Treasury Committee
Oral evidence: Bank of England June 2014 Financial Stability Report, HC 494.
Tuesday 15 July
Ordered by the House of Commons to be published on 15 July 2014.
Members present: Mr Andrew Tyrie (Chair); Steve Baker, Mark Garnier, John Mann, Mr Pat McFadden, Mr George Mudie, Jesse Norman, Teresa Pearce, John Thurso
Questions 1 - 121
Witnesses: Dr Mark Carney, Governor of the Bank of England, Andrew Bailey, Deputy Governor, Prudential Regulation & Chief Executive of the Prudential Regulation Authority, Donald Kohn, External Member of the Financial Policy Committee, and Martin Taylor, External Member of the Financial Policy Committee, gave evidence.
Q1 Chair: Good morning. Thank you very much for coming to give evidence to us this morning on this very important subject, new powers for the Bank, new systems of scrutiny for it. Could I begin by asking you, Governor, what effects do you think what you are proposing here on leverage will have on the banking sector?
Dr Carney: What we are proposing on leverage? As you know, Chairman, we are consulting on the structure of the leverage ratio. We put out this consultation paper that there is a variety of issues around. As part of that consultation, we have indicated that the FPC is currently minded to ask Parliament for powers of direction over the leverage ratio. That is obviously a decision for Parliament. The reason we are so minded is that we view the leverage ratio as an integral part of the overall capital framework. Properly designed it works in a complementary fashion with a risk weighted approach and with the stress testing approach that we are developing. The leverage ratio—to put it in its simplest terms—protects the institutions, but the system more importantly, from risks that people think are low but in fact are not. So properly designed, properly calibrated it works in a complementary fashion to a risk based approach, which focuses largely on historic loss experience, an approach based on stress test that looks at potential future tail events.
Q2 Chair: That is a very helpful introduction to the need for a leverage ratio in addition to RWAs and, of course, has been subject to quite a bit of scrutiny in Parliament over the last few years. The question, though, I was asking is: what effects do you think your proposals are going to have on the banking sector?
Dr Carney: Well, we think that properly designed the proposals will make the banking sector more resilient.
Q3 Chair: Do you think that this is going to result in any scaling down in banking? Have you done any work internally to see what the effects will be on bank balance sheets of the kind of structure you are proposing?
Dr Carney: In part, it obviously depends on the ultimate calibration. We do not want to do calibration before we get design. What we outline in the paper—and we have done work within the institution discussed at the FPC, discussed at the PRA Board and discussed more broadly within the Bank—is that the leverage ratio can have effects, particularly on building societies and investment banks. Those effects are schematically detailed in the consultation paper.
Q4 Chair: “Detailed” is a strong word for what is in there on it, to be frank. It is pretty thin on what the effects are going to be on the banking sector, and I think many people will find it surprising that you are not explicitly, and in some detail, consulting on the effects of various proposals on banking, but you are not.
Dr Carney: It is a consultation. We welcome views from all interested parties. We have received a range of views. We expect to receive more.
Q5 Chair: You are not going to say, okay. A crucial question will be: what counts as an asset, the measurement of total assets? A key question then is: how are you going to treat derivatives?
Dr Carney: Yes.
Chair: Do you have any preliminary views on that?
Dr Carney: As we discussed I believe in the last hearing in January, we have worked with our international partners to get an agreement on a disclosure definition at the Basel committee, and we think that as much as possible that we should look to implement in the United Kingdom that agreement, as interpreted by the European Union—
Q6 Chair: That is clearly desirable but is it essential?
Dr Carney: The judgment that would need to be made if there were material derogation from that agreement, through the European process, for example, would be whether they were best addressed through calibration. Now, may I go specifically to your question on derivatives?
Chair: Okay.
Dr Carney: Because one of the things that came out of the agreement in January, which we supported, was four derivative positions: the ability to net off, cash initial, initial and variation margin. So cash netted off from the derivative. That is entirely sensible. This is cash. That has been posted against those exposures. What we also thought was important—again, to go to the question of assets—was on-boarding of contingent exposures, including those for trade finance in a sensible way, and for liquidity lots.
Q7 Chair: If I can now come on this paper to the key interesting feature of it, it seems to me, on the basis of 24 hours’ acquaintance. It was only circulated 48 hours ago; at least we only saw it 48 hours ago. I quite understand that if you have completed it you want to get it out as soon as possible but if you can in future try to get these papers out with a little more of an interval between the publication and the hearing like this, it will be extremely valuable for scrutiny purposes. But from what I can tell a key aspect of your proposal is that you are intending to time vary the leverage ratio and, therefore, the leverage ratio will be fine tuned to keep it in line with the capital framework. Is that correct?
Dr Carney: We are consulting on that but there is a strong logic to varying the leverage ratio for adjustments to the capital framework, whether, as you say, it is time varying the countercyclical capital buffer—there is logic to varying the leverage ratio with that—whether for ringfence banks, the additional risk weighted capital requirement for ringfence banks and for systemic institutions. In all those cases, in order for the leverage ratio to properly perform its roles in a complementary fashion—in order for it not to be irrelevant, relative to the risk based approach—there is a logic to adjusting it, scaling up in effect for those. These are questions of consultation and we welcome views.
Q8 Chair: It does seem that you might be adding quite a lot of complexity into the leverage ratio calculations, which the idea of accrued leverage ratio was designed to avoid given that RWAs were such a catastrophic failure last time round in Basel for spotting and dealing with bank resilience in the crisis. The question that I am sure will be asked about this is whether it is sensible to time value a ratio that inevitably will reinforce any judgment you are making in the RWA sphere on the cycle, which is extremely difficult to spot. Do you have any comment to make on that concern?
Dr Carney: That is the meta question, if I may, which is the economics of second best. In other words, keeping a simple, fixed leverage ratio in the extreme for all institutions—the exact same leverage ratio for all institutions, is that a superior approach to making adjustments for the type of institution and the type of macroeconomic circumstances in which we may find ourselves? In an extreme for the time varying, if I can use one example, in a circumstance where the FPC might wish to reduce a countercyclical capital buffer, but the effectiveness of that were limited by the fact that the leverage ratio was not similarly adjusted down, that would be less than ideal from a macro financial perspective. But without question there is a trade-off between complexity and simplicity. That is why we put these issues square to the—
Q9 Chair: The Banking Commission looked at that in some detail and Parliament has subsequently. The main argument for giving you these powers, as set out in debates both in the Commons and the Lords, has been that this thing needs to be kept simple. Keep the leverage ratio simple. It is a crude measure. Yes, it has some distorted effects encouraging banks to hold risky assets. It does have other problems as well, but it is a backstop to RWAs—are you agreeing or not?—and it is not something that should be moved in some kind of heavenly symphonic exactitude with RWAs.
Dr Carney: We would disagree with the characterisation of the leverage ratio as a backstop.
Chair: It does look quite technical to me.
Dr Carney: We do not view it as a backstop. We view it as an integral part of the capital framework, first point.
Chair: Okay.
Dr Carney: Second point. As you are aware, Chairman, both the PCBS and Parliament more broadly—for example, for ringfence banks—following on the recommendations of the Independent Commission on Banking, were minded to recommend an adjustment to the leverage ratio for ringfence banks, so that is one example of complexity that has a logic to it on which we are also consulting. So the question is: how far do you make those adjustments? I accept your caution with respect to the countercyclical capital buffer, it is something we are actively—
Q10 Chair: Has the FPC had an extensive internal discussion about the issues that I am now raising with you?
Dr Carney: I would say it is an understatement but I would ask my colleagues to—
Q11 Chair: The FPC is a consensus institution. It might be helpful if we get some sense, if the veil is now lifted, on any nuances there are of views between the four colleagues we have on this subject, since we are at an early consultative stage. Before I bring in the independents, the outsiders, to give them a bit more time to think, why don’t I bring in Andrew Bailey who has the job of trying to get these numbers or the substance of—
Andrew Bailey: The FPC has spent an extensive time on this. First of all, I would say this is a genuine consultation. This is not something that we have made our minds up on and it is ready to go. It is a question of tying it up in a consultation. So I think that is an important point.
The second thing I would say—and just to use your characterisation of this, you said the risk weighted system had failed—is that there are almost two variants here at work. The simple system that you were setting out is one where you say, “The leverage ratio is a floor and you let the risk weight system do the work above that” and the cyclical element is done through the risk weight system but you have the leverage ratio level there as a floor. If you adopt that system that is an option. I would put back to you your own comment that the risk weighted system failed. So the question then is: how much faith and weight do you want to put on the risk weighted system in that place? I would say, as I did say in a speech last week, however, that as a supervisor we spend our time looking at risks, so we regard the leverage ratio, as the Governor said, as a complement but it is only a complement in that system. So that is one approach.
The second approach, which is set out in the paper, is that you say, “No, I am inherently nervous about the risk weight system, for the reasons we gave, therefore, I want the leverage ratio to more closely mimic in its behaviour what the whole capital system is meant to describe. That is a genuine choice. I think that should be regarded as—
Q12 Chair: The paper appears to be making that choice coming to review. I have the paper here—
Andrew Bailey: You asked me—well, hang on.
Chair: —at page 29 on the time varying leverage ratio. It does seem pretty clear on the point.
Andrew Bailey: You asked each of us to give our views as a member of this committee. I am happy to do that. I have not made my mind up on this point.
Q13 Chair: Okay. That is a very helpful comment. I think Donald Kohn is catching my eye. Donald, what do you think about this subject, looking at it slightly with an American perspective perhaps?
Donald Kohn: I very much supported the consultation paper as it went out. I think the word “simplicity” can be seen in a couple of dimensions. One dimension is the calculation of the ratio and the lack of reliance on formulas and past behaviour. But I also think that I would be concerned if we—the FPC—saw a reason to raise capital requirements in the system, and the leverage ratio did not also arise pari passu with the risk weighted because I think then there would be induced some complex risk developments within the financial system. So if I think of the leverage ratio as protecting against model risk, as protecting against tail risks that do not get built in to the model sufficiently, and I think the system needs more capital, I am not sure it is not more complex to raise both of these, to leave one down and the other up and thereby induce some risk shifting within the banking system. I think there is more capital needed. I think the backstop ought to go up or the complementary thing ought to go up with the risk weighted thing, or you can actually induce complex behaviour that you would want to avoid.
Q14 Chair: You are not concerned that we might build into the system vulnerability to the very herding behaviour of regulators that we saw in the run up to the last crisis?
Donald Kohn: I think herding behaviour is always a risk in the financial system.
Chair: I am talking about by regulators, the very people we are hoping are there to counter-weigh it. The regulators all rushed off a cliff saying that the banking sector was fine, didn’t they? Then Basel turned out to be a paper tiger, to mix a metaphor.
Donald Kohn: Right. So I do not see raising those two requirements together as herding behaviour. I see it as risk management behaviour.
Q15 Chair: I will have one more go. What I am asking is, given that you are having to make judgments about where you are in the cycle to set RWAs anyway, whether you think that extremely difficult judgment should also be introduced into what has been thought of as a crude but necessary tool, leverage?
Donald Kohn: So my going in position is, yes, I think that judgment ought to be consistent.
Q16 Chair: I would like to bring in Mr Taylor and then by all means come back, Governor.
Martin Taylor: This element of the design was not controversial at the FPC meetings, is the first thing to say. I think we genuinely believe that the backstop/frontstop vocabulary is unhelpful here and are trying to put forward a proposal where the two ratios would act in a complementary manner. The leverage ratio is simpler because total assets are simpler than risk weighted assets, but it is perhaps not as simple as we would like to pretend and I think we are facing that now.
I do not think it is quite right to say that the leverage ratio pushes banks to hold riskier assets. I think if you have a system where you only have a leverage ratio and do not have a risk weighted schedule that is certainly the case, but again the complementarity is crucial. If you look at the steps that this is going through, the first is to agree the denominator of the ratio that, as the Governor said, we are hoping the international agreement will fix for us. Secondly design, which our paper is very much about; thirdly, another element of design, which is on the quality of the capital that will count towards the leverage ratio. That is an important point. Then finally, all that settled I hope, we then come on to the calibration, the quantity of capital that has to be held. That is the last stage in what I think is a very thorough process.
Q17 Chair: These exchanges are taking some time but they have huge impact in the end on the real economy. They are absolutely colossal in importance—as we saw when these judgments were so fatally flawed seven or eight years ago—and that is why we are lingering on it, and they affect millions of people. Governor, you want a last rejoinder before I pass questioning to Mark Garnier?
