the whole and look at all those factors and ask oneself: what does the equilibrium look like, including what is the level of capital that the central bank needs to deliver its policy targets?
Q32 Stewart Hosie: Let’s put you on the spot. Prior to the crash the balance sheet was ridiculously small, £25 billion or so. Notwithstanding QE, looking forward what should the central bank’s balance sheet be in numbers? Should it be £50 billion, £100 billion, £200 billion? Where do you think it should be, given that this is a direct responsibility?
Dr Shafik: At this point all I would feel comfortable saying is that it will be bigger than the £50 billion it was pre-crisis and it will be probably smaller than the £400 billion we are at now. It will be bigger than it was because we expect banks to have much higher demand for liquidity going forward, given new liquidity requirements as a result of recent regulations, and so the new equilibrium will look different. Going forward, we probably will provide liquidity insurance to dealer-brokers, to central counterparties. We will be delivering a different set of services, and so that will require a different balance sheet, but I think we need to do a very serious piece of work on that agenda for the years ahead, including the question of the Bank’s capital.
Stewart Hosie: The answer we got there was really good, but from a base level of around £300 billion in between, we have got an error on either side of about quarter of a trillion. This is a huge range of potential balance sheets.
Q33 Chair: Do you want to narrow it down a bit more? You are not suggesting it is going to £375 billion or £350 billion, are you?
Dr Shafik: No, but—
Chair: Now what about £325 billion or £300 billion?
Dr Shafik: I think rather than run a Dutch auction, it would be better to do the analysis of what are the future needs and also look at those questions again about how the indemnities are handled, what is the appropriate size of capital, what are the appropriate accounting treatments and how profits are shared between the Treasury and the Bank of England. There is a whole set of questions and you can strengthen the balance sheet in many different ways. So I think you have to look at the whole.
Q34 Stewart Hosie: Given that all or some of this QE may be unwound, you have said to us that, “It is important that the Bank should liaise closely with the Debt Management Office to minimise the degree of disruption to gilt market conditions”. What are the potential risks in selling gilts and do you think for a period of time the central bank and the DMO should liaise more closely or one should take the lead so we don’t have two different bodies potentially selling near identical gilts into the market simultaneously?
Dr Shafik: On that question I believe there is already an operational plan that has been agreed jointly between the DMO and the Bank of England. I think it is refreshed regularly, and that is absolutely essential. I do think you need to keep separate responsibilities, because the two are selling gilts for different reasons—one fiscal policy, one monetary policy—and it would be a bad idea to muddy those waters.
Stewart Hosie: That is helpful. Thank you.
Q35 Mr Ruffley: Thinking of financial stability in general terms, what do you think is the biggest threat to financial stability contained in the UK housing market?
Dr Shafik: I think the biggest threat is the rise in household debt levels. Loan to value rates have gone up a bit but the real increase has been in loan to income ratios, and those numbers are worryingly high. If you look at current mortgages, about 20% of current mortgages have loan to income ratios in excess of four and about 10% have ratios in excess of five. Those households that have those high loan to income ratios are precisely the same households who tend to have a lot of unsecured debt, so they have multiple vulnerabilities to higher interest rates. As we saw during the crisis, households with high debt levels are very vulnerable. If shock hits they cut demand and consumption back dramatically, and that can turn an ordinary recession into a great recession. So the vulnerability around household debt is a very serious one. I think that the FPC’s decision, the so-called insurance policy on setting a ceiling on high loan to income ratio lending and on stress-testing those household mortgages to 3% interest rates, is a very welcome step. It is not binding yet. At the moment banks lending at those levels is about 11%, so nowhere near that 15% threshold, but I think it is a very good marker because it tries to pre-empt a worrying bubble emerging.
Q36 Mr Ruffley: That is very interesting. In terms of the LTI and LTV caps, the FPC noted that the use of these tools will require a high level of public acceptability. What do you say to people who think we are nowhere near that point of public acceptability? What do you make of it?
Dr Shafik: I think the public response to the FPC’s announcements were not particularly adverse. I acknowledge that macroprudential policies are new and the political economy of them is very difficult. As I said in my questionnaire, it is hard to get people excited about the crisis we avoided. There are many strong interests who would oppose those policies—first-time buyers, financial institutions who want to do more risky lending—so the FPC have a big explaining job to do because financial stability is not as simple a concept as an inflation target. What I would say is that so far public acceptance of these changes has been pretty good. I think it was very wise to do it pre-emptively before it is binding, so we can try to catch the problem before it becomes too serious.
