Oral evidence: The Appointment of Alex Brazier to the Financial Policy Committee, HC 1081
Tuesday 17 March 2015
Ordered by the House of Commons to be published on 17 March 2015
Written evidence from witnesses:
– Alex Brazier’s pre-appointment questionnaire
Members present: Mr Andrew Tyrie (Chair); Rushanara Ali, Steve Baker, Mark Garnier, John Mann, Jesse Norman, John Thurso
Witness: Alex Brazier, Executive Director, Financial Stability Strategy and Risk, Bank of England, gave evidence.
Q1 Chair: Thank you very much for coming to give evidence to us this morning, Mr Brazier.
Alex Brazier: Thank you, Chairman.
Q2 Chair: To some of us, you are a familiar figure informally; when we have met the Bank, you have often been in attendance, telling the Governor what to say. I am sure you disagree with that, but you are the unofficial Governor.
My first question to you has to be this. Are you one of nature’s insiders? This is now a public role. Is this the appointment of an insider’s insider?
Alex Brazier: It is true that I have spent my career at the Bank of England, but I see myself now as an independent, albeit internal, member of the FPC. Although I have spent my career at the Bank, I have not spent it telling people what I thought they wanted to hear. In fact, particularly over the past three years, when I have worked for two Governors, I have spent a lot of my time telling people, who on paper are significantly more senior than me, exactly what I thought.
I wouldn’t have taken the job, made the personal sacrifices and gone prematurely grey, which it involved, if I hadn’t been able to have a voice. I always found that I was able to say what I thought, and I always found both Governors and other senior people at the Bank very willing and able to listen to me. That is not to say that they always agreed with me by any means, but I have made a career out of saying what I think and being an independent actor. I have at least three years’ experience of telling people more senior than me exactly what I think, and I intend to carry that on at the FPC.
Q3 Chair: An unusual and interesting way to describe being the principal private secretary to a Governor, or the chief of staff to a Governor, is to say, “Far from being his eyes and ears, I was actually demonstrating independence behind the scene and running the show myself.”
Alex Brazier: I am not sure I was running the show in any way, shape or form. In some ways, I was his eyes and ears, and I ensured that he was well briefed on all the issues that he should have been briefed on. It is vital—you will know this, as senior people—that the people closest to you are able to tell you honestly and truthfully what they think. If I had just told them what I thought they wanted to hear, I would have been of very little use to either Governor I worked for. For me, moving on to the FPC and being, in a sense, mandated to say what I think all the time is not a step that I consider to be—
Q4 Chair: So when you speak up on the FPC, the Governor won’t be a bit surprised; he will just be hearing it in a slightly wider audience.
Alex Brazier: I imagine so, yes.
Q5 Chair: There is a second aspect of your appointment that might give cause for query. You have very extensive knowledge of monetary policy, but what expertise are you bringing to the piece on the FPC?
Alex Brazier: Three or four things. First, when the crisis hit, I was a part of Governor King’s office—I was his speechwriter. In that role, I played not just a speechwriting role; I was also responsible for—
Q6 Chair: You were offering him advice.
Alex Brazier: I was also responsible for playing a key role in some of the work post-crisis in reforming the Bank’s monetary framework to support financial stability. I played a role in the Bank’s management of the response to the financial crisis.
After that, on the forecasting group of the Bank, although I was responsible primarily for serving the MPC, I had a key role in analysing the effects of the financial crisis on the economy, which was a key part of our forecasting job at the time. I am well placed to continue analysing the links between the real economy and the financial sector, which will be a key part of the job on macroprudential policy.
The third thing to say is that over the past three years, I have been at the centre of the Bank as it has broadened out and accumulated new responsibilities—not least, of course, the FPC. I have been in the Governor’s office almost from the inception of the interim FPC up to the latest stress-testing exercise and the recommendations on leverage and housing-related tools. I have been very close to the development of the FPC for at least three years now, and I have in-depth experience of the domestic regulatory agenda. Also, in supporting Governor Carney as chair of the FSB, I have in-depth experience of the development of the international regulatory agenda as well.
Q7 Chair: Are you happy with the way the FPC is handling work, or have you got proposals in mind for reform?
Alex Brazier: I am happy with the way the FPC has established itself as an operational committee. It has established itself as having some bias to action, which is important that we preserve over time, and it has established itself as a real committee with real tools. It has made—I imagine it will continue to make—recommendations for tools that it should have to deal with risks as they emerge. In that sense, yes, I am very happy with the way the FPC has conducted itself. It is not a finished job, by any means. The regime is still in its infancy, compared with most economic policy regimes.
I talk in the questionnaire about the number of challenges that the FPC faces. Let me quickly highlight three. The first is to really establish clarity about the framework itself. With monetary policy there is a clear numerical inflation target, and we are obviously some way away from that. I don’t think we will ever get all the way there, but we should have a serious multi-year research agenda to bring as much clarity as we can to what we are trying to achieve and the instruments we use to achieve it.
Secondly, the FPC has a big job to play in explaining itself—not just to the financial sector, but to the public at large. We start from a position where the FPC and its work is not widely understood. As I say in the questionnaire, it is vital that it is understood, because its decisions directly and indirectly affect the availability of credit.
The third thing I would highlight is the need for the FPC—inevitably it has largely, but not exclusively, been focused on the need to restore resilience in the banking system—to broaden out a bit more and look more closely at the risks outside the perimeter of the banking system in so-called market-based finance. To answer your question in shorthand, I am very pleased with the way the FPC has developed itself to date, but it is absolutely no way a finished project. That is what makes this job so exciting.