Dr Carney: Essentially, you were asking for individual views. I will give you where I am minded at this stage, subject to the consultation. I am very interested in what we get. The scaling up for ringfence banks—as I think I have indicated since my first appearance here—seems sensible to me. The scaling up for systemically important banks also seems sensible.
On this question of varying over time, the countercyclical buffer, let me put it this way, which is that if the judgment of the FPC were to activate the countercyclical buffer, raise capital standards because of generalised risks in the economy, if the leverage ratio were not similarly adjusted—and we may decide for reasons of complexity not to do it—within the budget, in effect, that an individual institution has with the leverage ratio, as Don Kohn just indicated, they would have an incentive to fill that budget with riskier assets at a time where the judgment of the FPC is that there is higher risk. So that is the reason for the question. Now I would say, like Mr Bailey, my mind is not settled on that because it is a trade-off of complexity and simplicity. But there is a real economic issue at the heart of this and that is why we are having the consultation and then we will look to—
Chair: This is going to be one of the very biggest judgments that the FPC has to make—
Dr Carney: I agree, yes.
Chair: —full stop, over many years. Not just now but for many years to come.
Q18 Mark Garnier: Governor, my questions are slightly more philosophical I think, but I refer back to an article in the first Quarterly Bulletin about money creation and banks lending money into existence. So, as I understand it, the leverage ratio is pretty crucial to the amount of money that banks can effectively lend into existence. So doesn’t this have quite profound effects on money supply and, therefore, becomes an issue that is just as important to the MPC as it is to the FPC?
Dr Carney: It has an effect. In the situation we were just discussing, which is potentially a varying of the countercyclical capital buffer and the leverage ratio, because of financial stability risk, that would be the motivation. That is a situation where potentially that would impact the transmission mechanism and would potentially, depending on calibration, have a material impact on the outlook for activity and the pressure is on inflation, which the MPC would need to take into account. What that does to move from philosophy to practicality would reinforce the necessity of regular dialogue, shared analysis, between the MPC and the FPC, so there is full understanding of the motivations, the potential impact, potential future effects, and that the FPC understands as well the potential policy reactions of the MPC in order for the MPC to achieve its remit.
Q19 Mark Garnier: The lines between FPC and MPC on this particular point become very, very blurred. Are we getting closer to a point where—and I know it is one bank and I know you talk to each other the whole time—the MPC and the FPC should merge and become one committee?
Dr Carney: That is a very big question and my view is, no, we are not getting to that point. There are different skillsets that are required for the different areas. Some of those are bridged by the internal, some of the externals can bridge those as well. But it is the judgment of this committee, judgment of the Chancellor in terms of appointing the externals, but the mix of expertise that is needed for the FPC to function effectively requires some special skills that may not be fully applicable to the MPC. That is the first point. The second thing is that there are distinct remits here. They are complementary. The system is well designed. The third point is that it is absolutely essential that these committees work together as much as possible, they understand each other, they share analysis, there is challenge between those committees, and we have been doing that. We are giving considerable thought to how to regularise those interactions and potentially institutionalise them over time, but my personal view, given what I have seen, is that I do not think it is necessary or advisable to merge the two committees given the remits.
Q20 Jesse Norman: Mr Kohn, can I ask you to what extent are the present low volatility and risk premium in the financial markets a result of forward guidance?
Donald Kohn: I think they are partly a result of forward guidance when the central banks give assurance that interest rates will be low for a considerable period of time, however that is phrased. That is intended to encourage people to assume that that is going to happen, that those rates will be low and to base their decisions on that, so—
Q21 Jesse Norman: There is not much doubt about that. The question is: how much? I guess people tend to take the view at the moment in the markets that the very low levels of volatility are pretty directly influenced by forward guidance.
Donald Kohn: There is an influence and, you are right, the question is: how much? I think there are other things at play here too. So a very gradual recovery from the very deep recession, the lack of a threat of a new recession any time soon in the UK or the US. I think people feel that they know what the path ahead for the economy is going to be, as well as the path ahead for monetary policy; that the risks and the bad effects of the very deep recession have been overcome. I think there are a couple of sources for this.
Q22 Jesse Norman: Thanks for that. Mr Bailey, from a financial stability perspective, the Bank for International Settlements recently wrote that forward guidance could—I think the phrase is—“encourage excessive risk-taking and foster a build-up of financial vulnerability”. How far do you share that concern?
Andrew Bailey: We share that concern in the sense that you will see in the “Financial Stability Report” that we publish. There is a table in there that sets out our own observations on the developments in lending and financial markets, which point to the emergence of what in the language of the pre-crisis period is search for yield, and you can certainly see it. This is most evident in dollar markets.
Q23 Jesse Norman: I guess I am more worried about your personal concern rather than the institutional one.
Andrew Bailey: I am coming on to that.
Jesse Norman: Okay, good; goody good.
Andrew Bailey: You can see this in dollar markets. You can see it in US activity but you can see evidence of it now migrating into more broadly European activity. So as we said in the record of the FPC meeting, yes, we are concerned about it and, yes, we are doing work, and that work is twofold. First of all, we do have resources devoted to looking at the risks inherent in that activity, how it is developing. I would also say related to that is how—what I might call—the structural model of investment banking is changing away from the thing that built up pre-crisis of fixed income trading towards what is a more traditional model but in a new context, which is large scale underwriting, leverage loan underwriting, block trading.
The second leg of what we are doing is the stress tests. There is a specific element in a stress test. You can see it, for instance, in the assumptions we make about commercial property behaviour to test those propositions out. So the simple answer is, yes, we are and that is the work that we are doing at the moment in this field.
Q24 Jesse Norman: To be clear then, the answer to the question is you think forward guidance is contributing—
Andrew Bailey: No, I made no comment on forward guidance.
Jesse Norman: Okay, so let’s take that. Perhaps you can address that question then: how far forward guidance is contributing to the instability that you have identified and the measures you are taking to combat it?
Andrew Bailey: I think there are broadly two things at work here. I am not a member of the Monetary Policy Committee so I am not going to offer you any view on monetary policy. I would say that I think there is a long run trend of greater credibility in monetary policy that allows policymakers to be more confident in what they can say about future policy, and of course that is a good thing in terms of the signals it gives to the economy.
The second thing that is very evident over the last 12 months is not really to do with forward guidance. It is to do with the fact that the markets are discounting the effect of quite a wide range of things that are going on in the world that could easily in other circumstances create shocks. So whether it is Russia, whether it is Iraq, whether it is developments in other parts of the world, all of these things are not disturbing market volatility.
Jesse Norman: Yes, I am not saying that at all. Volatility is at very low levels. They do not seem to be picking that stuff up.
Andrew Bailey: No. We have seen—
Jesse Norman: It is a worry.
Andrew Bailey: No, indeed.
Jesse Norman: So if those things are not being picked up they are going to come in and they are going to unsettle everything.
Andrew Bailey: Indeed, which is why we are focused on this work because there is an interesting set of comparative charts in the “FSR” where we have the survey we do of practitioners saying, “What are you worried about?” and they say in slightly broad terms, “Geopolitical risks” and that has moved a lot. Then you look at the markets and you say, “How is that translating into market behaviour?” “Well, it does not seem to be moving anything in terms of implied volatilities in markets.”
Q25 Jesse Norman: So it is the worst possible outcome. There is a lot of complacency around but everyone is talking a good game and it is very important to the regulator.
Andrew Bailey: That is why we have to be—coming back to what I said first of all—very alert to this, and that is what we set out.
Q26 Jesse Norman: Yes. That is helpful; very interesting.
Governor, when you made your recent comments about rates rising sooner than expected, was part of the point of that to try to stir up volatility and combat some of this complacency about monetary policy?
Dr Carney: In terms of the short-term path of monetary policy, yes, absolutely, because the fact was our interpretation—
Jesse Norman: You were worried about this; you were worried about people being—
Dr Carney: It is my personal interpretation but it was also shared by other members of the Monetary Policy Committee that there is this broader phenomena, and we put a simple point on it. It does not take a genius to figure out that relative predictability of interest rates in a low interest rate environment encourages risk taking. We fully understand that.
Jesse Norman: They become less sensitive.
Dr Carney: They become less sensitive. There are other factors and if I have a moment I will go into the other factors. But I will answer your specific question, which is that we were concerned that markets were not reacting to data, a fairly long run of data that was as good as expected, if not slightly better. There had not been an adjustment in terms of expectations at the time of the first rate increase, despite pretty clear guidance that we had given: that it was going to be data driven, that we had no pre-set path and the only guidance that the MPC is now giving is around the expected medium-term path of interest rates, not the timing of the first move, and on asset prices.
May I say a couple of things about the broader issue because this is a crucial point that you are on? The first thing is that I share Don Kohn’s point that macro volatility has gone down; the underlying economic outcomes of that have gone down. I would add from the monetary policy side that it is not just about guidance, but it is being at the lower zero bound. There is an asymmetry in the outcomes. Thirdly, I would add for the overall environment, again for monetary policy, the stances of the ECB and the Bank of Japan are relevant here and they are both in continued easing mode. More broadly, though, to move towards the financial system, there have been some structural changes—
Q27 Jesse Norman: By the way, if I may just make a point. It feels to me like the markets are discounting further easing on the ECB side.
Dr Carney: The ECB has announced additional easing and the potential scale of that is still being digested by the market. I would put it that way.
The structural changes in the markets, a few that reinforces low volatility but reinforce your concern that we share: increase use of mark to market. So that leads to a trend following across a range of asset managers. An increased number of index funds, exchange trader funds. So again trend following. The still use of risk models that use trailing value at risk for measures of haircuts and taking in collateral, again is something that is a concern. Going against that—something we highlight in this report through some of the charts—is that as regulators we have pushed more liquidity risk into the core of the system to the core banks. So they have responded by dramatically reducing their inventories of bonds. They have lowered their lot size of trades; much lower. There is an illusion of liquidity because bid offer spreads are low, volatility is down. So there is the potential for an adjustment that, at this stage, would look to be largely borne by the end investors as opposed to the core of the system. But we do not take that for granted. That is why we are doing stress tests. That is why we did the exercise in the Fall. That is why, at an international level, we are looking to get an agreement next month on changing the way banks institute haircuts for repo and other security financing transactions to take out this trend following volatility that reinforces a low volatility environment.
I would add another thing, if I may. When you think about the impact of this search for yield environment back here in the UK, what we can directly affect. It is our core institution: first, through supervision. Secondly, the PRA announced, and we announced in this “FSR” a review of leveraged lending and commercial real estate lending to make sure the covenants are holding up. Then lastly I will circle back to where you started, which is on communication. I welcome the question very much because we are trying to draw attention to this, to the extent possible. Speaking as a member of the MPC, we do not know exactly when the rate cycle is going to start. It will be driven by the data. We do expect markets to react to that data and the guidance we give is a likelihood over the medium term, which is as much guidance for individual firms and businesses.
Last point. When I made my comments at Mansion House what one saw was an adjustment to those comments; a bit of a pickup in volatility relative to data; reaction to short-term data; but the medium term outlook for interest rates has not changed. So there was a rotation of the curve.
Q28 Jesse Norman: That is an extremely interesting and illuminating comment. Thank you very much indeed for that. To pick up the point you make about liquidity, if liquidity is optically better than it actually is does that not imply that if we do get a 1994-type reaction to rising interest rates that that could exacerbate the squeeze as well as the other factors you have mentioned?
Dr Carney: You are exactly right and there are several charts in the “FSR” that show estimates of liquidity premia that have gone negative at present, which highlights this point. So, Mr Norman, there is definitely the potential that if there is a reaction to broader interest rate policy—and I would have some humility about the impact of the Bank of England on this broader global environment for search for yield, but broader economic circumstances and, therefore, central bank policy—that there could be an overshoot in terms of volatility and market reaction.
Jesse Norman: I was less worried about it than I am now five minutes later, so thank you very much indeed for that. Chairman, can I pursue this a little bit longer because I have one or two further questions.
Chair: Two quick questions then.
Q29 Jesse Norman: Sure. Mr Taylor, if I might ask you a question. Is there anything that the FPC or the MPC, from your perspective, can do to reduce complacency, apart from give speeches and press conferences?
Martin Taylor: I do not think there is much the FPC can do about it apart from what we are doing. I think the Governor’s intervention at Mansion House was very useful, for exactly the reasons that you have mentioned. We do keep banging on about this, and I think the point Andrew Bailey made about the tendency in the markets entirely to ignore geopolitical problems of any kind at the moment is just bizarre. There are times when markets are very jumpy, even sometimes when interest rates are low, but at the moment people just do not want to know these things. I think there are some charts here showing how—there is the spider’s web chart—volatility has just pulled in and in. Let’s hope that this exchange gets reported.