Q37 Mr Ruffley: Thinking of tools other than LTV or LTI caps, whether binding or non-binding—and we hope those work—what are the other warning signals that you will be looking for apart from those numbers you gave, those rules of thumb, the breakdown you gave for multiples of income? What other warning signals are you looking for in the housing market that would not be welcome from your point of view?
Dr Shafik: In the housing market specifically?
Mr Ruffley: Yes.
Dr Shafik: Loan to income is an obvious one. Loan to value ratios are obviously worth watching as well because of what it means for affordability. I would also look at things that are captured by the countercyclical capital buffer and sectoral capital buffer in terms of bank exposures to the housing sector in assessing the vulnerability of particular institutions to the housing market.
Q38 Mr Ruffley: So a sort of fine-grained look at each significantly important financial institution and looking at its countercyclical buffers. Anything else?
Dr Shafik: In terms of particular things to look at in the housing market? I think it has been said many times that it is not the Bank of England’s role to manage asset prices or manage housing prices. We need to be cognisant of that, we need to be watching those numbers, but I think what is important for the Bank of England to focus on is the issues around how those affect financial stability. I would very much look at the housing market numbers from that angle, so looking at house price growth and so on from the perspective of financial stability.
Q39 Mr Ruffley: Am I right in saying that you think the two primary indicators that will give you a sign as to whether or not there is trouble brewing would be the LTI ratio and the LTV ratio? Those are the two things that should be watched out for?
Dr Shafik: Obviously one would look at non-performing loans as well more generally but also particularly in housing and if we are seeing any issues around foreclosures and that kind of thing. The other forward indicator that is quite important, which I think is already being looked at, is underwriting standards. That is also a forward-looking indicator of likely future problems, but I believe that is also being closely monitored by the PRA.
Q40 Jesse Norman: Welcome, Dr Shafik, and welcome as the second woman Deputy Governor of the Bank of England since 1694. Obviously our job is to ask not only questions about your views but also questions about your background and qualifications. If I may, I would like to touch on both those sides. One question I have always wanted to ask, and hopefully you don’t mind if I ask you—obviously it will be very different for individuals—is, when you write your questionnaire do you write it yourself? Is it your unvarnished work? Do you show it to the Bank? Do they look at it at all? Do officials comment on it? Do you have Jon Cunliffe marking your homework or Mark Carney or someone saying, “I’m not sure you want to say this, Minouche”? How does that work?
Dr Shafik: I write it myself. I do get material from the Bank of England. That is obviously sensible and the staff of the Bank of England have been enormously helpful in providing background information, reports, data and that kind of thing as needed, but I take full responsibility for writing it myself.
Q41 Jesse Norman: Do they comment on things or provide substantive ideas that might—
Dr Shafik: They do, but what is written down is my responsibility.
Q42 Chair: Did they send you substantive suggested points in response to individual questions?
Dr Shafik: They send material from—
Chair: I am asking what the material is. You said that already. I just want to know what the material is.
Dr Shafik: Things like the inflation report, papers that have been prepared on, say, the asset purchase facility and so on, so memos and that kind of written material, but I spent a lot of time drafting it myself and the views are mine.
Q43 Jesse Norman: You can imagine, “You might want to mention the Governor’s stunning intervention on the topic of X”. Do you get that kind of comment, tying it into promoting the Bank’s other objectives, or is it all your own thinking all the way through?
Dr Shafik: It is certainly my thinking, and of course I got lots of comments, but I take full responsibility for everything that is written there.
Q44 Jesse Norman: Thanks.
You have obviously had an enormously impressive career in international financial institutions—World Bank, IMF—and as an academic. Now you are at the Bank—and you haven’t even joined yet. Are you spending much time at the Bank now?
Dr Shafik: I have spent three days.
Jesse Norman: It is absurd to ask you the question but—
Dr Shafik: I haven’t started officially.
Jesse Norman: No, but you are going to have a much wider range of responsibilities than it seems to me you have had historically. I don’t know if that is right, and I am interested. You had a lot of experience in operations at the IMF but you have not had much experience with a national central bank balance sheet. Is that right? You are coming into it new at the Bank. You obviously have a team and staff, but it is not something you have ever run or had to think much about particularly.
Dr Shafik: I have managed many other balance sheets but not a central bank one.
Q45 Jesse Norman: What about risk management? Would the same be true—that you may have thought about risk management from an IMF or World Bank perspective, or possibly from a country perspective when you are dealing with them on the other side of the argument, but not necessarily from a central bank or a market perspective?
Dr Shafik: In every organisation I have ever worked in we have had a risk management framework, and I have been responsible for the overall risk management framework or as a risk owner of various risks in all the financial institutions I have worked in.