Q8 Mark Garnier: Good morning, Mr Brazier. Can I ask a few questions about the potential risk coming from Europe? I will start with the obvious one, which is a Greek exit. How likely do you think Greece is to exit from the euro, and what effects do you think that would have on the UK economy? Indeed, what contingency plans is the FPC putting in place?
Alex Brazier: First, I don’t presume to know how likely it is that Greece will leave the euro. Although the economic issue regarding Greece is, in some ways, very simple—there is a debt overhang that needs to be dealt with—the way it is dealt with is a political issue, and I don’t presume to be able to forecast the probability that the Eurogroup and the Greek Government will reach the necessary agreement on the way to deal with that debt overhang.
The direct impact of any event in Greece on the UK is relatively small. UK banks have exposures amounting to about £2 billion, which is 1% of their common equity, to Greece. The real risk is that a bad outcome to the negotiations could trigger a broader reassessment of risk in financial markets. As I say in the questionnaire, we start from a position where market pricing looks potentially subject to correction. I don’t view the situation in Greece as a big, direct risk, but it could potentially be a trigger for a market reappraisal.
It is beholden on the Bank to make contingency plans for a wide range of events. I don’t think it is sensible to give a running commentary on those contingency plans as we develop them. It is important after the event that we provide as much clarity as possible about what happened so people can begin to learn about the sorts of plans we generally make. That is exactly what we did, of course, with the Scottish referendum. But as a general rule, I don’t think it is sensible to give a running commentary on the contingency planning process.
Q9 Mark Garnier: As indeed you did with the Scottish referendum.
Turning to the wider market—you referred to the market valuations—Frances Coppola wrote a Financial Times blog entitled “The ECB’s policy mix is poison for banks”, in which she made an interesting comment; I would be interested to hear your views on it. She said, “The current policy mix is deadly for banks”—this is QE and negative interest rates in Europe. “QE imposes on the banking system additional reserves that it does not need, while the ECB’s negative rate taxes banks for holding those additional reserves.” How do you see that quandary?
Alex Brazier: I have two points to make. The most important is that all this—any monetary policy, European or otherwise—has to be seen in the context of the target that the monetary policy framework has been given. The ECB is pursuing its inflation target using a variety of tools at its disposal. It is vital that it does that.
Secondly, what you might call exceptional settings of monetary policy, as we now have in many countries, are obviously capable of generating financial stability risks. In those circumstances, it is vital for macro-prudential policy—and, to some extent, micro-prudential policy—to manage those risks so that monetary policy is not distracted from being anything but the very last line of defence against financial stability risks. It is true that quantitative easing has side effects, although, by the way, I do not see it as a tax on the banking system.
Q10 Mark Garnier: The inference being that the negative interest rates are an effective tax on the banking system—QE is forcing the banks to have greater deposits than they would otherwise want.
Alex Brazier: Although, of course, the other channel of QE is that it encourages banks and other investors to invest in other sorts of assets, thereby boosting the real economy. That is vital for financial stability. To the extent that there is a short-term cost to the banks from quantitative easing, that has to be seen against preserving broader economic stability, which has to be good for financial stability in general.
I would return to the point that exceptional settings of monetary policy do make macro-prudential policy a vital complement to it, which is why, not only in the UK with the FPC but in Europe, with national regulators co-ordinated through the ESRB, it is essential that the risks really are addressed and managed.
Q11 Mark Garnier: You talk about pushing money out into certain different areas; what then happens is that investors change their risk profile and are actually getting surprisingly little compensation for the greater risk that is being taken as people are forced to do it.
Another Financial Times columnist, Wolfgang Münchau, makes quite an interesting point about German life insurance companies, which are also struggling from the fact that they need to give these returns. In the longer term, we will potentially see a number of them unable to meet their liabilities. Because of that, some of them are pushing out into the slightly more exotic end of investment in order to get better return to meet their liabilities. Is that not another example of how negative interest rates are causing quite significant stress on big financial institutions?
Alex Brazier: I would not view it as an issue of negative interest rates, per se—
Q12 Mark Garnier: Or very, very low interest rates.
Alex Brazier: I would view it as very, very low interest rates. It is an example of where financial companies that have perhaps made promises more suited to a higher yielding environment potentially get into some difficulty, particularly if the policy setting persists for some time. That emphasises the importance of macro-prudential policy broadening out beyond the banking system.
Although UK insurers have not made anything like the sort of promises to which you referred, there are issues with the generation of a search for yield in a very low interest rate environment. The most egregious example of that in the insurance sector was, of course, AIG, which got into both excessive credit risk-taking through writing vast amounts of CDS, and vast amounts of liquidity transformation through a securities lending programme.
We do not have any insurers behaving quite like that, but that is why we must keep a watch outside the regulatory perimeter, because search-for-yield risks will not necessarily occur inside the banking system; in fact, I would suggest that they are most likely to occur outside the banking system. That is why I think there is merit in broadening our focus and in developing things such as the stress-testing of the insurance sector as well, to ensure that we are managing the risks, particularly those posed by a potential prolonged period of low interest rates.
Q13 Mark Garnier: I have one last question on the EU and financial regulation. You said in your written evidence: “The forthcoming EU banking structural reform proposals must retain sufficient flexibility for the UK to continue to implement its own structural reform measures.” My question is twofold. First, how likely do you think it is that the rules will allow us to have our own flexibility?