Q30 Jesse Norman: It is not like macropru policies are entirely uncontroversial or known to be maximally effective, in any case. If I can ask one final question, which is a factor that has not been mentioned by the Bank but it seems to be potentially of some interest is the effect of the build up in corporate balances of foreign currencies denominated debt. I wonder if that is something that is sitting in your thinking at all. That is an open general question. Obviously there are lots of emerging markets where you have businesses with foreign currency denominated debt and I think it will identify that it is creating a hidden vulnerability.
Martin Taylor: Depending on whether they have the assets to match them, and I will—
Jesse Norman: I do not know if you have any visibility on that. From a bank perspective role, if that is one of the things that you are thinking about at all.
Martin Taylor: —leave that to my colleagues.
Dr Carney: Yes, if I may, it is one of the concerns. These positions became relatively extreme in the spring of last year. In 2013 we saw the consequence of that, and in the last six months it appears that there has been a renewed build up through emerging markets of unhedged foreign currency borrowing. So it is a concern. It is something that we have been discussing internationally with our colleagues there and it is something that the FSB is taking an active interest in.
Jesse Norman: Thank you very much indeed. Thank you, Chairman.
Q31 Steve Baker: I would like to go on and talk about the Bank for International Settlement’s report and explore that. Before I do, Dr Carney, I was really fascinated by your very plain answer to Mr Norman about using your remarks to change the market’s expectations and produce some volatility. Mr Bailey made a comment recently in a speech that sometimes it is necessary to restate the obvious, so I hope you will forgive me if I do that. You must be aware at all times—
Dr Carney: It is our entire stock in trade, stating the obvious.
Steve Baker: With that in mind, you must be aware that large numbers of people are employed to analyse every nuance of what you say and what that means for markets. Is that the case, you are very conscious that your words are continuously analysed in every detail.
Dr Carney: Of course I am conscious of that, yes.
Steve Baker: Therefore, does that mean that it really is one of your key objectives to steer markets by setting expectations among market players?
Dr Carney: The monetary policy briefly. The core expectation we are looking to set is inflation expectations; inflation expectations aligned with our mandate, the 2% inflation target. I would reinforce—
Steve Baker: Yes, if I may—
Dr Carney: —no, I am sorry—that you have to go to the heart of it. I would reinforce that inflation expectations are extremely well anchored in the United Kingdom. The anchoring of those expectations has steadily improved over the last year. You do not have to take my word for it because we published, through the “Inflation Report”, a wide range of metrics that are indicators. We do not take that for granted but that is where we start in terms of expectations.
Q32 Steve Baker: Forgive me, but I was really asking you the meta question, which is that you accept that you are deliberately setting expectations in the market?
Dr Carney: The expectation that we are looking to set, from a monetary policy perspective, is the market’s understanding of our reaction function. In the case that we are talking about, in the case of Mansion House, the MPC took a decision in February to provide new guidance after the achievement of the unemployment threshold. That guidance did not make a promise when interest rates were going to go up. It was not time contingent guidance. It gave an observation about the likely path over the medium term and specific commitments around asset sales, which are relevant for the market. Those are the two things it did.
The combination of that and our core mandate to meet the inflation target, combined with the data, should invoke market—that is our reaction function—reaction.
Steve Baker: Thank you, so—
Dr Carney: Sorry, Mr Baker, I will be quick. The observation, not just of myself but of fellow members of the MPC, was a growing realisation that markets were complacent about that aspect. They were not responding to the data and so that was drawn to their attention. I drew to their attention it could be sooner, but subject to a variety of factors: performance of the labour market, sustained momentum and other aspects. Again this is about explaining the reaction function of the MPC, and if some people in the market were on the wrong side of that then so be it. In the end the objective is achieving the inflation target not satisfying those—
Q33 Steve Baker: Thanks. Could I ask Mr Taylor, as a previous bank chief executive, how do a bank’s staff change their actions in relation to the remarks made by committee members? Do they materially shift the actions of banks simply in reaction to words that are spoken?
Martin Taylor: I was a bank chief executive such a long time ago that these committees did not exist, so it is a double hypothetical. I will do my best. I think that central banks’ communication has carried more and more weight with the passage of time. I see it not so much as central banks trying to set expectations; they set expectations about things that they directly influence but there are very many things that central banks do not directly influence. It is important that central banks correct what they believe to be fallacious expectations, which I think—he will speak for himself—is what the Governor was doing on this occasion. A set of expectations are set by a series of remarks that are then interpreted and analysed by the very large numbers of people you talked about; perhaps too large a number. Some kind of result comes out that may or may not bear a close relation to what the central bank was intending. If it is not what it intends it will change it.
Q34 Steve Baker: Where this line of questioning is coming from is I happened to see an economist called Roger Copple last week. He has written quite widely on big players and how central banks are the paradigm of big players and how they shift markets and tend to cause herding and instability, very much to the point the Chairman made fairly early on. Donald Kohn, I wonder whether in your experience this effect of big players causing herding in markets is something that is discussed at all within central banks, particularly in the context of an economist like George Selgin who argues that central banks are a profoundly destabilising influence on financial systems?
Donald Kohn: So you are saying central banks are destabilising—
Steve Baker: I am not saying that. I am saying that George Selgin, the American free banking theorist, argues that central banks are a destabilising factor. I wonder whether any of these arguments are ever discussed when you are considering how your words will influence the trajectory of markets.
Donald Kohn: Certainly within central banks there is quite a bit of discussion about how to explain their reaction functions, what they are reacting to, how they see the economy going forward, and there is a lot of discussion about how that will be received in markets. I profoundly disagree with the notion that central banks have been a destabilising influence on markets. I think both in the inflation targeting, both implicit in the US and now explicitly in the UK in the lender of last resort role that central banks have had an important stabilising function. Central banks struggle—as we all do—to convey our ideas as clearly as we can but also recognise the limits of that. So you cannot be clearer than the underlying situation, and I think what the Governor and others have said is that sometimes markets feel like they know more than they really do because the course of monetary policy will depend on the course of the economy. There is an inevitable range of uncertainty about that course and it is good for central bankers—Governor Carney, Chair Yellen, Mario Draghi—to remind the market that central banks themselves do not know what the interest rate will be a year from now. They know what they will be reacting to and they have a guess about where the economy will be or forecast, but they don’t know.
Q35 Steve Baker: Turning then to the Bank for International Settlements, the Telegraph has reported the comments that the head of the Bank, Mr Caruana—I think that is how you say it—has made, “The world economy is just as vulnerable to a financial crisis as it was in 2007, with the added danger that debt ratios are now far higher and emerging markets have been drawn into the fire as well” and so on, and this idea that people are ignoring the risk of monetary tightening in their voracious hunt for yield. This continues the theme of monetary policy’s influence on financial risks. What do you make of the Bank for International Settlement’s annual report and its urging central banks to exit lose monetary policy, Dr Carney?
Dr Carney: I will say this. It is an interesting report, these ideas that we have discussed a bit. It is a report that is made in a vacuum, the vacuum of Basel; a world where the central bank does not have a mandate, a mandate given from Parliament; a world where a central bank is not accountable to Parliament, and through Parliament to the people, to achieve specific targets. Speaking as the Monetary Policy Committee, we have a responsibility to achieve the inflation target. At some future date Parliament may change its mind about what the mandate is for monetary policy and, if so, the Bank of England will respond. But we have a specific responsibility. As detailed in discussions here and also in the Chancellor’s remit letters of the last two years, we can adjust the timeline over which we return inflation to target—whether from above or from below—and the specific circumstance we are in and we are discussing, which is that inflation is below target and the question is: over what horizon does it return to target, potentially, in an environment where the BIS is advocating leaning against these financial imbalances by changing the stance of policy?
I am aware of today’s CPI number but I would only draw attention that in the May forecast of the MPC—the MPC’s forecast—inflation returns to target at the end of the forecast horizon. It only gets back to 2% three years out. In effect, what the BIS would be recommending to the Bank of England, if you take the core of the recommendation, would be to further extend the time over which it returned inflation to target beyond the forecast horizon, farther than it ever has intended to do so, at a time where this economy has just—first up, there is a question whether we can stretch our mandate that far—re-attained its pre-crisis peak, just re-attained its pre-crisis peak 2008. The same as France, I might add. It is unclear in a global environment of search for yield the actions that would be necessary, the tightening that would be necessary, the order of magnitude that would be necessary to influence a global search for yield by changing sterling short rates. I will let you draw your own conclusions on that feasibility or the advisability of doing that.
My basic point is that this is an analysis that is outside the political reality and the political economic reality, and one can have a big argument about the theory. Central banks have mandates. We have a clear remit at the Bank of England. We take our remits extremely seriously and we recognise that—to bring it back to the FPC—in order to fulfil the stance of monetary policy that is necessary, which MPC judges to fulfil its remit, that that creates risk for the financial system. So we at the FPC, partners of the PRA and the FCA, may need to take steps that we are taking to mitigate the risks that come from that.
Q36 Steve Baker: The Chairman has asked me to shorten my long list of questions to just one more. So could I ask Andrew Bailey if it is a problem, in that vacuum of Basel, that the Bank for International Settlements produces reports that are so much at odds with what is done by banks within nations where they are directly accountable to electorates through the process?
Andrew Bailey: I take the same view as the Governor that it is an interesting commentary from an institution that does not have direct policy responsibilities. The one observation I would make about it is that I think it is very much consistent with what the Governor said. In a way they are taking a view that debt levels are too high. You could say, “Well, of course we would prefer to be in another world”. If we did have the choice to not be where we are we could choose where we would like to be, but we are where we are. If you then extend that to, as I think they do say, “and we should take action to lower debt levels” then, as some commentators on the report have said, the consequences of doing that would of course be difficult. It comes exactly back to the political economy point. In that sense, it is an interesting commentary, which is respectable in terms of its commentary, but to my mind it does not offer practical solutions.
Steve Baker: Thank you very much.
Q37 John Mann: Let me ask the two externals, average house prices are now several times average earnings. Is that sustainable?
Martin Taylor: Average house prices have been rising on a long-term trend faster than wages for a very long time now. It is not sustainable indefinitely but it can go on quite a long time, would be my answer.
Donald Kohn: House prices can rise more rapidly than earnings but there are limits because that will affect demand and, more importantly, the concern that the Financial Policy Committee had was that, as those prices rise relative to earnings, then the people buying the houses tend to become increasingly stretched in terms of the debt they assume to purchase those homes. Our actions of a couple of weeks ago were designed to limit the extra stretch that people were taking on, to the extent that that extra stretch might endanger the financial stability of the system.
Q38 John Mann: When would you, as externals, expect the house price growth to fall back in line with nominal income growth?
Martin Taylor: We do not concern ourselves with house prices, per se, but we look at the indebtedness consequences of what might happen if the scenario that is described in the latest “Inflation Report”, the so-called upside scenario, were to happen where house prices continue to rise very much faster over the next three or four years. If that were to happen household indebtedness could rise to levels that would concern us, and that is why we put in place the mechanism that we did.
Q39 John Mann: You do not have a view of when there should be a convergence?
Martin Taylor: Not really.
Q40 John Mann: Do you have a view, Dr Carney?
Dr Carney: If I may, Mr Mann, what the FPC did was to rely on the MPC’s forecast of house prices. The MPC forecast is that within about a year house price growth will converge with the growth of nominal income.
Q41 John Mann: Yes, I know that. Can I ask the externals, is it right that you are relying on the MPC’s forecasts? Are you over-reliant?
Donald Kohn: I think that is a good starting place for us, and then our job is to look at the implications of that forecast or deviations from that forecast for the implications for financial stability and to take actions to protect financial stability if the forecast turns out to be incorrect, and that is what we try to do.
Q42 John Mann: Is there a consensus among you that you should be relying on the MPC’s central forecast?
Martin Taylor: I do not think we are relying on it as much as treating it as normative. What we are concerned about is what happens if it is wrong. It is precisely that that our measures are trying to address. I think what ought to concern you would be if we were to say, “Well, look, we have looked at the MPC’s central forecast, it seems perfectly fine to us so there is nothing for us to do here”. We are not particularly concerned about the path outlined in the MPC’s central forecast. We are concerned about what happens if it turns out to be too optimistic about the rate at which things converge.
