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Treasury Committee

Oral evidence: Bank of England Financial Stability Reports, HC 140

Monday 16 January 2023

Ordered by the House of Commons to be published on 16 January 2023.

Watch the meeting

Members present: Harriett Baldwin (Chair); Rushanara Ali; Mr John Baron; Dame Angela Eagle; Emma Hardy; Danny Kruger; Alison Thewliss.

Questions 241-339


I: Andrew Bailey, Governor at Bank of England; Sam Woods, Deputy Governor for Prudential Regulation at Bank of England, and Chief Executive Officer at Prudential Regulation Authority; Jonathan Hall, External Member at Financial Policy Committee; and Dame Colette Bowe, External Member at Financial Policy Committee.


Examination of witnesses

Witnesses: Andrew Bailey, Sam Woods, Jonathan Hall and Dame Colette Bowe.

Chair: Welcome, Governor and team, to this Treasury Committee evidence session. We will be talking not about inflation—we will park that until we have you before us for the monetary policy section of your evidence later this year—but with this group about financial stability. I invite the witnesses to introduce themselves, starting with you, Governor.

Andrew Bailey: I am Andrew Bailey, Governor of the Bank of England.

Dame Colette Bowe: I am Colette Bowe, external member of the Financial Policy Committee.

Sam Woods: I am Sam Woods, Deputy Governor and chief executive officer of the PRA.

Jonathan Hall: I am Jonathan Hall, external member of the Financial Policy Committee.

Q241       Chair: Good afternoon, everyone. I want to start with you, Sam. In November, when the Government published their response to Solvency II and the consultation, they did not accept the recommendation that you made on the reforms to the fundamental spread—you will help the public out by explaining exactly what it was that you preferred to see—and they are in fact going ahead with cutting the risk margin. In your opinion, how much riskier are our insurers after that decision?

Sam Woods: Thank you for asking about that important topic. It is worth noting that it is a very wide package of reforms, including all sorts of other things, such as reporting, internal models and things of that kind. You are right that there has been a disagreement over one part of the package, which is the capitalisation of the annuity business within insurers.

It is the case that if you cut the risk margin and do nothing about the fundamental spread, that increases the riskiness of the sector. I think it would be unwise to try to put a precise number on it, but it is a material, if not a huge increase. That is the best way of describing it. I think that point is acknowledged by the Government, as well as by the executives of those companies, some of whom are on the record saying exactly that.

There has been a disagreement, as you say. None the less, we accept that the Government have reached their final view on it, after very lengthy debate and conversations. As you say, we have put our views in public. It depends on where Parliament gets to with that, but if Parliament endorses the package—that is only one part of the package, if an important part—our mind is now turning more to implementation and to just getting on with it.

Q242       Chair: This is important, though. You are asking Parliament to make the final decision and, obviously, it is up to us, but you are providing a key piece of the evidence that Parliament will need. Are you saying that you fundamentally disagree with the conclusion that the Government have come to on the riskiness of insurance companies?

Sam Woods: I would put it in the following way. We have had a disagreement about the fundamental spread. The fundamental spread attempts to assess risk in the assets that insurers are taking on, and therefore deducts a certain amount from the returns in the future that they will bring forward into capital today. The debate is around what portion of returns from the assets that insurers have can safely be considered to be risk-free; the rest of it should be in the fundamental spread.

Essentially, we think the fundamental spread is too low. We have presented a range of evidence for that and I have made various public comments about it. It is a topic on which—because it’s ultimately mostly about the decomposition of bond spreads and other asset spreads—people can reach different conclusions, and the Government has in the end reached a different view on it. I don’t want to speak for the Government, but I think they acknowledge that there will be some increase in risk because the package overall is a loosening package, and I think that’s an intended effect. That is why the Government has also equipped us with a set of additional tools—or it proposes to—in order to ensure that we can manage risk in the sector. I would like to say a word on those tools, but I’ll stop there for the moment.