Secondly, on a much more profound basis, a huge amount of financial regulation coming from the EU refers to the eurozone. A simple example is the clearing houses, where the previous rules were that you could do clearing houses only within the eurozone area. We are now the only country in Europe—notwithstanding what might happen with Greece—that is so far absolutely guaranteed not to join the euro, thereby ultimately leaving us as a country of one with non-eurozone membership of the EU, where everyone else has eurozone membership. In this country we have a very strong financial services sector and that is very important to our economy.
On that basis, do you think that in the very long term we have a problem in that we are going to become increasingly isolated from the rest of Europe in terms of financial services so that we will not be able to keep control of our regulations? Do you see that as a disadvantage or is there a possible advantage?
Alex Brazier: Starting with the first question—trying to remember back to it; it was some time ago—at the minute, I have no concerns that the forthcoming EU structural reform regulation will not include the necessary carve-outs for the UK. It is absolutely something that we should make sure we continue to keep an eye on, but it is not a concern that that carve-out should disappear.
On the UK’s role in European financial regulation, I have a couple of points. First, you referred to clearing houses, and I think I take some comfort from the recent ruling of the European Court that these sorts of issues are a single market issue rather than a eurozone issue. It is of vital importance to us that we continue to view financial regulation as a single market issue rather than a single currency issue.
You referred to the UK’s importance as a financial centre. That makes it even more important for us than it is for many other countries that not just our financial system but other financial systems, particularly those to which we are connected, are resilient. Being part of a single market and a single financial regulation system is helpful in that regard. Let me give an example.
The EU has in some ways led the way globally on implementing reforms and regimes to enable resolution of banks. The European BRRD was one of the first and most detailed regimes to give national regulators the tools to resolve failing banks. I think that significantly benefits the UK, not just because we now have that sort of regime but also because those people with which we are most closely interconnected also have that regime. From observing the development of those rules, I can tell you that the UK had significant influence on their development, and that is partly because of the UK’s position as a financial centre, as you described. Being a part of that debate has, I think, been quite valuable to the UK.
Q14 Jesse Norman: Welcome, Mr Brazier. You placed a lot of emphasis in your earlier remarks on your willingness to speak truth to power with two successive Governors, so I was surprised that when Mr Garnier asked you a perfectly straightforward question on how you assess the risks on Grexit, you ducked as though it was a purely political question. Of course it isn’t. The Bank has to reach a view about the likelihood of Grexit and you are at the centre of that decision-making process. Would you like to say a bit more about what you think about the risks on Grexit? From a truth to power perspective, though we don’t have any power here.
Alex Brazier: You are a very powerful man, Mr Norman, surely. Let me speak truth. The truth is, as I said to Mr Garnier, that it is extremely difficult to assess the likelihood of a Greek exit.
Q15 Jesse Norman: Right, but that is what I am asking you to do. What is the likelihood? Is it a high, medium or low likelihood?
Alex Brazier: I really cannot say because it is an exercise in political forecasting rather than economic forecasting.
Q16 Jesse Norman: But so is the Financial Policy Committee. You have to make decisions about things that are going to be highly contentious politically. There are political inputs. It is about the housing market and things like that. You are going to have to make those substantive judgments. I asked you a perfectly straightforward question about a substantive judgment involving some politics, where the economic question is at issue, and you can’t or won’t answer it. That worries me because we are putting you on the FPC.
Alex Brazier: Let me come back to your housing market example for a second, just to speak some truth to your power again. I would distinguish that from the Greek issue. The FPC’s decisions on the housing market may have political ramifications but they do not involve forecasting any political outcome. The FPC is taking decisions on housing market tools from a purely economic and macro-prudential perspective.
In the case of Greece, as I said the economic issue is very straightforward: there is a debt overhang that needs to be dealt with. The political issue—and I do not pretend to have any insight into how the euro group can or will in the end reach an agreement with the Greek Government—is much more difficult to forecast. That does not mean we should not do anything about it.
Q17 Jesse Norman: I understand that. Will you give us an example of an area where you have had a material disagreement with either of the two Governors you have been working with?
Alex Brazier: First, let me say that, as I think you would expect from your closest advisers, there should be some degree of doctor-patient confidentiality between Governors and their private secretaries, after all, so I would be cautious about highlighting areas where I had particular disagreements at any point in time, but let me give you one example going back a few years to 2012. I am not sure that it classes, to be honest, as a big disagreement, but in 2012 I was an advocate of combining of what you might call hawkishness on capital policy with what you might call doveishness on liquidity policy.
This was a period when the SLS was coming to an end, so in effect liquidity conditions were tightening. I did not encounter any particular disagreement, but I felt the need to advocate the position of replacing the SLS with some other mechanism. I advocated that position to Governor King and he discussed the issue with very many other people; I stuck to my guns throughout; and in the end the Bank was developing things such as the FLS.
Q18 Jesse Norman: That is interesting. Who do you think has been the better Governor, Mr Carney or Sir Mervyn King?
Mark Garnier: Take the fifth.
Alex Brazier: I shall certainly take Mr Garnier’s advice on this one. Let me give you what you might call a boring answer. What I found striking about Governor King and Governor Carney were their similarities, in that they are both incredibly committed public servants and both incredibly demanding of analytical rigour and performance of their staff. If I had to ascribe my recent success to any one thing it would be that both of them pushed me to the edges of my limits.
Q19 Jesse Norman: Gosh. That is a withering indictment.
How do you prep Governor Carney for his meetings with us?