Q46 Jesse Norman: Would that include risk modelling? You would be responsible for thinking and interrogating the various ways in which that institution thinks about risk.
Dr Shafik: Absolutely.
Q47 Jesse Norman: That is helpful. And different kinds of risk, credit risk, market risk, countercyclical risk, things like that?
Dr Shafik: I was on the finance committee of the World Bank: AAA lender, worries about net income, credit risk, country risk, quality of loan portfolios and so on.
Q48 Jesse Norman: There are some international institutions that play a role in the financial markets. The World Bank is an enormous borrower in the international markets. But you have not really been directly involved in the financial markets specifically yourself, have you?
Dr Shafik: I have been managing a $10 billion pension scheme at the IMF, which has a pretty good track record of meeting all market benchmarks over the last few years.
Q49 Jesse Norman: In trying to understand how close you have come to the market coalface, the answer is managerial rather than trading floor?
Dr Shafik: I have never been a trader, if that is what you asking me.
Q50 Jesse Norman: Or sat behind the traders thinking about particular risk positions, or those kinds of things. I am just trying to get a sense of where that is. That is really helpful.
Can I now ask about the Fair and Effective Markets Review that you are doing? It is obviously a very important piece of work. It has an interim deliverable, which is a recommendation on further benchmarks that you are going to be bringing into the regulatory perimeter. When do you expect that to be published?
Dr Shafik: We expect it to be published next summer.
Q51 Jesse Norman: Next summer? No, the final thing will be published then. When will the interim be published? Obviously you will have to make a decision relatively quickly as to what falls in or why it should.
Dr Shafik: Correct. The proposal is to produce that this coming autumn.
Q52 Jesse Norman: In the autumn? Autumn is somewhere between August and December.
Dr Shafik: I would narrow that down to between October and November.
Q53 Jesse Norman: Perfect. Without front-running the investigation, what are the kinds of criteria you think ought to be used in assessing whether or not a benchmark is going to be brought into the regulatory perimeter?
Dr Shafik: First, I should say it is obviously a very important exercise given the recent events in those markets. I think we all know how important it is that people have confidence in these wholesale markets. We are currently doing the work on precisely that question, and I think the team has just started to pull together ideas, so I don’t want to pre-empt that discussion, because there will also be a consultation process around that.
Q54 Jesse Norman: You will do a public consultation in the autumn before you make that final decision?
Dr Shafik: Correct. Obviously size and importance and which ones are most widely used and have the biggest impact will be key variables.
Q55 Jesse Norman: Have you formed a view on the adequacy of the regulator’s existing powers in the key areas of benchmark, potential manipulation or actual manipulation?
Dr Shafik: As I am sure you know, there is currently something called the NIPs Code, which is a voluntary code of conduct for the operation of some of these markets, particularly the foreign exchange market. That code has no statutory underpinning. Other jurisdictions have similar voluntary codes—New York, Hong Kong, Singapore, Tokyo—and I think one of the main questions we have to ask is whether this voluntary approach to conduct around benchmark setting has been adequate. I am not privy to the details of the ongoing investigations by the FCA, but I think there is sufficient reason to think that there are serious problems and that the current practices are not adequate.
Q56 Jesse Norman: So we might have to get statutory and international or something similar?
Dr Shafik: Correct. As you imply, international will be key and already a number of other jurisdictions have contacted us and are very interested in this work, because I think they see that it will require an international consensus.
Q57 Jesse Norman: How are you going to tie that work into what is happening with the FCA? Presumably you want to be very close to them, but they are dealing with a quite specific set of questions that might inform you but also might, in a funny way, be blindsided by you or vice versa.
Dr Shafik: As I think you know, this is a tripartite effort that I will be chairing with two co-chairs: Martin Wheatley, the head of the FCA, and Charles Roxburgh from the Treasury. I think we have a clear division of labour with the FCA. The FCA’s work is looking backward and holding people to account for past practices and that is purely their business. The purpose of the Fair and Effective Markets Review is to look forward to say: what changes do we need to make in the way these markets operate to reduce the risk of having conduct problems going forward? The FCA is vital in helping us do that.
Q58 Jesse Norman: Sure, but presumably there will be restrictions on what you can see of the FCA’s work, will there, or will you get full transparency of the work they are doing?
Dr Shafik: There will be a process of getting legal advice about that.
Q59 Chair: Have you asked that question?
Dr Shafik: Yes, that has been asked.
Q60 Chair: What was the answer?