Q243       Chair: Yes, because this is really important. You are the independent regulator who has assessed the riskiness of the insurance sector and you are now saying to us that you think the Government has recommended to Parliament that we accept something that is considerably riskier than you feel comfortable with. That’s what I’m hearing you say there, Sam.

Sam Woods: That is broadly right, but I would put it slightly differently, in the sense that with this particular set of rules, because of the way they have been imported from Europe, it has always been the case that the Government has had a role in the making of them, and we have had a role. We have had all those sets of hands on the steering wheel, and Parliament will be on it as well.

I don’t find it enormously surprising that on that area, where Ministers have to take account of a wider range of things and a different set of considerations from us, we have in fact reached that difference of view. But at the same time, we have accepted that the Government has reached that view and—subject, as you say, to where Parliament gets to on it—we are moving on to the next stage of the thinking.

I think the Government would acknowledge that the reform package as a whole increases risk. The Government is doing that because the Government believes that that will also aid growth, and that is a trade-off that the Government has made. It is not one that we would be able to make in the same way, but the Government has made it and has explained its reasons.

Q244       Chair: But what you may be saying here is that the Government may be recommending it, but you have this opportunity this afternoon to urge parliamentarians to vote against these proposals. Is that your recommendation?

Sam Woods: Look, I am not urging parliamentarians to do that. I think parliamentarians should, though, when it comes to the parliamentary part of that process—which will, I think, be done through a statutory instrument—look at the arguments that we have made on one side of this debate.

If I might just touch on the tools briefly for a moment, the Government is proposing to equip us with some additional tools to manage risks; and those, particularly the ability for us to publish individual firms’ stress test results, will have to come through Parliament. I would urge you to support those. But I want to be clear that I don’t think we should or we can use those tools to reverse engineer the same effect that we were trying to get through the fundamental spread reform. I know there is some concern in the industry that we might try to do that, but if Parliament ends up supporting the package as it is, Parliament should assume that we will not use those in that way. We will use them and they will be very useful, but we will not use them to reverse engineer the thing that we were trying to achieve in another way.

Q245       Chair: You are mentioning other topics, but what I am hearing you say is that you would prefer it if Parliament voted down this statutory instrument, because you do not feel comfortable with the amount of risk it will put into the insurance sector. That is what I am hearing you say.

Sam Woods: I am not sure I would put it quite that strongly. There has been a very public difference of view between us and the Government on this topic, but we do need to move forward; we cannot carry on this debate forever. The Government has made its position plain. We need to move on to the next stage, but it leaves unaddressed the problem that we think there are good reasons to address. As I said, it is a thing on which, because it is about the decomposition of asset spreads, people can reach different views, and in this case they have.

Chair: Very interesting. Governor, you wanted to add a point to that.

Andrew Bailey: Sam has made half the point that I was going to make, which is about the tools, particularly the stress tests, and the fact that we will be publishing individual firms’ stress tests for insurers for the first time. We do it for banks, but we have not had the powers to do it for insurers.

I want to add one more point, also on what was announced. The Government announced that we will have to regularly report to Parliament whether our risk tolerance has been met. I don’t think the details of this have been decided yet, but I would imagine this means that we will be reporting to you, and I think that is very important. As Sam said, reasonable people can disagree on credit spreads; that is possible. We are one part of the distribution. The industry, needless to say, is in a different part of the distribution. I am not surprised by that. The Government has reached a view. What will be very important, though, is that we make this report to you as Parliament—I would think regularly—as to whether our risk tolerance has been met.

Q246       Chair: Okay. This is very interesting because it feeds into this whole debate that was happening before Christmas around whether Parliament and the Government should have in legislation a call-in power. As you know, the Government dropped its plans to have a call-in power. It is alleged in some quarters that this was because they came to an agreement with yourselves about accepting the increase in risk through the reforms to the insurance sector. Governor, can you assure us that these things were connected?

Andrew Bailey: Were connected?

Chair: Yes.

Andrew Bailey: No, they were not connected.

Chair: They were not in any way connected?