Alex Brazier: Good question. We go through a number of steps. The first thing is to try to identify the sorts of issues that you will all be interested in. For some sessions that is much easier than for others. In an inflation report hearing, for example, the topic will of course be the inflation report. My role in my previous job was then to ensure that staff teams provided briefing on all the issues that—
Q20 Jesse Norman: Do you go through the Twitter feeds, Facebook posts and all that?
Alex Brazier: I don’t think so. Using the inflation report example, we go through the substance of the inflation report, to make sure that Governor Carney and in fact all the other committee members who appear before you are fully briefed on all the issues that were in that report. The same applies to the financial stability report.
Q21 Jesse Norman: Interesting. You are sitting in the bath and you think, “What would I do if I were the Governor of the Bank of England now?” What is the big thing that you would do if you were the Governor of the Bank of England?
Alex Brazier: That is purely hypothetical, of course. I am not the Governor of the Bank of England; I am the Executive Director for Financial Stability Strategy and Risk.
Q22 Jesse Norman: We are testing your ability to give advice to the Governor. That means that you have to think in his role. You are taking his persona on and wondering, “What would I do if I were in that position?” You are lying in the bath and thinking, “Gosh, I really need to regulate this or that.”
Alex Brazier: It is absolutely not my job to put myself in his shoes. Going back to the Chair’s original question, it is my job to be an independent actor on the FPC and not to try to think about things necessarily from his point of view.
I would highlight a couple of things, just to play with your question a little. Both, I think, are the same as the direction the Bank is moving in under its current strategic plan—and this is relevant to me in my new role as Executive Director. First, it is absolutely vital that in having all these new functions the Bank does not deploy them in a sort of siloed way. At the top of the Bank, the Governor is the one person who can give real direction to joining these things up. Over the past 18 months, since the Bank has had all these new responsibilities, I think that in that respect things have performed incredibly well. It is vital that that continues.
Secondly, it is vital that in my area, as in other areas of the Bank, we continue to develop a culture in which not only me—as I talked about—but everyone is not scared about speaking truth to power. I have to develop a culture where I make sure that I listen to people too. As I say in my questionnaire, in macro-prudential policy it is vital that we have a culture in which people genuinely do worry a lot about risks and are not easily persuaded that things are not a problem.
Q23 Jesse Norman: One final question. How are you going to remedy your lack of direct experience of financial stability? How are you going to make yourself an effective person in that area, since it is essentially, in direct terms at least, new to you?
Alex Brazier: First, as I said to the Chairman at the outset, this is not a new area to me. I would highlight one area, which I mention in the questionnaire and which goes back to the need, as I said to Mr Garnier, to take the boundary of macro-prudential policy well beyond the banking system. I intend to do a couple of things in that regard. The first is that within the regulatory community, we have to—I will take a lead role in this—develop our relationship with the FCA to the same level as we have with the PRA. That relationship has developed not just because the PRA is a part of the Bank, but because the FPC has been focused on the banking system to some degree. My job will be to take the relationship with the FCA up to the same level, so that we can broaden out into market-based finance.
The second thing I have to do—this is not something that I have been active in over the past few years—is to go out and engage directly with financial sector participants. There is a big job we have to do in collecting intelligence from the financial system, and we have to do it from places where maybe we do not have much data. We must avoid the tendency simply to focus on risks that are easier to measure than others. So I intend to spend a lot of time engaging with financial sector participants and seeking intelligence about developments in financial markets.
Q24 Steve Baker: Good morning. The Bank’s stress tests: what is wrong with them and how would you improve them?
Alex Brazier: The first thing to say is that the first concurrent stress test of the banking system last year was a big step forward for macro-prudential policy. Let me start answering the question by telling you what is right about them, and then I will tell you what we can do in the future with them.
What I think marked last year’s stress test out is two or three things. First, it was really tough: it had a 35% fall in house prices embodied in it, for example. Secondly, by testing firms concurrently, you can see whether things add up. The FPC was keen to ensure that the banking system was not in any way an amplifier of the stress, so from a macro-prudential perspective, firms were not allowed to assume they responded to the stress by cutting back their lending, since that would mean they were an amplifier of the stress. Those sorts of macro-prudential judgments had not been fed into stress testing before. In that regard, it was a great success.
How do we need to take it forward in the future? I would say maybe three things. First, from a macro-prudential perspective, it would be great to think about linking the scenario severity to the stage of the cycle, so that in upswing periods, you would expect the scenario to be tougher than in periods when credit growth is much weaker. I do not view that as a short-term thing; quite a serious research project is needed to figure out how to do it, but ideally that is the way I would like to go.
Secondly, we need to develop our understanding of the interconnections within the system. I talked about, effectively, banks not being allowed to cut lending. I would like to develop the interconnections within the system in the stress test by perhaps including other people in the financial sector. The obvious candidates, at some date, would be central counterparties, which have big exposures to all the banks and, in a stress, could act in a pro-cyclical way. Including them in the stress would give us a richer understanding.
The third thing I would like to do is develop our own modelling and understanding of these risks, so that we can perhaps more vigorously challenge the banks’ individual results that they give us on the stress tests.
Q25 Steve Baker: Thank you. I want to dig a bit deeper on some of the previous questions. Are market events Gaussian? Would you expect a normal distribution of market events?
Alex Brazier: No, I’m not sure I would. There are various reasons for that, many of which are documented in the literature. I will just take one small example: sometimes market shocks that generate big falls in prices at the same time generate big rises in volatility, which then generate further falls in prices. So I absolutely would not expect these sorts of events to follow that sort of distribution.