Q43 John Mann: But you are not creating your own view in relation to that, so you are reliant on the MPC’s forecast.
Martin Taylor: No, I do not think we are reliant on it. I do not think it is the job of forecasts necessarily to be right. I think it is their job to be normative. We look at what the MPC produces. I personally think it would be very odd if different parts of the Bank of England were coming up with different forecasts for the likely path of the economy. That would be maximally incoherent. But the forecast—
Q44 John Mann: That would not stop either of you deviating from the MPC line, would it?
Martin Taylor: But there isn’t a line, Mr Mann. It isn’t a line. It is an economic forecast. Whether the world turns out to be what the forecast says will depend on whether things turn out the way the MPC was expecting. We are not relying on the forecast. In fact we are saying, “There is a danger that this forecast proves to be wrong and we are putting insurance in place so that household indebtedness does not get to a dangerous place should it turn out to be wrong”. I think that is what we are doing.
Q45 John Mann: Are you confident that the data that is feeding in is sufficiently detailed to properly analyse the housing market, in particular the phenomenal growth in buy-to-let and the potential impact of indebtedness on the multiple numbers who are newish to the buy-to-let market?
Donald Kohn: We took a close look at buy-to-let and its role in the mortgage market; talked about it. We also have said that this is something we are going to have to keep an eye on if our constraints begin to bite on homeowners’ ability to purchase homes, get mortgages, whether the buy-to-let market wouldn’t absorb some of the risk. Mr Bailey and the PRA will be looking at that. We have asked him to report back to us, so we are very aware that the buy-to-let market is a potential safety valve that might not be totally safe.
Q46 John Mann: In terms of the external expertise input—my final question, Chair—as externals you are putting in, average earnings to average house prices ratio is just over seven to one at the moment. What would you regard as an optimal ratio between those two figures?
Donald Kohn: I personally do not have a view on the optimal ratio. I think the determination of house prices is fundamentally given by demand and supply factors. One of the issues in the UK, as has been explained to me many times, is that the trend in demand is exceeding the trend in supply and that is putting upward pressure on house prices. I am not sure there is a particular level relative to income that one needs to achieve and it depends very much on interest rates and the tenor of the mortgage and so on in terms of affordability. I do think there is an issue about that relentless upward pressure on house prices, but it is not one that the Financial Policy Committee can really address.
Q47 John Mann: Would you agree with that, Mr Taylor?
Martin Taylor: The supply part of the equation is clearly very important and it is something over which we have no influence. We are certainly aware that a higher ratio of prices to incomes can pertain if interest rates are low. That is why we have put in an affordability test to make sure that if interest rates rise—all this really links up in a way to the search for yield questions that Jesse Norman and others asked—just as we are concerned that some people in the markets are not complacent about interest rates being at very low levels forever, so we are concerned that householders do not make bad decisions that they cannot live with if rates go up, with consequential problems for consumption in the economy and potentially for the banks. That is something that we are concerned about, yes. I think the affordability test and the attempt to restrict the wilder shores of the mortgage market are what we consider was needed now.
Chair: There are a number of other colleagues who also want to come in on housing.
Martin Taylor: Sure.
Q48 Mr McFadden: I would like to continue on this theme. Governor, going to the measures announced by the bank a couple of weeks ago on mortgage regulation, can I begin by asking: looking at this in the context of the wider economic position, how worried is the bank by the housing market and what was the signal you wanted to communicate by the measures taken a couple of weeks ago?
Dr Carney: Well, my personal view, shared by the committee, is that this is the biggest risk over the medium term to the durability of the expansion, issues associated with housing. Now, to pick up on comments of colleagues, what specifically are we worried about? We are certainly aware of price dynamics and these ultimate issues that Mr Mann was raising, but we do not target house prices. Similarly, we are aware of the structural supply issues. There are fundamental deep structural problems in the UK housing market that have existed for some time and bias prices upwards and create a dynamic where individuals stretch more and more in order to afford a house.
Potentially—and here we start to move into the risks that are most relevant to the FPC, which are risks around indebtedness—what concerns us is indebtedness. It concerns us for two reasons. First, the potential direct impact on the banking system, banks and building societies. We have taken steps, as you are aware, in the past to raise the capitalisation of those institutions prior to my arrival and proceeded over the course of last year. We are undertaking a major stress test, which we can go in more detail, which at the heart of it is a severe housing shock, prices down 35%, unemployment up 6 percentage points, interest rates up substantially, and a three-year recession associated with that, so something that really tests the resilience of the major banks and building societies and the co-operative movement against that shock. We will report later in the year because we want to make sure that these institutions are resilient for tail risk. It is not a prediction but for tail risk. That is the direct issue and that is why you did not see last week anything directly related to the banking sector, past actions and the stress test undergoing.
What we were trying to address or would look to address is the indirect risk—that is the risk, as Mr Taylor says, from indebtedness that is of cohorts of highly indebted families—and the macroeconomic consequences of those. History shows that the British people pay their mortgages. There are very low default rates on those mortgages. What happens if they are borrowing at multiples is that, of course, they have to economise on everything else in order to pay their mortgages. If enough people are heavily indebted, that has a big macroeconomic impact. It can tilt the economy back into recession and we start from a position of vulnerability. Household debt to income has gone down but it is still roughly 140% of income. That is high. We start from that position of vulnerability and there is the possibility that what are currently responsible lending standards become irresponsible to reckless. We have seen that happen time and time again and there has been a sharp increase in the proportion of high loan to income loans; gone from about 4% prior, a few years ago, to over 20%, about 24% of the flow. Sorry, it is about 10% of the flow but there has been an increase. I am quoting above four and a half times. It is a higher number above four times. There has been this increase and we wanted to take out insurance against a marked deterioration in that.
Mr McFadden: Okay.
Dr Carney: Let me finish the detail, and then I will get back to the core message we were trying to send. The reason we took out insurance as opposed to tried to reverse activity right now is because we are in a relatively low interest rate environment, because we have the affordability test put in place so it is shocked for a higher interest rate environment, there are a number of households for whom a high ratio mortgage could be appropriate. That is a decision of banks and building societies whether or not it is the case. Think first time buyer, starting out, higher earnings prospects over time. About half, a little more than half, of current lending at four and a half times or above is to first time buyers. It is a decision for the banks and building societies, but we did not want to shut off this activity. We want to limit the extent to which it increases and that is what we were able to do both with the combination of the affordability test and the cap of 15%.
The message we were trying to send is that our concern is indebtedness. We do not want what are currently responsible underwriting standards to become reckless. We have seen this happen time and time again in the past and so we are taking out insurance today in order to prevent that from happening. Last point: by taking action early we can be more graduated and proportionate than if we waited until there was a clear and present danger.
Q49 Mr McFadden: Okay. To summarise, it is potentially a high risk to the recovery. Your concern is indebtedness, not price per se. People should interpret this as an insurance policy against things getting out of hand.
Dr Carney: Yes.
Q50 Mr McFadden: There has been some debate, including some debate within the bank—perhaps before your arrival—about what is appropriate for the bank to do in these circumstances and what decisions should be for Government to make. If you were worried that this risk was increasing, that the insurance policy signal, as it were, had not been heeded, what else in policy terms do you have in the locker? What else might happen? For example, is it conceivable that the bank would say, “Look, rather than doing this on a proportion of a loan book where you say currently about 10% of loans are more than four and a half times income, we are going to lay down a rule that says from now on we do not want mortgages given out on an individual basis above a certain level”. I use that as an example, but what else do you have in the policy locker if the signal that you sent out a couple of weeks ago is not heeded?
Dr Carney: There are several things. Just so we are clear—I know you are but just so anyone watching is clear—we are not currently contemplating any additional measures, but I will answer the question.
Mr McFadden: I understand.
Dr Carney: We have these measures. The MMR, the higher underwriting standards, are still taking effect. We have the stress test ongoing. We have other measures we took at the end of last year to take our foot off the accelerator. All these effects are acting to promote a more resilient housing market or to mitigate the risk from housing. In terms of additional options, other things we could do, we could adjust the cap that we put in place, obviously. It is calibrated—
Mr McFadden: The 15%?
Dr Carney: The 15% and the level at which it is there we could adjust or we could add another proportion at a lower level. If everything bunches up, if all mortgages became at 4.4 times, if you will, obviously through supervisory oversight that is unlikely to happen but we could do something like that. We could have loan to value restrictions, although we do not see marked movements towards higher loan to value lending yet. We could look at a sectoral capital add-on, so in other words more capital being put against mortgage lending. It would be quite helpful to have that informed by the stress test, obviously, and I am not saying that that is any prospective outcome of the stress test, but it would be hasty or precipitate to have used something like that prior to getting the results of the stress test. We could look at the overall countercyclical capital buffer, which, of course, would have economy-wide effects. We would certainly be very prudent in the potential application of that given the pressures on lending to the corporate sector or to the SME sector as well. There is a range of other tools we could use, including starting with just variants in recalibration of the tools that we have used.
I will finish here. One of the points that we did make in our document was that by acting early we felt we could take insurance, but also we put ourselves in a position that we can learn from the impact of this and recalibrate as necessary. One of the impacts that is hard to gauge is the impact of taking out insurance on expectations because just the very fact of acting could have a broader expectation effect on individuals in terms of the outlook for housing. We will gauge that in the coming months.
Q51 Mr McFadden: You said before, I think quite early in your tenure, something along the lines of, “We are not going to make policy for inside the Circle line” and obviously the central London market is very specific. Is the bank also conscious that this debate about house prices can look very, very different from other parts of the country? My local paper gave me some figures this morning about house prices in a town called Bilston, which you may not have heard of, Governor, in the Black Country, where house prices are £4,000 lower on average now than they were in 2009. The world can look very, very different from outside London in terms of this housing policy debate. Is the bank conscious of that? Do you take that into your thinking?
Dr Carney: Very much so. I do not want to go into policy design, but just to put some substance behind that statement, we all travel around the country, visit the regions. I have been to every region of the country—in my first year I have been to every region and there are 12 regions—and in every meeting that I have had there is a substantial proportion of the time that is spent on the local residential and commercial property markets, not surprisingly given their relative import. We track very closely the data by the various regions. We also get updates from our agents that are present in the regions.
This brings me to policy and this was part of our discussion. This was very much part of our discussion in terms of setting the policy and calibrating it. One way to think about this policy is to recognise that the proportion of lending to above four and a half times income, two-thirds of those types of mortgages today are in London and the southeast. If you are a bank or a building society and you are at the cap, you are at that 15% cap, you have to make six mortgages below the four and a half times for every one you make above the four and a half times. That biases you or that incentivises you to make mortgages where people are demanding those types of mortgages, where people think that those types of mortgages are appropriate with their circumstances and local prices. In other words, not just outside the Circle line but outside of London and the southeast. That has the impact if it becomes binding of encouraging institutions to write mortgages, to provide mortgages to individuals outside of London and the southeast, across the country. There are a few institutions that are effectively at the cap. As a whole, the system is not but there are a few institutions that are effectively at the cap. They have national networks and we would expect that behaviour and we will be monitoring it.
Q52 Mr McFadden: Okay. I think others are probably going to come in and pursue this housing thing, but could I ask one further question on a slightly different subject to you, Mr Taylor, while I have the floor, as it were? We have recently had more information about what the ringfence measures will look like for banks subject to this.
Martin Taylor: Yes, the secondary legislation, yes.
Mr McFadden: There has been a lot of debate about the degree to which interest rate hedging products and things like that should be inside this if at all. I recall that when you were giving evidence to the Banking Commission a year or perhaps more ago you had really strong views about this. In fact, I think the phrase that you used at the time was a category error to include this stuff in what was intended to be a simplification of banking. What do you think now having seen the secondary legislation?
Martin Taylor: That was my last stand, I am afraid. I think I have lost this battle. It is inscribed on my personal war memorial. I pointed out what I thought were the dangers of this a number of times, and you were kind enough to give me an opportunity a year ago. One just has to say it has been very heavily scrutinised by Parliament, by both Houses. It is coming back as secondary legislation. The Treasury has been all over it. My concerns are widely known and I am satisfied with the result.
Q53 Mr McFadden: You have not changed your mind but you will just see what is there?
Martin Taylor: I do not think it is going to blow the world up, no. I hope not.
Mr McFadden: Sorry?
Martin Taylor: I hope it will not blow the world up. I do not think so.
Q54 Chair: Are there any others who want to chip in on this hedging product issue while we are lingering on it or is Martin completely isolated? It looks as if he is isolated even on the FPC.