Andrew Bailey: No, and I can tell you that I made it very clear that this is not a deal here. I think the Economic Secretary said something similar when he was in front of you. I would never consider doing a trade of that sort, because it is contrary to our statutory objectives. As you know, because I have said before a number of times in this Committee, I was against the so-called call-in power. I thought it would severely undermine our international credibility and, frankly, severely undermine the independence of regulation, so I was against it, but we did not trade Solvency II for the call-in power.

Q247       Chair: And you do not think that the Government were using the threat of a call-in power to try to focus your minds on this issue?

Andrew Bailey: None of us can speak for the Government, so I cannot tell you what was in their mind at the time. I did read what the Economic Secretary said to you in his hearing, and I thought it was fairly consistent. I cannot speak for them, but I can speak for us, clearly, and say there was no trade.

Q248       Chair: Were the subjects ever discussed in the same meeting between yourself and the Chancellor or the Economic Secretary?

Andrew Bailey: No; not explicitly, no.

Q249       Chair: So there were never any meetings where the two topics came up in the same meeting.

Andrew Bailey: I cannot remember any, to be honest. If you want me to go back and check, I will check. We went through quite a few Chancellors during that period, I have to say. That is one of the reasons why my memory is—

Chair: Can you remember any, Sam?

Sam Woods: It is of course possible that both those topics may have come up in meetings I had with the Economic Secretary but, just to reiterate what Andrew said, there was never any linkage of the two in that way. Had there been, for us, we certainly would not have engaged because it is just wrong to trade off those two things.

It is also the case that the Government do not need the call-in power to achieve what they want to achieve in this area because of the thing I was describing a moment ago about how it has come in. For what it is worth, I think it was a wise decision not to proceed with the call-in power. I think we are worst placed to make that argument because it looks self-interested when we say it, but actually there are good reasons—both of financial stability and competitiveness—why it is not a good idea to have such a thing.

Andrew Bailey: It is also worth noting, of course, that the Government were the decision makers on both those things, so we were not trading one thing that we were the decision makers on for one thing that they were.

Q250       Chair: Okay. Does anyone else from external scrutiny want to make any points on this particular topic?

Dame Colette Bowe: The only thing I would want to support, Chair, is the point that Sam just made, which is the importance that one attaches to the independence of regulation. In my view, as an external, the call-in power would have undermined that.

Q251       Chair: Are you all happy with where things have ended up and with the proposals in the current legislation?

Dame Colette Bowe: I am. I cannot speak for my colleagues, but I am.

Jonathan Hall: Colette and I, obviously, have the pure financial stability mandate. From our perspective, there are two issues with this whole set of reforms: do they increase the risk of instability and, if they do, do we have the tools and so on to deal with that? From that perspective, we are looking at what is happening within the PRA with an overview of the financial stability perspective.

Obviously, there is this secondary issue, which is more relevant to the call-in power, which is: is it potentially undermining our ability to satisfy the mandate to which we are accountable? That obviously would be a much larger concern, but we are happy. That is why, as a FPC external member, I am very happy that I am able to continue to satisfy the mandate that has been given to me because there is no call-in power.

Andrew Bailey: For the record, I think we have said a number of times in public that we were very content with the Bill that was introduced into Parliament; it was a question of whether it would be amended with the call-in power.

Q252       Rushanara Ali: I was one of the MPs, among others, who asked you a lot of questions, Governor, about call-in powers, as well as the FCA. There was collective agreement that this attempt at a power grab by the Government would be damaging to independence and to the international reputation of our regulators, and I am glad that it has been dropped by the Government. There seems to be a bit of a pattern of attempts to seize some of the regulators’ powers of independence.

I want to pick up on the Chair’s questions in relation to Solvency II. Sam Woods, you said that reform packages as a whole increase its risks. Could each of you talk through what that means? It is quite something that the PRA’s recommendations on reforms to the fundamental spread have not been taken on board by the Government. There is clearly a big difference and concern about risk. It feels like we will have to enter into yet another dialogue as Back Benchers and Committee members with the Government to try to get them to see sense—or is that not something we would need to do?