Q26 Steve Baker: I am sorry to interrupt, but we are short of time. On value at risk models, do you accept that traders are pretty good at stuffing risk into the tail?
Alex Brazier: I accept that there are serious failings with those sorts of models, but I will make a point about risk weights in general. Of course, they would be the ideal framework if we knew the risks. But if the financial crisis proved nothing else it is that risk is neither constant nor in some way independent and God-given. That is why it is vital to complement the risk-based regime with these other two prongs of the leverage ratio and the stress-testing regime. The leverage ratio gives you the backstop that stops risk where it is falling too far, and the stress-testing regime gives you a forward-looking assessment of risk.
Q27 Steve Baker: I will put to you something that Professor Dowd put to the Committee when he gave evidence. In his written evidence he said, “The combination of VaR and Gaussianity is particularly dangerous: as we have seen, the first is blind to the tail, and the second leaves the user much more exposed than they might think.”
Professor Dowd went on to say in oral evidence that the stress tests are a joke. He pointed to the experience of Iceland, Ireland and Cyprus and said the models were “unscientific” with “very poor assumptions” and “terribly gameable”. When John Thurso reminded him of a list of characteristics that stress tests should have, he went on to say that “regulatory stress testing is a catalogue of failures…they missed…Cyprus collapsing and so forth. It is a joke.”
Are these stress tests a joke? If not, where is Professor Dowd wrong, given that he is founding his criticism on historical experience, the non-Gaussianity of market events and the recognised shortcomings of value-at-risk models?
Alex Brazier: Of course, I think he was wrong because I am absolutely not of the view that we should abandon the stress-testing regime. Perhaps to caveat that: do I think the stress-testing regime is the be-all and end-all of ensuring resilience in the banking system? No, absolutely not, but I do think it is part of a three-pronged approach.
What those remarks miss is, first, the need to assess the system as a whole, which is partly what the stress test does. It takes individual banks and stress-tests them at the same time and, in doing so, allows us to think about the interconnections in the system.
The second is that, although we can’t say that we can always identify perfectly the main risk to the system, we do from a macro perspective have a sense at any given time of the biggest risk. Last year, the FPC rightly decided that that biggest risk was a domestic correction, if you like, in indebtedness, as a result, in the housing market. That is why it was right to stress-test the banks for that risk.
We did not take those results as Gospel and say, “That’s fine; that’s what you’ve decided. That’s the result.” We rigorously reviewed their results and also confronted them with the consequences of their results. They could not all, for example, try to take more deposit market share. Those are the sorts of advantages of stress-testing, but I don’t think it is the be-all and end-all of ensuring resilience in the banking system.
Q28 Steve Baker: I think Professor Dowd would want me to say that he does not propose abandoning stress tests, but we won’t go any further into his views. He just wants to do them differently.
I want to put two questions to you. You talk about testing the interconnectedness of the system. To what extent can modellers actually obtain the information they need in order to construct a model that is actually worthwhile, instead of creating an appearance of scientific modelling where in fact there is not?
Alex Brazier: I don’t think there is any suggestion that we create an appearance of scientific modelling. There are growing amounts of data on the exposures financial firms have—not just to the real economy, but to each other through various channels. A job for the stress-testing regime is gradually to build not just the data we have available to us on those interconnections but their incorporation into the stress test.
I talked before about central counterparties. The growth in the use of central counterparties has been one of the important innovations after the crisis. In some cases it has dramatically reduced the complex web of exposures that we saw was a particular problem in the aftermath of the crisis. Of course, it concentrates the risk at one point, in the central counterparty. That is why it is vital that we have a good understanding and good data about those sorts of connections, and about how central counterparties would respond in a stress.
Q29 Steve Baker: You mentioned the need to adjust the stress test to our position in the credit cycle. Bearing in mind the consensus views expressed in the lead-up to the crisis, how good are we at predicting or stating where we are in a credit cycle?
Alex Brazier: Good question.
Steve Baker: I know it’s a good question!
Alex Brazier: Let me give you a good answer. I would not want the macro-prudential regime to rely on being able to spot the position in the credit cycle, so I think it is absolutely necessary to ensure a baseline level of resilience in the banking system and financial system more broadly, such that if you have got your position in the cycle wrong, it does not create a financial crisis.
That said, we do have information about the stage of the cycle. To give one indicator, the so-called credit-to-GDP gap—the ratio of credit to GDP relative to its trend—was flashing red before the crisis. That indicator is now a key part of what we call the guiding indicators for the counter-cyclical capital buffer. It is not a perfect indicator by any means, but if you look back at its history, it does give you a guide to periods when credit was growing very rapidly and, as a result, perhaps underwriting standards were slipping and risks were growing.
Q30 Steve Baker: One final question. You have noted that “the FPC could consider whether and how stress testing might be extended to non-bank financial institutions”. Which non-bank financial institutions do you consider to be the highest priority?
Alex Brazier: Two or three. I have mentioned at some length in these questions central counterparties—that’s one. In response to an earlier question, from Mr Garnier I think, I talked about the insurance sector. And I talk about a third in my questionnaire as well—the asset management sector, which has grown extremely quickly over the past decade and poses some particular risks to financial stability.
I am not saying that all these things should be included all the time—one of the merits of the stress test is that we focus on what we believe are the major risks—but these are the things that we should think about incorporating not only in the annual stress test over time, but in ad hoc individual sector stress tests.
Q31 Steve Baker: Is there research work to be done in those three areas to determine whether or not the value-at-risk problems and the Gaussianity-of-market problems apply to them?