Dr Shafik: I think it is best if we don’t get involved in the FCA’s own investigative backward looking work, or see that as separate. There will be a market participants panel, which will be chaired by Elizabeth Corley. She is in the process of assembling what I think we all want to see as a very representative group of market participants, buy side, sell side, financial market infrastructure and legal expertise. They will have legal advice working with the market participants panel that will then govern the issues that they will speak about in that forum. The market participants panel will produce a report for the review based on the deliberations that they have among themselves.
Q61 Jesse Norman: The consultation presumably is going to have to be six to 12 weeks in the autumn; your interim publication of something will be in, say, November; there will be your market participants panel, lots of legal inquiries; it is going to be a miracle to get this done by next summer, the summer of 2015, isn’t it?
Dr Shafik: It is going to be very hard work. I hope a miracle is not required, but it will be very hard work.
Q62 Jesse Norman: I don’t envy you the responsibility. But you are going to need to look at the FCA quite closely, because one of the judgments you are going to need to form is under what circumstances market abuse is most likely to occur. Seeing how market abuse has occurred in quite a precise way, looking at issues of market power and transparency, when it comes to actual specific matters of how these things get fixed, you are going to have to have a precise understanding of that, ideally practitioner-based. You are not going to want to have to replicate what the FCA is doing in order to understand that stuff. Am I right? You are going to have to have quite a close understanding of what the FCA has actually discovered.
Dr Shafik: Yes, but what we need is very important input on the nature of the problems that exist now. What we don’t need to know is the names, ranks and serial numbers of those who were involved. Their input will be critical for the diagnosis of the problem.
Jesse Norman: Do you want to develop that, Chair, for a second?
Q63 Chair: Yes. Have you given consideration to the fact that weaknesses in conduct risk in the FCA may mean that the information you are being provided with will make the management and identification of systemic risk more difficult?
Dr Shafik: Could you explain that further?
Chair: Your job is to make sure the markets work and don’t go down and cause system-wide problems, but some of the information on the basis of which you are going to be taking decisions on how that could be accomplished and how the markets can best be protected will inevitably be collected by your sister regulator, so you are dependent on their information flow. If they are not doing their job properly or they are not collecting the right type of information, you have a problem, have you not? Even though it may seem easy to say, “They are doing the retrospective stuff, we are doing the forward looking”, it does not take you very far really, because the information that they are collecting you are going to need to do your job.
Dr Shafik: They obviously will provide a vital input, but they will not be the only input of information. There will be a market participants panel; we will be reaching out to other players who—
Jesse Norman: Other regulators?
Dr Shafik: Other regulators. We have already had initial contacts with other regulators, so there will be multiple sources of information to diagnose what the problems are.
Q64 Jesse Norman: To be fair, you don’t think at the moment that your understanding, or the team’s understanding in embryo, or the Bank’s understanding is anything like what it is going to need to be to make decisions about that?
Dr Shafik: I have spent three days in the Bank of England and I haven’t started my job yet officially. I think it is very early days.
Q65 Jesse Norman: Okay. Do you have an instinct about where in the wholesale markets the greatest difficulty is likely to be found: fixed income, currencies, commodities?
Dr Shafik: There is a very capable team that is being assembled literally now, and will be complete hopefully around next week or thereabouts, made up of staff from the Bank of England, the FCA and the Treasury who will be pulling this together. In terms of your question, I think there are problems in all three—in fixed income, currency and commodities,—and we will look at all three.
Q66 Jesse Norman: Sans peur et sans reproche—you are going to be pretty tough about it.
Dr Shafik: Collusion is unacceptable.
Q67 Jesse Norman: The final question is in two parts. Do you think the UK’s financial markets warrant a separate set of rules from the EU’s approach, and why would that be the case?
Dr Shafik: I think there are some aspects where a separate flexibility is required. I would not say a separate set of rules is what is needed. There are huge benefits to the single market and the UK benefits enormously from the single financial market. London is Europe’s financial capital and it is a huge comparative advantage to the UK economy to have those financial services provided in the UK. However, I think it is important that in the development of the single rulebook there is sufficient flexibility when required, and there are some good examples of where that has happened. For example, in the way that commercial property was treated under CRD IV, the UK got a slightly different treatment because of concerns about certain risks in that market in the UK. Similarly, under the EBA stress tests, the UK is doing its stress tests. The EBA process will cover four UK banks; the PRA process will cover eight banks. There are some slight differences in some of the variables that we will be using. I think that is appropriate. Benefiting from being in a single financial services market but also having some areas where there is some flexibility for national idiosyncrasies is probably the best combination.