Sam Woods: I come back to the point that it is a very broad package. There is a whole bunch of other stuff in it that we are very keen to get on with.

Q253       Rushanara Ali: But on the specifics, my question was about the specific point you have made about reform packages as a whole increasing its risks. After the mini-Budget fiasco, we have had an attempt by the Government with the call-in power, which it has had to subsequently scrap because of the representations you have made on this Committee, and others have done, about the risks to the international credibility of our independent regulators. Can you answer this specific question that you have raised concerns about, and that the Government are ignoring you on? What do you make of that?

Sam Woods: I do not think the Government have ignored it; they have just reached a different view. Again, the Government should speak for themselves, and I am sure they do and will, but the assessment that the Government were making was of the level of weight they wished to put on the growth part of this package. They considered, taking into account evidence that they heard from us and also from the industry—which, as Andrew said, was in a very different place on this topic—that to advance with changes to the fundamental spread of the sort that we had outlined, or things of that kind, would in the Government’s view have frustrated the ability of the sector to invest at quite the level they want it to do.

Now, whether or not that point is true cannot be conclusively proved one way or the other. The proof will be in the pudding, but—

Q254       Rushanara Ali: But is there a risk to financial stability? We are very exercised about that, given what Liz Truss and her Government did. It is a serious issue.

Sam Woods: I do not think that this particular set of reforms, notwithstanding disagreement on this piece of it, is a major financial stability issue. I think it is much more of a policyholder protection issue, because ultimately, what will happen here if it turns out that this was a problem—as I say, people can debate either side of it. That should have been addressed at this point, rather than at some point later or not at all then the way it comes home to roost is if there is not enough capital backing pensions. Now, you can look at history to give you a guide as to what is likely to happen if that occurs, and I would say it is highly likely that that comes back to the public purse if that occurs. It is our job to think about such things and worry about them.

Q255       Rushanara Ali: What exactly are you saying, then: that it is a risk that we should be able to tolerate, or if it becomes a problem it will cost the public? If I have not misunderstood this, you seem to be trying to have it both ways. I do not think we are getting a straight answer.

Sam Woods: I am trying to give you as straight an answer as I can, but it is complicated. Our position, advanced within the scope of the statutory objectives of the PRA, was for a package including all the elements that are currently in there, plus this one reform to the fundamental spread. We thought that was the right place to go, given our risk tolerance and the objectives of the PRA.

The Government have a wider and different set of objectives, and they reached a different view on that one element. I think the effect of that will be to increase risk—not, as I say, to a huge degree, but I think it will increase risk as a net effect of the whole package—and I think the question for Parliament will be, “Does that seem like a reasonable trade-off that has been made, and do we support it or not?”

Q256       Rushanara Ali: We know what happened in the recent past with the Government taking a different stance to what the Bank has been doing, and how that can be damaging where the two are not working in concert—where they are not aligned. Given that with the Edinburgh reforms, which I know other colleagues will come in on later, we’ve got ringfencing, there are quite a few things that are now happening. When you look at the sum of those things as well as competitiveness, which I am going to come on to as another dimension to regulation now, is there a risk that these things are going to go in different directions and then present a risk to financial stability?

Sam Woods: On the Edinburgh reforms—colleagues may want to come in too, Andrew in particular—if you look at the package of things announced in December, I do not believe that there was any commitment made in that set of announcements that presents a significant risk to financial stability, but there are two things that are part of that package. You mentioned one of them, which is ringfencing; the other one is senior managers, where we are more at the beginning of a process than at the end of it.

I do not know whether you want to go into those two, but in those two, there are areas where we will want to be very closely engaged, because there are obviously things—at least in our view—that you could do with those regimes that could present such a risk. But those commitments have not been made yet.

Andrew Bailey: Perhaps I could illustrate by going over to the LDI issue for a very brief moment. The big issue that we had with LDI is that we had a movement in long gilt rates that was outside historical experience. The question that always arises—we get it when we do stress-testing of banks and in the capital regime for banks—is: where do you put the line down, in terms of what level of risk you are protecting against with the regulatory system, and what backstop do you have beyond that if something out of the ordinary happens?