Alex Brazier: I think there is a broad research agenda to be done in all those areas to understand how the financial system is changing and how the risks are being managed in each of those areas.
Q32 Chair: Have you ever turned to a risk modeller as a risk matures and said to him, “Well spotted. Well done! If we hadn’t had that model, we wouldn’t have identified that”?
Alex Brazier: I personally have not.
Q33 Chair: And you have never been in a meeting where that has happened.
Alex Brazier: No.
Q34 Chair: There is some understandable scepticism about risk models, isn’t there?
Alex Brazier: Yes, absolutely. Let me give you one example, if I may—if there’s time—from the stress test this year. In that stress test, we saw risk weights on residential mortgages going from an average of 15% to an average of 30%. Any risk weight where the crystallisation of the risk results in a doubling of the risk weight tells me something about the model.
What that emphasises is, first, the importance of doing the stress test to uncover that and capitalising the banks effectively for their stressed risk weight rather than their normal risk weight. It emphasises the importance of the leverage ratio, which this Committee and the Parliamentary Commission pushed very hard, and which the FPC has now made recommendations for a framework on—by the way, I would support strongly this year’s stress test, including not just a hurdle rate for risk-weighted capital, but also for the leverage ratio.
Q35 Chair: On leverage, the Government were not an enthusiast. It has been a hard pounding.
Alex Brazier: It is fair to say that thanks to the efforts of this Committee, we have got to a good place. The third point I would make is that the stress test reveals a problem in particular with some models that extrapolate, particularly, recent performance to be long-running performance. I think that supervisors take the results of the stress test and will be dealing particularly with those banks that have those sorts of models.
Chair: That was a very interesting answer to a tricky question.
Q36 John Thurso: Can I just go back to one question that Steve Baker asked? Did I understand your answer with regard to stress tests to be that actually, in many ways, it is more interesting to see the accumulated—the aggregate—result of all the stress tests put together than necessarily for an individual institution, as that gives you a systemic overview?
Alex Brazier: Certainly from a macro-prudential perspective. If I were a supervisor of an individual bank, obviously I would be worried about the results for that bank, but the really useful thing about stress testing them all at the same time is that you can confront them with issues like, “Well, if you are all planning to cut your lending or all raise your deposit market share at the same time, that simply won’t work and the result will be worse than you think.” This year’s stress test in particular started to incorporate those sorts of—at the basic level—adding-up constraints that you would not get if you just tested each firm individually.
Q37 John Thurso: Did that process show a particular risk? At the end of the stress test, did you see that a particular risk had risen or gone down, or did you see movement that you did not expect?
Alex Brazier: Good question. I am not sure that the results of the test overall were surprising. The capital ratio of the system as a whole went from about 10 to about 7.5, which with that sort of level of stress was not a great surprise. To pick up on the Chair’s question, one thing that was a surprise was the extent to which model-based residential mortgage risk weights shot up. That is something which we have had to take from the stress test and look into in much greater depth. To answer your question, that was one surprise from the test.
Q38 John Thurso: So that is something about which we might ask you questions as we go forward?
Alex Brazier: I imagine so, yes.
Q39 John Thurso: In your questionnaire response when asked what the single biggest risk might be, you said that it was not sensible to look at one risk and then went on to name four risks or four headings. Do you think that the FPC should in fact be ranking risks?
Alex Brazier: Let me say two things. I think we should, because there has to be some prioritisation to our efforts to address risk. If we go about trying to address everything at the same time, we will be less effective. In relation to that, and maybe I should have said this in the questionnaire, I would say that the world economic risks are currently the major risks facing the UK.
Q40 John Thurso: You pre-empt my obvious next question. Please rank your four risks.
Alex Brazier: This highlights the difficulty with the issue of ranking. I would say that the world risks are the top priority, particularly in the circumstances of market fragility that I highlight. I am not sure that I would want to rank all of the others. I am concerned about the way the housing market could evolve although, given the actions the FPC took last year, those risks are being managed. I am concerned about cyber and conduct risks. Perhaps that is the order, but that is not in any way to belittle those that come slightly lower down the list.
Q41 John Thurso: One thing in looking at a risk is that you have the gross risk, but you then have actions you can take and so you end up with the mitigated risk, as it were. Does the FPC look at risk in that way? Is there therefore any series of actions that you can judge it against, because of taking the difference between the gross risk and the residual risk?
Alex Brazier: I think that is right in some areas. Take the housing market, for example—that is the obvious area where you can make the distinction you just made. A year or so ago, it was clear that the risk of a growing tail of indebtedness in the household sector was very real. That risk still exists.
We start from a position where the household sector is still very indebted, but the FPC has put in two insurance mechanisms—the 15% limit on high loan-to-income mortgages and the stress test on new mortgages—and that, in effect, manages the risk to some degree. It does not mean that the risk is absolutely in all circumstances managed, and I can quite imagine circumstances in which the housing market evolves in such a way that the FPC would want to take further steps, but for now those risks have not got any bigger and the FPC’s insurance steps are in there, so the distinction you make works.
I think that with the world risks, it’s much more difficult, because obviously we can’t take any direct action to mitigate the risks themselves. What we can do in those areas—
Q42 John Thurso: That is an interesting distinction, because actually you have two categories of risk: the ones we can do something about, and the ones we just have to man the ramparts against.