Andrew Bailey: I do not think Martin is isolated. There is a real dilemma, I think. No, seriously, this is a rather awkward thing to say given history, but given the customer base that a ringfenced bank would be expected to have, some of those customers will have a legitimate demand for hedging products. The reason I say this is an awkward thing to say, of course, is the dreadful record of British banks in selling hedging products to customers. I understand that, but there is an underlying need among customers for hedging. It just needs to be properly done. The dilemma is do you say to a customer, “You cannot buy that product from the ringfenced bank that is your main counterparty. Off you go to another bank or off you go to the non ringfenced bank to buy that” or do you say there are some relatively simple products that it would be sensible for the customer to be able to acquire from the same institution? Now, if you do go down the second line, and there is a logic to the second line, then you have the real challenge, which is how you define a simple derivative. That has been a real test and honestly, like Martin would say, I think it will continue to be a test because, of course, this will be—sorry to use the word in another way—tested repeatedly by the institutions. History always tells us that this will happen. We will have to be very vigilant about this. I think there is a logic to having customers able to access these products. By the way, the ring-fenced bank also needs, of course, to be able to hedge its own risks. That is all logical. The challenge is how we can be vigilant to keep it there.
Martin Taylor: May I be allowed ten seconds, Mr Chairman?
Chair: You may. It is not a minor issue and it just could blow us up.
Martin Taylor: Going back three years now to the publication of the ICB report, what we envisaged then was that the ringfenced bank would act as an agent for non ringfenced banks so that the small business that needed a derivative could go into the ringfenced bank and get it. It just would not be provided by the ringfenced bank. I had a very strong feeling for the precise reasons that Andrew Bailey gives that when you start to say this is a simple derivative the definition will move over time and it will move until it no longer encompasses derivatives that are just simple, and that it was far easier for the supervisors to police a ban than a more complex set of measures, and we are back to the beginning.
Mr McFadden: Or to say what is simple and what is not and things like that.
Martin Taylor: Right. Some of my ICB colleagues, I believe, who know more about it than I do have changed sides on this one and I am happy to go with them.
Q55 Chair: Mr Bailey, you have set out the choice there and this debate has been going on for several years, since the interim Vickers report.
Andrew Bailey: Yes.
Chair: The choice is between some flexibility but also bringing complexity and requiring banks for whom servicing this relatively limited group of customers would require them to create a non ringfenced bank to do so. Have you looked carefully at what it would really cost those banks to create a non ringfenced bank and whether you can find ways of handling that up to a threshold to make sure that they really are just looking after customers, as a crude tool to make sure they are looking after customers rather than engaging in prop trading or other activities?
Andrew Bailey: We have. This remains and continues to be a very substantial piece of work to get to the bottom of this. You are correct to say that there are some major banks where you can see the ringfenced bank as being a fairly small proportion of the total balance sheet of the institution. There are others where you can see it as being a very substantial proportion of the total balance sheet. Now, the second class, by the way, of course, make the argument that they should in a sense be given a waiver to not have a ring fence, essentially, and the argument is no, I am sorry. Martin and his colleagues were quite clear that if you are doing activities that are beyond the definition—and, by the way, you left quite a big middle ground where there is optionality precisely for this reason—
Martin Taylor: We did.
Andrew Bailey: If you are doing things that fall outside that middle ground, I am sorry, that is pretty clear. That point is understood.
You are right that we are going to have to be very alert—because we have obviously had this discussion before in a number of contexts—to the fact that if a small, non ringfenced bank is created for the purposes of servicing those activities that did not fall within the boundary, that are in a sense in accordance with the customer base, that it does not go beyond that. To be honest with you, that is no different to the challenge we have with these institutions today. I am very alert to what these institutions are doing in terms of their trading activities, what you might call quasi investment banking today. We live with that and we are very alert to it, so I do not see that as a new issue for us. I see it as one that will take a somewhat different form with the ring fence.
Q56 Chair: Have you examined how costly it is for them to create a non ringfenced bank?
Andrew Bailey: Yes, we have been through that. We are working individually—
Q57 Chair: Is it your view that they have a strong point that this is going to increase costs and a burden to the customer?
Andrew Bailey: Well, I think some of them—
Q58 Chair: Or do you discount that view heavily? That seems to me to be a key criticism since their key argument is, “We are trying to help our customers”.
Andrew Bailey: Well, first of all, I do not dismiss it. We are working with every institution individually on this very question. Some of them I think will make choices as to whether they want to continue to undertake the non ringfenced bank activities based on that cost.
Q59 Chair: That will depend partly on the on-cost of creating a non ringfenced bank?
Andrew Bailey: Yes, it will.
Q60 Chair: If I can ask that question again: is it very costly or do you think that they are exaggerating?
Andrew Bailey: Well, we will be consulting on a—
Chair: Because they are coming to us, or a number of us, privately and making this point. Now I am asking you to tell us whether we should take much notice.
Andrew Bailey: We will be consulting over the next year or so—we are going to break this up into pieces because it is so big—on a whole range of issues, which have a big bearing on the answer to your question about just how costly it is. It is not just about the balance sheet. It is about governance. It is about management. It is about control functions. It is about shared services. This has also, I should say, a strong congruence to the debate about resolution planning. It is entirely in everybody’s interests that we run these two things together, but we will be consulting on this because you are right, it is a big issue and we recognise that. We are not dogmatic about this. We want to get these issues out. We are working with each institution to bottom out exactly what the costs are.
Chair: Jesse Norman has a quick rejoinder and then we will come back to housing.
Steve Baker: No, it was me.
Chair: Sorry, it was Steve.
Q61 Steve Baker: It seemed to me there were two problems with interest rate hedging since it came up. One is the misselling by the banks and the other one is the height of exit costs. We have heard in evidence that the reason for the height of exit costs is that monetary policy has been extraordinarily low. They have explained that the arithmetic of exit costs works out that small businesses have been inadvertently hammered because bank rate has been so low. It seems that there is a trap there because you could not have won either way.
Dr Carney: I have seen some of this evidence. It goes directly to misselling because there is not a matching of the hedge and the maturity of the loan. It creates a break. The institution has to rehedge. Boom, this just goes right back into the misselling issue and it is not a monetary policy issue.
Q62 Steve Baker: Okay. That is not quite what I understood the evidence to be. Once the product has been sold—
Dr Carney: Missold.
Steve Baker: —and somebody wishes to exit it, the arithmetic of the exit calculation results in high exit costs precisely because bank rate is low. That was the evidence that we heard.
Dr Carney: Look, if you buy insurance, which is effectively what you are doing by hedging through an interest rate, and if you match the maturity of the hedge to the maturity of the loan, then this is not an issue. If you were speculating by using it and saying, “I took out insurance at a certain interest rate and I want to redo it”, then, yes, there is always a break fee. The stance of monetary policy is determined not by interest rate speculation but by achieving the inflation target. There is specific evidence that has come up that relates directly to this point, where the hedge does not match the maturity and that creates a need to rehedge, which is obvious is not clear was properly disclosed and the risks around that. We can agree to differ on it but it seems straightforward.
Chair: Do you want to agree to differ or would you like to have another go?
Q63 Steve Baker: I suppose I have just fallen into taking the perspective of the small businesses in my constituency who are suffering because they face these high exit costs. It is probably as simple as that. As far as they are concerned, they face high exit costs. We have heard the evidence that the high exit costs result from monetary policy. I am really just putting it to you that it is an inadvertent consequence of having low bank rate.
Dr Carney: I will put back to you that if a firm has decided to borrow at a fixed rate, which in effect is what we are talking about, and if interest rates end up subsequently to be lower than that fixed rate, yes, there is a cost to that decision but that is hardly news. You can reterm it as an inadvertent consequence of monetary policy, but it is just the fact of borrowing at a fixed rate and interest rates move. Sometimes you borrow at a fixed rate and interest rates go up.
Q64 Steve Baker: At the risk of referring to people like Selgin and all the rest of them on that side of the argument, I suppose the problem I have is that when people took out those interest rate swaps they had absolutely no idea that by authority the Monetary Policy Committee would suppress rates to such a low level. It was well outside anybody’s expectation of where interest rates would go, but I think this possibly opens up a can of worms we do not want to explore at this point. That is my issue, that it was not a result of market forces, it was a result of the MPC’s—
Dr Carney: No, I am sorry, I cannot accept that. We can talk about the exact timing of when these firms in your constituency made these commercial decisions, but the decisions of the MPC prior to my arrival reflected the economic outlook and the consequences for inflation. There was a need, and there can be an argument whether there was enough stimulus that was provided over that time—people can differ about that—but the fact of providing that stimulus had a couple of consequences. One was to fulfil the remit given to it by Parliament; secondly was to create better demand conditions, including for the firms you are referring, than would otherwise have been the case. I will say further, since the reference to free banking, in a free banking world with the absence of a central bank to provide lender of last resort and other liquidity support would have resulted in a wholesale collapse of the financial system and this discussion would be irrelevant.
Q65 Teresa Pearce: Housing. Some of the questions I was going to ask have already been answered in the answers to my colleagues. One of the things I was going to ask you is the FPC’s recommendation regarding mortgage lending and the stress by a rise in the bank rate of three percentage points. Could you tell me what proportion of mortgage lending currently falls within that affordability test and does it vary by region?
Dr Carney: Currently, to our best estimate, 85% of mortgage lending falls within a test between two and a half and three times, so we are moving to the upper end of that test. We view that as best practice, appropriate practice in this environment. We are not aware of any particular regional differentiation between that given that what is relevant is the level of bank rate, which is obviously set nationally. If I may, Ms Pearce, the process we went through, advised by the PRA and discussed by ourselves, was are those sensible tests that most institutions are applying? We thought three was more sensible than two and a half so we went to the upper end of that. We judged it was sensible. Why did we put it in if most were already doing it? We were conscious that what we have seen in the past is that what starts out as sensible, prudential, responsible, people get caught up in a rising housing market, underwriters get caught up, and then they stop applying these types of tests. That is why we wanted to make it a much higher hurdle for any adjustment.
Q66 Teresa Pearce: To what extent do you expect 5% fixed rate mortgage lending to increase as a result of your recommendation? Would you like there to be more five-year fixed rate mortgages?
Dr Carney: I hesitate to give personal financial advice.
Q67 Teresa Pearce: Do you think it would add stability?
Dr Carney: This type of affordability test that the vast majority of institutions are currently practising, and we want them to continue to practise, helps level the playing field between a variable rate mortgage, a credit decision around a variable rate mortgage, and a fixed rate mortgage. The actual decision for an individual family will vary over time and depend on the economic circumstances. Five-year fixed, there are many attractions but I hesitate to ask the nation to all go five-year fixed because it depends on the pricing of those and it also depends on someone’s judgment of their own economic circumstances.
Q68 Teresa Pearce: Okay. We have talked about housing and you have talked about risk and the risks that concern you. Basically, what we are talking about here is home ownership and mortgage lending. The risk that concerns you, in my view, is the risk to the financial institutions that lend the money, whether or not they get that loan back should—
Dr Carney: No. No.
Q69 Teresa Pearce: Right, okay. You have talked about indebtedness and you have talked about people paying their mortgage and you have talked about whether or not it is a sustainable loan and people can afford that loan. The risk, surely, that you are looking at is the risk to the loan going bad.
Dr Carney: That is a risk but that is not the risk that these measures were designed to address. You are on to a very important point and so I will explain. The concern of the committee was very much the prospect of a large number of households taking on big debt burdens, big mortgages, and not that they would not pay those back but that the aggregate impact of having a large proportion of the population with highly indebted mortgages, a high ratio of mortgages, would have a bigger macroeconomic impact. In other words—
Q70 Teresa Pearce: On disposable income?
Dr Carney: On disposable income and on the economy, on jobs, on growth, because the experience has been, both in this country and internationally, that recessions that follow a build-up of debt are much deeper and are much more prolonged. We start from a position of relative vulnerability. We are concerned that there is the possibility—against which we have taken insurance now—that a large proportion of the population could become highly indebted and that would set up the prospects in the medium term for a deeper recession.
Q71 Teresa Pearce: You have the two risks. You have the risk to the loan, whether the loan would go bad or being paid back the mortgage, and you have the risk to wider society on the fact that people do not have any money to spend?
Dr Carney: Yes.
Q72 Teresa Pearce: Yet in the buy-to-let market where, on an average, people are getting 6% back on their investment because rents are high, you have conflict there because you have the people who have the buy-to-let mortgage—who if rents go up are making more money on their buy-to-let mortgage; therefore, the risk to the loan is less—yet the risk to society because rents are rising is higher because people do not have any disposable income to spend. That is a bit of a quandary, is it not?