In a way, this debate about fundamental spread is about saying where you want that line to be and what the consequence is if, as Sam rightly says, you put it in a place where you are somewhat more likely to go beyond it than you would be if you put it further out. I agree with Sam: I don’t think it is likely, all things being equal, that it is a risk to financial stability, but it is a risk to policy holders.

Q257       Rushanara Ali: Sorry, it is a risk to who?

Andrew Bailey: To policy holders. We are talking about annuity policy holders here. Bear in mind that it has happened. It happened in the case of Equitable Life, so it can happen. That was a different period and a different product—well, a somewhat different product.

There has to be a choice, and that choice is a judgment. It is subjective; you can’t draw an objective line. The very important point that Sam made a few minutes ago about the backstop is that if something happens beyond that sort of line, first, it is the Financial Services Compensation Scheme, which is the industry scheme, and beyond that it is potentially the public purse. That is what we have to recognise.

Q258       Rushanara Ali: So how big a risk to the public purse is this direction of travel, which is going in the opposite direction from what Sam is proposing?

Andrew Bailey: It is not a large increase. What we should do as part of the setting out of risk tolerance to Parliament is do our best to calibrate that.

Q259       Rushanara Ali: It would be good to have a bit more that is calculated to this Committee. What the public will want to know is what the cost to the public purse is of this divergence.

Andrew Bailey: I think we can see to do that.

Q260       Rushanara Ali: That would be really valuable.

Turning to competitiveness, Dame Colette and Mr Hall, do you see risks to financial stability as a result of the PRA’s and the FCA’s new remits and objectives having a greater emphasis on competitiveness?

Dame Colette Bowe: Sorry, I missed the very end of that. A greater emphasis on?

Rushanara Ali: On competitiveness.

Dame Colette Bowe: Do we see risks to financial stability?

Rushanara Ali: Yes.

Dame Colette Bowe: The short answer is no, but as you might expect from someone like me, there are a few caveats in there. It is extremely important that we have a focus on that for all the reasons that everybody on this Committee knows and understands.

In pursuing a competitiveness objective, you have to be extremely careful to balance that with, let’s say, the ability of new entrants to the market to deliver to clients of the banking sector, be they households or businesses. Yes, it is right to pursue competitiveness, but you had better have a bit of a careful weather eye on what is actually happening in the market and whether new entrants can actually deliver on what they say they are going to deliver. If they can’t, that is where you get your financial stability risk. Perhaps in a more diffuse way, that is where you get a risk to public confidence in the system, which is of course the raison dêtre of what we are doing here. It is about confidence in the system.

Sorry—that is a rather lengthy and rambling answer, but I hope you can see where I am going.

Q261       Rushanara Ali: That is really helpful. Thank you, Dame Colette. Mr Hall, did you want to come in on that?

Jonathan Hall: This is to do with the PRA’s objective. From our perspective, the question is: is it an issue for financial stability? Of course, we ourselves have a secondary objective. Our primary objective is financial stability, and our secondary objective is to support the Government’s productive growth. We and the Bank as a whole have experience of managing a primary and a secondary objective.

The clue is in the name; the primary objective is, clearly, the thing we focus on the most, and we ensure that we do not harm the secondary objective. Or, if we can enhance the secondary objective without causing anything negative for the primary objective, then we will do so. I think that the structure of having a primary and secondary objective is something that we are used to and able to work with, and that it should not necessarily harm financial stability.

Q262       Rushanara Ali: Do you think there is a risk that you might find yourself in conflict—find the two working against each other—where, although your primary objective is financial stability, that might slip because of the additional things that you need to think about, such as competitiveness?

Sam Woods: If I may come in, no, I think it will be okay. As Jon was saying, we are used to having a secondary objective.