Alex Brazier: I wouldn’t say you took the words out of my mouth because you are much more eloquent than I am, but I think I would agree with that. Take the world risks, for example: the most important thing is that we ensure that the banking system and the broader financial system are sufficiently resilient to deal with the risks that we cannot actually manage down. Maybe the distinction is helpful for macro-prudential policy generally, and this goes back to my answer to Mr Baker. You have to establish a baseline level of resilience in the banking system, because you cannot hope to spot each individual risk and squash it.
There are some you simply cannot squash and there are others that you will not spot, and you have to be sensible and mature enough to admit that. It is vital that we have that sufficient baseline level of resilience, but at the same time it is also important that those risks which we can manage, we do. The FPC has taken action in that regard in the housing market, and I think that over time we will look at other markets. In my questionnaire I mentioned commercial real estate and leveraged loan markets. That is not to say that they are an immediate problem, but they are the sort of areas the FPC will look at to spot growing risks.
Q43 John Thurso: Let me turn briefly to another subject. You talked about communications. Who do you think should be the primary audience—or who do you think is the primary audience—for the financial stability report? Who must read it?
Alex Brazier: Who must read the financial stability report are participants in the financial sector, for two reasons. First, in many respects, and unlike monetary policy, the financial sector is the channel through which macro-prudential policy is implemented. For example, setting a 15% limit on high LTI mortgages, I definitely would like every bank CEO to know about that limit, since that is the channel through which it is implemented.
The second reason in explaining our thinking on the risks and how we might respond to them—going back to our previous question—is the need to establish a level of understanding in the financial sector which allows it to begin to anticipate how we will respond. As we have seen in the monetary policy sphere, that anticipatory effect can itself be stabilising and helps to increase the effectiveness of policy. That is why I would like to see a financial stability report that is quite focused on the risks we are interested in; has details of the options available to us to address them, even if we haven’t taken those options yet; and begins to build a level of understanding in the financial sector about what, in the jargon, is our reaction function—how we will respond to risks as they emerge. That is what will make us more effective.
Q44 John Thurso: You mentioned in your report your concern that the stability report was really rather long and given to repetition. You have just repeated that: you would like to see a shorter, sharper version. Is that something you have already raised within the Bank?
Alex Brazier: I have not raised it with the FPC. I have raised it with some of my new teams, who are reviewing the FSR as it stands and I will raise it with the FPC as we conduct a review process of the FSR over the coming months.
Q45 John Thurso: So we can come back to you on that one in due course, or our successor Committee can?
Alex Brazier: Yes.
Q46 John Thurso: A final question: from what you have said, communication is not simply a question of informing people what you are up to; it also becomes a weapon in stability in its own right. Is that what I understood you to say?
Alex Brazier: I think that is right, particularly with regard to the financial sector itself.
Q47 Rushanara Ali: Mr Brazier, can I turn to SME lending? In your written evidence you said that there is a concern about the persistent weakness of credit availability, especially for SMEs. How big a concern is that persistent weakness for the FPC?
Alex Brazier: Let me take a step back. The purpose of macro-prudential policy is to ensure that the financial system effectively serves the real economy—that at the very least, it does not cause havoc for the real economy as it did in 2008-09, but also that it is in a position to support the economy. What we have seen post-crisis, as the banking system has contracted in this way, is a particular burden on small and medium-sized enterprises, which do not have access to the same capital market funding that large enterprises have. I think you issued a report on this last week. So it is a concern from that perspective that SMEs continue to report some concerns about access to finance, although I would caveat that with the fact that, over the past year, the proportion of SMEs reporting difficulties seems to have roughly halved.
I do not think there are easy remedial steps we can take. Your report highlighted some of the steps that could be taken. Let me pick up on two. First, I agree with your conclusion that the Bank broadly should ensure that we have sufficient data about the credit that is being made available to SMEs from big banks, smaller banks and outside the banking system. In the crisis, those data were very incomplete, they are now slightly incomplete and there is merit in developing that.
The second point is that the post-crisis performance of SME lending really emphasises—this goes back to something this Committee and the Parliamentary Commission have talked about a lot—the importance of competition in banking. It is difficult to think of a model where SMEs suddenly get access to all sorts of market-based financing.
Q48 Rushanara Ali: Do you think there is sufficient competition?
Alex Brazier: I think there is merit in developing structures that would create more competition. Let me give an example of where the FPC’s actions have helped. The leverage ratio will help, in the sense that it stops big banks being able to run with really low risk weights that smaller banks, which do not have access to internal model approaches, can run. Ring-fencing will obviously help. Also, measures to increase the ease with which big firms can exit the market—this is about resolution—will allow, and have allowed, regulators to loosen requirements on new entrants.
One final point I should make is that the Bank has been taking some individual measures to assist SME lending, the FLS being one example, and another being ongoing work to ensure that credit histories of SMEs are shared not just between the big banks, but more broadly across banks. That is the sort of structural change we need to ensure that challenger banks that say they are committed to SME lending actually have the means to do it.
Q49 Rushanara Ali: We took evidence from challenger banks, and they do not feel that there is a level playing field. There is a sense of complacency in terms of creating the conditions for a more competitive market and space for innovation—the right kind of innovation obviously. Also, in the last quarter, lending from banks participating in the funding for lending scheme was down by £800 million. I take your point about the fact that there seems to be less concern from those who are trying to borrow but isn’t this a concern for you, that it is going down?
Alex Brazier: The pattern of SME lending, as I think you identified in your report, is one in which, after the initial, shock, we have seen signs more recently of credit conditions for SMEs finally beginning to ease a little. I take some comfort from that, but I would not overestimate the amount of comfort that I take. It is important that we continue to have a focus on measures that will establish a more level playing field in the banking system.