Dr Carney: Let me say a few words about buy-to-let. As colleagues have already indicated, this is something that we are watching quite closely. Current volumes in buy-to-let are consistent with historic averages. About 15% of all mortgages are for buy-to-let. That is the first point. In terms of the underwriting standards for buy-to-let, we have not seen the same deterioration or loosening of underwriting standards in buy-to-let. Median buy-to-let is 75% loan to value today, as we meet, which is consistent with historic averages. The average median interest coverage on buy-to-let loans, so how much of the interest is covered by the rent, is 1.23 times, which is consistent again with historic averages. It has not basically moved. What we have not seen in buy-to-let is the shift in underwriting standards, but we are watching very closely for the possibility that that is one of the consequences not just of the actions we have taken but changes to the pension system, other dynamics in the overall economy. We will look and if there is a need to act we will.
Q73 Mark Garnier: Andrew Bailey, can I continue with this buy-to-let discussion? I think you made some answers to Chris Giles of the FT in the stability report press conference. I am interested more in the dynamics of what is going on as we have obviously had a couple of questions about this and it is something that people are focusing on a bit more. Isn’t it the case that the reality of the buy-to-let market is we are now seeing a relatively high level of approvals for buy-to-let mortgages and that this is skewing the whole of the property market? You are taking owner occupier property out of that stock and moving it into the buy-to-let market as we get more and more people doing it. Is this causing you problems in trying to assess values of property? Can you expand more on what your thoughts are about it?
Andrew Bailey: As the Governor has said, if you take buy-to-let lending as a share of mortgage lending, it is about 14% or 15%. If you take it as a share of overall housing transactions, I think it is around 7%. That is below the level that it was in the immediate pre-crisis period when I think it was around 11%. I see this very much, of course, as the consequence of the distribution of owner occupier housing and rented housing. That is what it is, really, in terms of the distribution. The only thing I would add—
Q74 Mark Garnier: Hang on, you are saying the demand is there rather than the fact that the owner occupier market is now getting so out of price for most people that they have no alternative but to go to it?
Andrew Bailey: Yes, the demand is there, yes.
Q75 Mark Garnier: But it is driven by a lack of supply in the—
Andrew Bailey: I think so, yes. That is the point I was going to come on to.
Mark Garnier: Okay, sorry.
Andrew Bailey: That is the point I was going to make. It just comes back to this point we have made a number of times, that in a world where there is an imbalance between supply and demand in the housing market that is forcing up the cost of owner occupier housing, then the demand for buy-to-let, of course, which is rental—
Q76 Mark Garnier: It is a self-fulfilling prophesy. That is the point I was trying to make. The more you have an opportunity for buy-to-let owners to make money out of it because there is a greater demand because people cannot get the supply of owner occupier houses, the more the owner occupier houses are moved out of that sector into the buy-to-let sector so that people can meet that demand.
Andrew Bailey: I agree. This is why the buy-to-let issue is much broader than just our interest in it. We are obviously going to see it from the point of view of prudential standards. As the Governor has said, we do not actually observe particularly marked developments, but we are watching it very carefully. It will be in the stress test. We do asset quality reviews on it. I think you are right that as a consequence of this underlying supply and demand imbalance this is the pattern of activity that you are seeing. This goes well beyond our responsibilities. As a broader issue about housing policy, yes, it seems to me it is an issue, but it is not one that we can deal with.
Q77 Mark Garnier: Are you saying you have no measures, no tools in your toolkit, that can tackle the buy-to-let mortgages? For example, one of the differences between owner occupier and buy-to-let is owner occupier you have to have a repayment plan; buy-to-let you do not, you can have interest-only mortgages.
Andrew Bailey: When you say tools in our toolkit, you have to come back to our statutory objectives. Our statutory objectives are around financial stability, safety and soundness of banks. That is what we do. We do not have toolkits to wade in and say, “Let us do something with the supply and demand imbalance”. That really is, I am afraid, in your domain in Parliament. We know it is a difficult question, we know all the issues, but we have clear statutory obligations. We know the limits of what we can do. We will, of course, pursue those objectives because that is our job, but we cannot do wider things.
Q78 Mark Garnier: Okay. So you are not going to do anything with the buy-to-let market or buy-to-let mortgages?
Andrew Bailey: No, that is not true. We will be very, very attentive to buy-to-let in the context of our statutory objectives.
Q79 Mark Garnier: Okay. Did you want to add anything, Governor?
Dr Carney: Well, I would reinforce what Mr Bailey just said. The consequence of watching closely and focusing on the prudential standards, potentially as the FPC if there were a change in the underwriting standards that was having a broader macroeconomic effect that had greater externalities measures could be taken. Measures could be taken before it comes to the FPC just in terms of supervisory guidance if that were appropriate. What we are saying is that we would not stretch out to the broader societal issues, obviously, and also what both of us are saying is that our current judgment—and this was discussed, as Mr Kohn said, in the run-up to taking action—was current underwriting standards in buy-to-let appear consistent with the historical patterns and, therefore, did not warrant a response at this stage.
Q80 Mark Garnier: Okay, that is very helpful. Can I turn to the wider housing market? Again, we have had quite a wide-ranging discussion about certain issues. Perhaps if I can go to the external members, are you satisfied that the Bank of England really has the granularity on what is going on with the housing market? When Andy Haldane came before us a few weeks ago, he said that there is the intention of the Bank of England to invest more into building a database on what is going on exactly in the housing market in terms of vulnerability. Mr Kohn and Mr Taylor, are you both happy that there is sufficient information? Is the Bank of England moving quickly enough and do you think that you will have to react to imbalances in the housing market before you have that data that you need?
Martin Taylor: I would not say that I was happy. I believe the bank is moving quickly. Clearly, this whole issue has become an important one for the FPC over the last several months. It was about this time last year that we began working on it seriously and I can certainly tell you that the data flows we have and the understanding of the market is a great deal more advanced than it was then. This is a market where the data is in itself imperfect, the data from the various providers. It comes in a little bit late. If you look at a simple question like what is happening to prices and volumes, you get very precise data but lagged from the tax authorities. You get sample data coming in from the chartered surveyors, from the Halifax and Nationwide, which frequently contradict each other. Trying to pick out very precise trends as to what has happened in the last four or six weeks, for example, can be quite difficult. The bank is extremely apprised of this and there are an awful lot of people now working on the housing data to improve our understanding.
Donald Kohn: I agree with what Mr Taylor said. We had an extensive review of the housing market. We used all the available data. The staff did considerable analysis that supported it and I felt fully supported in making the decision that we made. Having said all that, it is always possible to improve the data that you are getting and the ability to project and try to see what is going to happen next. This is a key area in the UK economy. More data and better analysis are always possible and it will be a continuing focus of the Financial Policy Committee because it has been so key. One of the sources of information will be the stress tests. From the depository institution side, we will be able to see whether there are vulnerabilities to this very substantial, as the Governor said, 35% decline in house prices and how that is distributed. That will be an important source of information.
Dr Carney: One of the things that Mr Haldane I am sure was referring is that part of his role as chief economist is overall responsibility for our data strategy at the bank. We need to start the use of big data. We need to improve the sharing of data and analytics across the various areas. There is an initiative under way relating to the housing market that is moving down to much more granular data, which marries both house price dynamics, debt and incomes down to the postcode-level type analysis, and that could be particularly helpful.
Now let me bring it back up to the macroeconomics, which is that in these historic housing boom/bust cycles that we have seen, whether it is in the UK or in the US recent examples, sometimes you see extremes in certain geographic pockets. For the biggest macroeconomic impacts they are not necessarily the wealthiest pockets either. It is when the ripple effect goes more broadly. To have the ability to track that a little better and do some analytics around that is important.
If I make a larger point, one of the things, whether it is the FPC or the MPC—and it is also relevant obviously for the PRA but for the two macro committees, if you will—we need to get much better at over the medium term is our understanding of credit-constrained households and their behaviours and their dynamics. Our focus, as per the discussion with Ms Pearce, has been around indebtedness and the cohorts of highly indebted individuals, understanding their reactions to different rate environments, different macroeconomic environments, where the tipping points are. We are as clear as we can be in the FSR and in terms of the calibration—how we calibrate it, the steps we took—that we see an inflection point around a debt service ratio of around 35% to 40%. That has been historic experience. That is a rough rule of thumb and we need to become more sophisticated in our understanding of the behaviour of credit-constrained individuals given the overall levels of indebtedness, actual and prospective. That is a big task and that is going to take a lot of data and it is going to take a lot of work through the data and it is going to be an imperfect science for some time.
Q81 Mark Garnier: Okay. When you last came before us after the MPC meeting, I asked you a few questions about bank forbearance and what was going to be the behaviour of banks. You said no, you cannot answer that because you are embargoed. Anyway, here we are back again, and I think you can answer these questions. If you remember, my questions were to do with the behaviour of banks as interest rates start to rise. This is certainly to do with forbearances being afforded to households but it is also just as applicable to businesses, which have seen forbearance. Obviously, with the productivity puzzle and various other issues that are going on, there is a lot of focus on the businesses, so perhaps you might want to focus your answer more on the business level. As interest rates start to rise, at the moment it is costing banks 50 basis points at a basic level to offer forbearance to businesses. If interest rates rise by just 25 basis points that has increased the forbearance cost to banks by 50%, which is starting to become quite a significant increase. Even though it is in absolute terms still relatively low, it is picking up. What is your view on the high street banks’ ability to continue to offer forbearance to businesses in the event of rising interest rates?
Dr Carney: Well, I will say a couple of things. One is the concentrations of forbearance. One of the concentrations of forbearance has been in commercial real estate, secondary and tertiary commercial real estate, where we have begun to see a recovery. The improvement in commercial real estate markets is not solely a primary or central London phenomenon, it is spreading out. There are still big issues without question, but there is the prospect of a reduction in the degree of necessary forbearance in commercial real estate. That is relevant and it is an area of focus not just for the institutions but, as you would expect, for the PRA. Mr Bailey can expand, but we are spending time on this thematically and across institutions. Certainly, the supervisors are spending time on that. As the economy recovers and the commercial real estate improvement broadens out, there is a reduction in this forbearance. This is, if you will, good forbearance. It worked.
Mark Garnier: Absolutely, yes.
Dr Carney: But you are right, there are a range of firms that are servicing their debts at very low interest rates but will not be able to at higher rates, and, quite frankly, that is part of the process and the recycling of capital and jobs and individuals that comes as a consequence of that. It does factor into—and now I am stepping back to the other committee—the MPC’s decisions in terms of the outlook for the economy and, therefore, the appropriate path of monetary policy, but I would not say it is decisive, in my personal view. The order of magnitude here is not decisive.
Q82 Mark Garnier: No, I can appreciate that. An economist will turn round and say this is not a bad thing to happen as those businesses have not collapsed over the last six or seven years and, therefore, you now have a mess as they do collapse. You have the trimming back, if you like, of the rose bush to allow the fresh growth and you get a proper redistribution of capital to where it needs to be used. Nonetheless, when we start seeing businesses going to the wall because the forbearance is no longer being offered to them, you then start seeing all the headlines coming out again and that is the point at which we as politicians or the bank as bankers or you as the central bankers will start coming under a lot of flack. I think it is very helpful for us in anticipation of this to understand what your feelings are about it and, to a certain extent, how you would respond to the criticism that a hike in interest rates can directly bring about job losses.
Dr Carney: Is that the question, the last sting in the tail there?
Mark Garnier: Discuss, yes.
Dr Carney: Yes. Well, since this is a Financial Policy Committee hearing, Mr Garnier, I am unable to answer that question directly. By achieving our remits, whether it is financial stability or monetary stability, we put in place the essential conditions for sustainable economic growth; therefore, sustainable job creation and income creation over time. That is the answer. We have to stay with our remits in order to put in place the right conditions for what is no longer a recovery, but we are trying to make our contribution to a durable expansion. Continuing forbearance ad infinitum to manage monetary policy for that purpose would not be consistent with either of those objectives.
Andrew Bailey: One thing I would add to support that is I think we have published at least once and maybe twice in Financial Stability Reports quite a simple chart that looks at the pattern of indebtedness of UK companies broken down between those that are either in the property market or dependent on property as a source of collateral and those that are not. It is very interesting over the last 10 years that those that are not have adjusted their debt levels quite substantially and quite rapidly and those that are have not, which goes exactly to your question. It is the latter group, of course, exactly to the Governor’s point about trends in commercial property prices, that I think (observing that there is a restructuring of balance sheets in response to those rising commercial property prices) will help to get that sector of the economy adjusted in the way that those that have been in the better position have already done. That is an important point to watch in the context of your overall question.