Q68 Jesse Norman: Will the banks for the European stress-testing and the stress-testing of UK banks fall under your purview as well?
Dr Shafik: That will be done by the PRA. I will be sitting on the PRA board but the operational responsibility for that is with the PRA.
Q69 Jesse Norman: As Deputy Governor for Markets and Banking, will that include thinking hard about the current oligopoly in the commercial banking sector in this country?
Dr Shafik: The PRA now does have a secondary objective of promoting competition in the banking sector, which is a very welcome change, so it is really through the PRA that one will be able to address that issue.
Q70 Chair: We were not told it was very welcome when we first proposed it. On the contrary, we were told it was very unwelcome, so I am very glad that—
Jesse Norman: That you think it is as well is very good news.
Dr Shafik: I think competition is good. As you know, there have been some changes on entry requirements and some increases in the number of new banks. There are some quite good proposals that have been made on SME lending and on securitisation that could hopefully increase competition and access to credit for SMEs. There is some work that has been put in train and we have to see if it is sufficient.
Q71 Chair: Where regulators have gone and asked for voluntary changes to the way markets are operating under the code, are there any cases where they have not complied?
Dr Shafik: Do you mean with the NIPs Code?
Chair: Yes.
Dr Shafik: The NIPs Code is not regulated. It is a voluntary code of conduct.
Q72 Chair: My question is, have there been any cases where that voluntary code has not been voluntarily adjusted to take account of a recommendation to it?
Dr Shafik: The Bank of England oversees the development of this code. I have not started my job yet, but my understanding is that there have been cases where people have been made aware that firms are not complying with the code, and those concerns have been passed on to the FCA, but that is all that I am aware of.
Q73 Chair: Have you taken a look at the risks posed by high-frequency trading?
Dr Shafik: Not yet, because I haven’t started in this role, but I am aware of some of those risks.
Q74 Chair: Have you any experience of looking at the issues?
Dr Shafik: I have some knowledge of the issues. It is obviously a key issue from an investor protection point of view.
Q75 Chair: Have you come to a view on what caused the flash crash?
Dr Shafik: I don’t have a detailed view of what caused the flash crash. I am aware of the current regulatory changes that are occurring in the US in particular because of concerns about high-frequency trading. In the European context some of these issues are being addressed in the context of MiFID and that has laid out a comprehensive set of reforms to try to address particularly issues around transparency, pricing and best execution. The detailed regulations to implement those new MiFID rules are being developed I believe at the moment and so I would want to take a look at that once I have started.
Q76 Chair: But you haven’t yet?
Dr Shafik: I haven’t started yet, yes.
Q77 Chair: There is quite a bit of evidence around on the basis of which a number of people have come to a firm view. Is high-frequency trading in your view part of the problem of the flash crash or not?
Dr Shafik: I don’t have enough data to know about that.
Q78 Chair: Could I ask you one last question? Or it might be a set of questions. What evidence can you give us of independence of mind, particularly where you need to show it in an environment that it may not be easy to express?
Dr Shafik: I have spent the last three years at the IMF telling Governments all round the world things they didn’t want to hear.
Q79 Chair: Isn’t the tougher job telling the IMF what they don’t want to hear?
Dr Shafik: The IMF is showing its independence, which is something we should welcome, I think. I was responsible for a whole series of difficult messages that had to be delivered around the eurozone crisis, be it the need to recapitalise European banks or the need to deal with Greece’s debt overhang.
Q80 Chair: That is not independence of mind. That is IMF positions, worked out, that you are coming to tell them have to be implemented.
Dr Shafik: There was quite a lot of internal debate, which is not really appropriate to go into in detail, in which I had to participate to come to those views. Like any good organisation, there is quite a lot of independent thought that goes on in an organisation like the IMF. The other example I would give is that—again, one can’t go into specific examples—part of the job of a good permanent secretary is to tell Ministers things they don’t want to hear, and I think I have a bit of a track record on that too.
Q81 Chair: If you got them in, would they confirm that you gave it to them with both barrels?
Dr Shafik: Yes. I think my last Minister had a quote recently in the Telegraph where he said I stared at him with my beady eye and totally disagreed with him, but he still liked me.
Q82 Chair: That is very helpful. David is asking which Minister, so you may as well tell us.
Mr Ruffley: Was it the Secretary of State for DFID?
Dr Shafik: Yes. I think he gave an interview where he basically—
Chair: Thank you very much for giving evidence this afternoon. We will now go into private session.
Oral evidence: The Appointment of Dr Nemat Shafik as Deputy Governor of the Bank of England, HC 492 11