Do not underestimate the fact that we have come from a position where big banks, in effect, had looser capital requirements than small banks, because they were able to adopt lower risk weights through internal models and because smaller banks were subject to tight entry requirements. We have now moved to a model where big banks have additional capital surcharges, where the leverage framework stops them exploiting lower risk weights, and where, as a result, supervisors have been able to reduce the burden on new entrants. From a macro-prudential perspective, I think that that is absolutely desirable. We should make absolutely sure that we do not just stop there. It is important for macro-prudential policy that we keep our eye on this and continue to develop measures that will establish a more level playing field, particularly with respect to SME lending.
Q50 Chair: We are very unhappy with the level of competition in the SME lending market and have been for years. Hopefully you will do whatever you can to assist with that.
We have been talking about how you go about assessing risk and you had some exchanges with Jesse Norman and a couple of other colleagues on this. Let’s just go back to Greece for a moment and ask some simple questions. Do you think the Greek economy can recover at current exchange rates—really?
Alex Brazier: I think it is possible.
Q51 Chair: So it is not very likely?
Alex Brazier: What the Greek situation shows is the difficulty of dealing with a debt overhang in a fixed exchange rate regime, because you can arrive in a cycle of attempting to deleverage and, in doing so, just drive down prices—
Chair: I will come on to that in my second question.
Alex Brazier:—and you end up in the same position. That is why the economic issue is to deal decisively with the debt overhang.
Q52 Chair: Okay, well let’s go on to the second question: do you think it is realistic that Greece is going to be able ever to repay the overhang of that scale, on the basis of anything we know about its tax base?
Alex Brazier: Of course there are numbers for the primary surplus Greece could run, in principle, that would deliver the repayment of debt over some horizon. Is the political pain involved in running that sort of primary surplus tolerable? I find that difficult to believe.
Q53 Chair: Right. So you are basically saying, no, they cannot repay their debts and, although it is possible they could survive and recover at current exchange rates, it is unlikely? Is there anything that I have said there that you disagree with?
Alex Brazier: I think that you have missed one important thing out, which is that—
Chair: That’s all right, you can add that in a minute. Do you disagree with the first two points?
Alex Brazier: Probably, but I cannot remember what they were. Let me think. I think Greece will not, in any realistic economic scenario, repay its current level of debt.
Q54 Chair: That is one of the two questions. The other question is: although you said it was possible that the economy could recover at current exchange rates, the use of the word “possible”, particularly after such a long, pregnant pause, suggests that you think the odds are that it will not.
Alex Brazier: A sufficiently decisive programme of dealing with the debt overhang and of structural reform could deliver the sort of outcomes we have seen in some other peripheral European countries.
Q55 Chair: I began with questions about whether you were an insider’s insider. Are we going to see you speaking up and stretching what is permitted as the boundary of collective responsibility for decisions?
Alex Brazier: Two points. First, I am not sure that you should expect to see me stretch the boundary for stretching the boundary’s sake, but anything that is on or in the boundary, you can expect me to be saying.
Q56 Chair: Do you think there is merit in at least considering developing more of a public discourse between independent members or between members of the FPC more akin to what we have seen on the MPC?
Alex Brazier: I make two points on that. First, as a general rule I don’t think it is sensible for individual members’ communications to contain huge, newsworthy announcements on policy. That is not sensible for our effectiveness or indeed our transparency. To be clear, I do not think that means that each individual member should in any way be gagged. It places the emphasis on our official, collective communications to describe not just where we ended up but all the arguments that were weighed and the trade-offs that were made in reaching where we ended up. If the records of our meetings provide sufficient detail like that, we can all have the freedom to go out and describe not only where we ended up but how we got there.
Q57 Chair: So you are going to be a strong advocate of very detailed records?
Alex Brazier: Well, I don’t think they need to be—
Q58 Chair: Are you going to have the space in order to be able to say that publicly?
Alex Brazier: They need to be sufficiently detailed to give us the space to describe not just the final decision but how we got there.
Q59 Chair: You are going to be pressing for that?
Alex Brazier: Yes, but I would make one point, which is that I do not think it is helpful for accountability, in an environment where each of us has signed up to a consensus, for any of us then to go out after the event and say, “Well actually, there is a nuance to my position,” or, “I didn’t really mean it.” That is completely undesirable from a transparency perspective.
Q60 Chair: Those two are very different. A nuance is a qualification to a position, which one might want to amplify, but to say “I didn’t really mean it”—in other words, “I disagree with the consensus”—is not.
Alex Brazier: I think there is a grey area between the two. Take the recent debate on the leverage ratio. In the end it was a multidimensional agreement, involving a baseline, a scaling requirement and restrictions on so-called alternative tier 1 capital. Committee Members have been out and about since, explaining their position on the leverage ratio and saying things like, “I would not have been able to sign up to a 3% baseline alone. I signed up to that because there was the scaling for systemic banks as well,” or, “I wouldn’t have been able to sign up to the package without the additional constraint on AT1.” There has been no constraint on Committee Members doing that.
The record has been sufficiently detailed and Committee Members have had no problem providing what you might describe, in that sense, as nuances. That should continue and we should keep the record under review, such that if anyone ever felt that they were breaking the rule I have described of giving newsworthy announcements, it would probably tell us something about the record not containing sufficient detail.
Chair: Thank you very much for giving evidence to us this morning. It has been extremely interesting.