Q83 Mark Garnier: My final question is a general question to anybody who particularly wants to answer it. Do you collectively or individually think that the more efficient redistribution of capital as a result of this will come quick enough that any hardship will be relatively short lived for anybody who loses their job in terms of bad manufacturing circumstances?
Donald Kohn: When interest rates rise it will be in the context of a strong economy, and I think an important point that was implicit and a little bit explicit in what the Governor said was under those circumstances incomes will be rising, rents will be rising, property prices will be rising, and forbearance will be less necessary. I think that is a circumstance under which there will be more churn in the job market. People who might lose their jobs under those circumstances should find jobs more available. I think this will be a good time for the UK economy and for people in the economy. Rising interest rates will be a good sign under most circumstances. The adverse circumstance would be if for some reason inflation expectations rose, and that is the stress test that we are putting on banks. What you should count on is rising interest rates will be symbolic of a better economy. Everybody will be better off.
Q84 Mark Garnier: Mr Taylor, do you agree?
Martin Taylor: I note that the Garnier fusion of the MPC and FPC appears to have taken place. I agree with everything that my colleagues have said. I would just like to sound one note of caution about forbearance in the mortgage market. One of the things that surprised me coming back to the banking world on a different side of the table has been to see how long mortgages have got at origin. In the 1990s, a mortgage was between 20 and 25 years at origin, usually. Now it is often 30 and even 35. The reason is not hard to find. It allows people to stretch by spreading out the repayment over a longer period. It is a way of handling the stretch in John Mann’s ratio of incomes to prices. The beauty, if you like, of a relatively short mortgage term was that if the borrower got into trouble it was reasonably easy for the bankers to show forbearance by lengthening. With where we are now, even with people working into their 80s, it has become more difficult.
Andrew Bailey: This is a very important point that I would reinforce, which we are watching carefully because it is rising. It is rising as we speak almost. It is quite interesting if you look at other countries. Sweden is a really good case here. They have a pattern of very long mortgages, ridiculously long mortgages given life expectancy. My assessment would be that they also have a welfare system that means that lifetime income is more evenly distributed than I think we do here, but I do not have the figures in my head. I think we have to watch this very carefully because if mortgages extend beyond the point at which people’s income falls off, then we have a long-term problem.
Dr Carney: Just a coda to two very important points. This is one reason why when you are considering powers of direction for the bank over composition of mortgage portfolios that this is relevant to that debate, which will be before Parliament, because—
Q85 Chair: What do you mean “composition”? Do you mean by region or by sector?
Dr Carney: No, composition meaning of the portfolio, so loan to income, loan to value and amortisation, which would be part of a potential package so it is relevant from that perspective.
Q86 Chair: Okay. You did talk about the need to try to get the data better broken down by region and by sector earlier.
Dr Carney: Yes. If I may say, by region for house price, mortgages, it is not bad and—
Chair: It is already available.
Dr Carney: —marrying for income, but moving down to postcode level it is getting down, I would say, by cohort, by income strata and the behaviours of different income strata that become significant from a macroeconomic perspective. I know that sounds unnecessarily wordy but the experience—
Q87 Chair: People do tend to think that particular sectors or particular regions float on air, that somehow they will be exempt from downswings.
Dr Carney: Correct.
Chair: It is that that you are looking to address, presumably?
Dr Carney: Well, it is partly that but it is also what is the behaviour of C4 consumers when they have certain levels of mortgage debt through the cycle, when do you reach critical mass there in terms of having a broader macro or financial impact. You do need quite granular data. Amir Sufi and others’ work– I can give you the references—in the United States around the sub-prime crisis, really draws quite heavily on what in the US is called the zip code level
Chair: Is there something you want to add on that, Mr Kohn?
Donald Kohn: They have looked at income and indebtedness by zip code and consumption and they have found that what we have been concerned about in the UK did happen in the US, that is that more highly-indebted zip codes had much sharper falls in consumption.
Chair: Surprise, surprise.
Dr Carney: But it is the order of magnitude. Directionally that is clear but given the scale, where does it rise to a level that it merits policy action? The committee is comfortable we have taken the right action here but we can get better in terms of our analytics around that and that was the spirit of the original question.
Q88 Mr Mudie: Governor, we thought it was a good opportunity with you and Andrew Bailey being here to give us some reassurance—and certainly I would want personal reassurance. We had some questions down on high-frequency trading but after doing a bit of reading, if we asked you questions about that it would be too easy; it is the toxic mixture of high-frequency trading and dark pools, private exchanges. This is the “London Review of Books” reviewing Michael Lewis’ book. It says, “In the week of publication inquiries into high-frequency trading were announced by the US Justice Department, the FBI, the Securities Exchange Commission, the New York Attorney General, the Commodity Futures Trading Commission and the European Union”. We do not seem to have that same concern over here.
Do you want to whisper, Andrew? You can take the question if you wish. Could you reassure us that the Bank shares the same urgency and concern as these other organisations?
Dr Carney: Let me start and Andrew can supplement, or contradict.
The actions to which you refer have been announced, have been taken by authorities with responsibility for financial market conduct. These are conduct issues, which, as you appreciate, are not the responsibility of the Bank of England.
Q89 Mr Mudie: So it is Martin Wheatley to blame, is it?
Dr Carney: Well, it is the FCA’s responsibility.
Q90 Mr Mudie: That is what King used to say about the FSA and it is history repeating itself, that it is of no concern to the financial stability. I remember the 2010 crash caused by high-frequency trading among other things so it does have a financial stability part to it. So why is it of no interest to the Bank?
Dr Carney: There are issues of conduct around high-frequency trading and dark pools. I accept that. I have raised them myself, I raised them in a speech two months ago as part of a broader pattern.
Mr Mudie: That was also King’s line. He always raised the future crash in speeches.
Dr Carney: Okay. But the action that came was consistent with that speech for the areas that are under the direct responsibility of the Bank, which are fixed income, interest rate, foreign exchange and commodity markets. We have announced a review headed by Minouche Shafik, whom you saw last week—which includes Martin Wheatley and a representative of Treasury—and it is underway with her arrival. It is looking at broader market-structure issues. The issues around high-frequency trading are in the direct purview of the FCA. Where it becomes of interest to us given our mandate, Mr Mudie, is the impact—
Mr Mudie: I accept that. You need not go further because time is pressing. But that was why we reorganised the whole system because Lord King said, “It is the FSA’s job; it is nothing to do with me” although he was the Governor of the Bank of England and it ended up having a lot to do with him.
I am simply seeking some reassurance from this grand new structure. Here we have something that the European Union, all the regulators in the States, are chasing with great urgency—speeches are being made in the Senate—and when I ask you, you say, “That’s the FCA’s job”.
Dr Carney: This is quite straightforward. We are not the conduct regulator. We are not the securities regulator. But analogous issues—
Mr Mudie: You are the Governor of the Bank of England.
Dr Carney: I am. Analogous issues that are serious— fixed income markets where there is LIBOR, FX markets with FX fix, more broadly across—where we have some responsibility, any element of responsibility, we worked with the Treasury and launched—
Q91 Mr Mudie: Have you discussed it with Martin Wheatley?
Dr Carney: Yes.
Q92 Mr Mudie: Right. Can you tell me what he is doing and has been doing? How many dark pools do we have? How many banks have their own dark pools? What is the market share of the dark pools in the UK? It is 45% to 50% in the States. These are very, very serious questions. If you have spoken to Martin I hope it is of concern and what has Martin said back to you? What has he said: “I’m on to it. I’m doing this, this and this”?
Dr Carney: The chief executive of the Financial Conduct Authority is very capable of responding to questions that are directly in his responsibilities. It is not my role to be his spokesman.
Q93 Mr Mudie: All right. Do you know how many dark pools there are in the UK? It is just a question; you do not need to elaborate on it. If you say no, fine. I don’t know. I can’t find out.
Dr Carney: The precise number I do not know. I know that the volume, though, of high-frequency trading as a proportion of LSE volume is substantial. It is preponderant.
Q94 Mr Mudie: You are asking me to ask Martin. That is fair. But did Martin give you reassurance?
Governor, I will tell you why I ask and why I frame it this way. At your first meeting I felt I would never play cards with you. Your director of markets sitting beside you was asked by Andrea Leadsom about how we were dealing with forex and he was responsible for the markets. She asked, “Have you been looking into it?” We were just on the back of LIBOR. He said, “We have gone through a process recently of asking people whether they knew of any other issues in the markets. It is not our job to go off hunting for rigging of markets”. Your face had just the slightest tremor, but it was just so slight I wouldn’t play cards with you.
She then asked, “Is it not the Bank of England’s job to do that?” “Not to go out searching for it. If we come across it, that is very important to us”. Now, there is a book here, “Dark Pools” 2012, Scott Patterson. He pre-dated Michael Lewis. It goes into huge detail right from the start. The title is very interesting. “Dark Pools: The rise of the machine traders and the rigging of the US stock market” 2012. Is it not a legitimate question to ask: have our regulators read the book; have they done anything; are they doing anything? If not, it is not very reassuring that we have put all this money in to get in a new regulatory structure that has the same faults as the last one.
Go on, Andrew.
Andrew Bailey: There are three legs to this. Market conduct is the direct responsibility of the FCA.
Mr Mudie: Yes, I am well aware of that.
Andrew Bailey: The Governor has set out the work that the Bank is doing with the FCA on the fair markets review. The third leg of it, my own concern, is what does this tell us further about the governance, culture and risk management of institutions? That is a big issue. So please do not think that we are inactive on that question because we are not.
Q95 Chair: You would agree there is systemic risk in these markets too?
Andrew Bailey: Yes.
Q96 Chair: Also destabilisation. So you do have a responsibility beyond governance?
Andrew Bailey: But also, as I have said quite openly—I said it last week—the continued series of legal actions related to conduct that are coming up—they are mainly US actions but as Mr Mudie says, this is not uniquely US activity—
Mr Mudie: This is in both markets.
Andrew Bailey: Absolutely. I am just about to agree with you.
Mr Mudie: I get it. You are argumentative even when you are agreeing with me.
Andrew Bailey: I am going to agree with you. This is true of anti-money laundering; it is true of financial sanctions. These are not uniquely territorial activities to one country. But these actions are coming up in the US and they are a very big issue for us at the moment in terms of the consequences of them from the point of view of prudential regulation and financial stability. So there is a question of dealing with the consequences but then there is a bigger question of what does this tell us again about risk management, governance, culture.
Q97 Mr Mudie: This is all very good theory, Andrew, but tell me—
Andrew Bailey: It is not theory, it is practice
Mr Mudie: —do you know how many dark pools there are? Do you know what your colleague in the Financial Conduct Authority has done on it? For example, I think you said, “We have set up a review, he has set up a review, and we have set a review up with the Treasury”. Right. But if there is a book that comes out and names a British bank at least but a behaviour that is clearly more than it is in Europe and they are investigating it, you would expect the UK to say, “If it is there, it is here; we had better go into these dark pools”. First, are these dark pools regulated? Secondly, to your knowledge, after your conversations with the person responsible, a colleague, have they gone in to these organisations and looked at their systems to see if there is front-running; to see if there is favouritism given to certain partners; all sorts of behaviours that are in this book, detailed fiddles that have been going on for years?
Andrew Bailey: These dark pools are predominantly based in the US but they have activity that goes outside the US borders. You really have to ask these questions to Marin Wheatley. I cannot answer these questions on Martin’s behalf. They are important questions and I do not think Martin would disagree with that, but you really must ask Martin Wheatley.
Q98 Chair: There is an aspect in these question that I think it is reasonable to ask you about, Andrew, which is how much information is being passed from the FCA to the PRA, given that we used to have a unified regulator and you are now separated. What is the co-operation like and can you give us some evidence of that co-operation by telling us some of the data that George is asking for?
Andrew Bailey: The information is passed. If there is an enforcement action taking place that puts limits on the passing of information while that activity is undertaken. Otherwise there is a fairly open passing of information. I am sorry; I do not have the information. I am happy to send you the information or I will ask Martin to send it. I will do one or the other. That is absolutely fine. No problem doing that whatsoever.
Q99 Chair: We would be delighted to receive it.
But are you saying that if you have some concern about a firm and an enforcement action is started by your sister regulator, you find yourself having no access whatsoever to that information?
Andrew Bailey: No. It is constrained while they conduct the case.
Q100 Chair: Let’s just clarify what this constraint is. What is this constraint?
Andrew Bailey: It is a legal constraint.
Q101 Chair: I understand the legal constraint. But are you getting the information? Is there a window or an avenue to obtaining all the information that might be relevant—
Andrew Bailey: Yes
Chair: —to enable you to do your job in the light of the fact that information is now being collected on somebody who is in an enforcement action.
Andrew Bailey: Let me distinguish two sorts of questions. The questions that Mr Mudie is asking, I would have no difficulty getting that information.
If you asked me a different question, which was, “So the FCA are doing an enforcement investigation, so who are the guilty people?” I would say, “No, I cannot get that information because that is a case that is proceeding”. You know the issues.
Chair: We are not talking about that.
Andrew Bailey: I draw that distinction.
Chair: That is a straw man.
Andrew Bailey: No, I was drawing a distinction in an enforcement case. Mr Mudie’s information, yes, you can have that. I do not have it here today but you can have it.
Q102 Mr Mudie: No, I was looking for reassurance. We have a new structure. This is not a single trader misbehaving. This is a new phenomenon, high-frequency trading, disappearing into a private institution. I have asked, “Are they regulated?” You do not know. I have asked, “Have they been visited and their logarithms looked at? Have they been front-running?” You do not know.
Dr Carney: If I may?
Mr Mudie: You may.
Dr Carney: Thank you. We have enormous responsibilities at the Bank of England; enormous responsibilities. Those responsibilities do not include direct supervision of conduct or equity securities markets. Those markets are regulated and supervised by the FCA.
Q103 Mr Mudie: What I am asking is this: those dark pools that you do not know the existence of, how can you tell me they are regulated? That is the assurance I am looking for.
Dr Carney: It is the responsibility of the FCA.
If I may reinforce another point, Mr Bailey’s cultural point, which becomes a prudential concern and if it is widespread enough becomes a financial stability concern. We are concerned enough about the structure of fixed income markets, foreign exchange markets and commodity markets—and not just the structure of those markets, but the conduct in those markets—to have launched with the Treasury and with the FCA a major review of those markets, which intends to come to specific recommendations.
Q104 Mr Mudie: I want to ask you about that. That was my last question. I am interested in the past and it looks like the present. Regulators have been so idle that they do not care to go and look; they care to hear, see and eventually produce a line and new regulations. Well, that is what is happening here. By the sound of it he has not gone in but, “We’re reviewing it”.
Now there are two reviews going on. There is the FCA review but their reference to dark pools and high-frequency trading is just about co-location, which is just a physical thing that we all know about. Your political review announced by the Chancellor at the Mansion speech on the same markets, the wider markets but including this, is just so general. Which review can we be reassured is going to cover the relationship and operation of high-frequency trading within dark pools: the regulation of it; the ownership of it and the conduct of it?
Dr Carney: Okay. Two points, if I may. Equity markets are outside the review in which the Bank of England is involved; the fair and effective markets. We are not addressing those issues. They are out of scope of that issue. It is the responsibility of the FCA to be absolutely clear.
I would not accept the characterisation of the review of our fixed income markets, of FX markets, of commodity markets. There will be changes that we are helping to drive internationally. There will be changes to the structure of how these markets work; how LIBOR is set; what is the underlying floating interest rate for derivatives contracts; how the FX fix is set; how other commodity fixes are set. Those are changes to how these markets work. There are consequences for what is a regulated activity, some of which was announced by the Chancellor at Mansion House but there could be other consequences, other standards could be brought into those markets. That is the point of that review. It is a real review. It will have consequences and it will have consequences because London is the centre of global markets and our markets have to be seen to be, and to be in fact, the fairest and most effective markets. So it is a wide scope but—your specific question—it does not include equity markets, which are the sole responsibility of the FCA.
Andrew Bailey: Can I make one other point? As I understand it one of the key points in the allegation on Barclays’ dark pool is that—
Q105 Mr Mudie: So you have read this?
Andrew Bailey: I am aware of it.
Q106 Mr Mudie: But you have not read it? Andrew, you should read it.
Andrew Bailey: I am coming up to the Barclay case. Please let me finish. There was a misrepresentation by Barclays of the way in which clients were using the dark pool.
Mr Mudie: I am not asking you about Barclays. Barclays is mentioned just in passing. Yes, you are right; this allegation against Barclays is different from the Goldman Sachs one, we know. But Barclays is up to the same conduct as the rest and it is documented in this book.
Andrew Bailey: Can I just finish what I was saying?
Chair: Finish the point you were on, Mr Bailey, and then I am going to ask George to have another shot.
Andrew Bailey: The allegation is that there is misrepresentation in the description of the operation of the dark pool by Barclays to its clients of the way in which the clients were given access to the dark pool. I have read the Barclays dark-pool literature so I understand how they represented the dark pool to their clients. What I have not seen because that information has not yet come out of the US yet, I believe, is the information that backs up the allegation that they have misrepresented it. Of course we have an interest in that for the reasons that I gave you but that is not my direct responsibility. But I do have a very clear interest in it because it is very relevant to risk management, governance and culture.
Q107 Chair: I would like to ask you, Dr Kohn, since so much of this derives from US experience, whether you have examined this issue carefully and offered your view to the FPC.
Donald Kohn: I have not, Mr Chairman. I do not have any special expertise in the high-frequency trading and dark pool area; I have not
Q108 Chair: It is important that we get to the bottom of the extent to which there is consumer benefit from dark pools, which it is widely held by participants that there is, and the extent to which it nonetheless is creating scope for abuse at a broader level.
Did you want to say something, Mr Taylor?
Martin Taylor: I would simply say that, like Andrew Bailey I have, with my FPC hat on, been very concerned about the governance and culture issues and the conduct costs. These bills are piling up for these institutions. But I am grateful to you for alerting us to what you think are systemic risks. We’ll look at them. Systemic risk are in our business.
Q109 Chair: We will be coming back to this subject as a Committee and we will probably have a brief word about it in an informal session.
Mr Bailey, a moment ago you said the US investigations into high-frequency trading raised prudential issues; I think that was the phrase you used. How? Is that through the size of the potential fines? Or is that because of what has been uncovered.
Andrew Bailey: Two things. Let me just broaden it for a moment, if you don’t mind, from high-frequency trading to the other cases that are coming up. There are two aspects to this. There is the fine. The level of fines, as Martin has just said, of course is a substantial headwind to the rebuilding of capital in the banking system. But let me be clear, these banks cannot be immune to prosecution. That must be clear.
The thing that is also a very clear issue that we have to deal is that where there is the prospect of action being taken as a consequence of these cases that would disrupt the operation of the institution—this is particularly true where there is for instance a suspension of access to dollar clearing, which we saw in a recent case—we have to be very clear that we can handle that from the point of view of the stability of the system and that there is sufficient contingency planning—punishment is necessary—that the consequences of those actions can be managed from the point of view of the system. That is something that we are very focused on—it is a very intensive activity—because we have responsibilities in terms of financial stability and safety and soundness that go directly to that.
The second thing is that there are the consequences of what we learn from these cases for what is directly relevant to prudential regulators, which again is risk management, governance and culture.
Q110 Mr Mudie: Andrew, can I just say this? You have said that very quietly and I will say this very quietly. We all were saddened by the way the old structure worked. Here was a crisis—Northern Rock was the starting point—where the Bank saw it was not their business and blamed the FSA and the FSA clearly tried to speak to the Bank. But they were different institutions. We have spent millions and brought in a lot of highly-paid staff and when I raise a matter that as the Chairman says could have systemic consequences—and you agree—“That’s their job”.
Andrew Bailey: I have tried—
Mr Mudie: No, no, not the statistic but, “They are examining it. They are controlling it. They are interfering in it and stopping it. That is their job”.
Chair: I think this is a conversation we will develop later. You have heard the concern from the Committee. Have one last rejoinder.
Andrew Bailey: You created a system, which I have been a great supporter of, that gave responsibilities to the prudential regulator and the conduct regulator. I think that is a substantially better system than the one that came before.
Q111 Mr Mudie: Why? You still do not talk to one another.
Andrew Bailey: We do talk to one another. But what I will not accept—
Mr Mudie: Not in enough detail.
Andrew Bailey: No—sorry—I do not accept that. What I will not accept is the idea that therefore we have to cross over each other’s responsibilities. We talk to each other. Martin and I talk to each other very regularly, very frequently. It is not a question of Martin and I not talking to each other. But we do that in the context of respecting the objectives and responsibilities that Parliament gave us.
Q112 Chair: Have we got those objectives in the right places, Mr Bailey?
Andrew Bailey: Yes.
Q113 Chair: Do you think in practice, with market risk being divided—conduct risk in one place and systemic risk from markets in another—that although it looks pretty on paper, this is a practical way in the long run to regulate markets? I am asking Mr Bailey.
Andrew Bailey: We will no doubt learn a lot from all the work that has been going on. I think it is possible to do it but it is a reasonable issue for you to raise that all the work that has to be done through the fair markets review, for the work that the FCA has to do—
Chair: That is the point I am asking you about.
Andrew Bailey: —has to prove, does this system work. A lot of what has been done by the FCA so far has been in the consumer conduct area. Mr Mudie is absolutely right that this raises big issues in wholesale markets, so these are right questions to ask.
Q114 Chair: I want to end by asking the Governor a question where we began. I began by asking questions about leverage, which we have had virtually no time to look at as a Committee because the paper came out just before the hearing today; less than 48 hours before the hearing. I have now got to page 35 while I am sitting here—it is the last page—and there I discover that this consultation period ends on 14 August, in the middle of the holiday period. Why did you choose four weeks for the consultation for something you yourself have said is an extremely important issue?
Dr Carney: The timetable is dictated in part by the parliamentary timetable. The intent is to have legislation in this Parliament. So there is the feedback from this consultation—
Chair: We have another whole year of that.
Dr Carney: If I may: there is this consultation; feedback from that consultation; the FPC’s incorporation decisions or recommendations around the structure; then Treasury has a responsibility to undertake their consultation. At that point we are towards the end of the year, November——
Q115 Chair: So was this because Treasury came to you and said, “In order to give Parliament time we had better get an answer back”?
Dr Carney: No. It is a product of several things. First it is a product—as Mr Kohn and I indicated earlier—of extensive debate and analysis by the FPC itself around the issues, so this paper was produced. We had a special FPC meeting in order to sign off on this paper last week.
Q116 Chair: That is all fine but I am trying to get to the four-week consultation. That is all I am asking about. Why only four weeks of consultation and why in the holiday period? That is what I am asking.
Dr Carney: In order to be consistent with the parliamentary timetable, this is what we need to do.
Q117 Chair: So this was the Treasury coming to you and saying we have to get this through Parliament?
Dr Carney: No, it was not—
Q118 Chair: So you were taking a judgment yourself on what you thought Parliament would like. Who has been telling you that this is a parliamentary-timetable-driven question?
Dr Carney: We have been advised by colleagues, including those in our parliamentary affairs area, in terms of what time is needed.
Q119 Chair: These are very long answers to the question. Was it staff who came to you and said, “14 August, Governor”?
Dr Carney: Our intention is to put Parliament in a position to decide whether or not these powers should be given to the Bank of England. We are working to a timetable consistent with that. We were given the opportunity to produce this. We produced it. There are two consultations; this one and the one that comes from Treasury. There is a Treasury observer on the FPC who provided input as well on the optimal timing of this.
Q120 Chair: Okay. Are you familiar with the Government’s advice to public bodies on consultation periods? Has anybody ever alerted you to the fact that this advice exists?
Dr Carney: I have a feeling someone is about to alert me to it. No one has alerted me to it, no.
Q121 Chair: I do think it is worth your taking a look, Governor. It says that at least 12 weeks is recommended for big new issues such as this—and certainly ones that involve controversy—and that holiday periods should be avoided. Two weeks of the four fall in a holiday period. I think the lack of time to think through this paper will generate quite a lot of concern out there and unless there is a cracking good reason, which neither you nor I have been able to identify in this brief exchange, there may be a case for lengthening that consultation period. I would ask you to reflect on that and take it away.
Dr Carney: I shall do so.
Chair: Thank you very much all of you for giving evidence. It has been extremely interesting and enlightening. I am sorry it has gone on a little longer than planned but I think it was worth letting it run.
Oral evidence: Bank of England June 2014 Financial Stability Report, HC 494. 14