The other important thing to bear in mind here is that this secondary objective is being added in the context of us being given—if Parliament agrees—a lot more rule-making powers. I do not think that it is unreasonable for the Government to say, “If there is a process that, in the European context, we used to input into directly, and it is now being devolved down to you, you will need to take growth and competitiveness into account a bit more than you would have done beforehand.” I have always thought that that was a reasonable proposition.

However, the nature of the objective as secondary is vital, because it is then very clear for us internally. It says that we may not do things to promote the secondary objective that damage the primary. That is actually a pretty clear line. The people who think that it should be a primary objective worry that that means that we cannot do much. That is not true: we will be able to do loads, but I think we will be able to do it in a way that does not damage the primary.

Andrew Bailey: Can I add two points? The first one—it goes back to the point made on the call-in power—is that effective regulation adds to competitiveness, particularly when you are an international financial centre.

Q263       Rushanara Ali: Do you think that the Government understand that? Because they wouldn’t have used the call-in power if they had understood that, would they?

Andrew Bailey: I cannot speak for the Government. What I will say is that effective regulation does add to competitiveness. Good firms want to do business in well-regulated centres—also centres that have robust legal systems. Those are the things that underpin business.

The second thing is that we are particularly clear that one of the strong planks of competitiveness is international standards, where there are international standards; they do not exist everywhere. The obvious case in point would be the Basel system. That is an international standard—a very strong international standard—and well established. Abiding by those standards is part of competitiveness.

Q264       Rushanara Ali: One final thing: do you feel that the Government understand that clearly—the primary financial stability objective coming in the first order, followed by competitiveness, and that point about international standards? Do you feel, in your discussions with Government, that they are very clear that—you have said it in various fora—they must not undercut international standards in the pursuit of competitiveness, in giving you that secondary objective? Do you think they understand that?

Andrew Bailey: I really do think that they do. I think they get a lot of other voices who say different things.

Rushanara Ali: Such as?

Andrew Bailey: Well, industry. I mean, industry is—some parts of it; not all—

Rushanara Ali: They seem to have won: ringfencing is going, and the senior managers regime is going—

Andrew Bailey: By the way, look, I do not want to generalise about industry, because there are parts of industry that are very firm on the need for strong international standards, and there are other parts that are less firm, frankly.

Q265       Chair: Frankly, Governor, I think that what we heard you offer during Rushanara’s questioning was that you were going to come back with an estimate of the increase in the probability—

Andrew Bailey: On Solvency II.

Chair: —that there might be a call on the public purse as a result of this package of changes. That is what I think I heard you say.

Andrew Bailey: I want to be clear on industry, because I do not want to paint them in a bad place. A lot of what they say is actually strongly aligned with us. I will give you a current example from the Basel 3.1 programme. We set out our consultation on it, and it is very much aligned with the Basel agreement, but we do hear some voices that say, on one or two particular points, that they would prefer what we think is the proposed EU version of the implementation of Basel 3.1.

Well, the EU—we had this experience when we were members of the EU, under its previous implementation of the Basel 3.0 package—is not compliant with Basel. It is sub-Basel. That is an example where you can get different voices, frankly.

Q266       Chair: But you have agreed to send us that analysis.

Andrew Bailey: Yes. And we will do our best to not send something vast over, because it can get very long and very complicated.

Chair: Thank you. That would be helpful.

Q267       Alison Thewliss: I have some questions around the UK’s international credibility. The Financial Stability Report says that, in September and early October, “there were signs that foreign investor demand for UK assets weakened. While this has since reversed, foreign investor appetite for UK assets could be vulnerable to future shocks.” Can you clarify a wee bit more about why that has happened and talk a bit more about that vulnerability?

Andrew Bailey: I think what we saw after the events in late September and early October—we have obviously discussed this in some previous hearings and in the monetary policy context—was that we saw a risk premium enter into the interest rate curve. My judgment would be that that has pretty much gone now and we are back to where we were before.

But if you look at the data—for instance, on foreign net purchases of gilts, which is a good indicator—we saw foreign sales of gilts, particularly in September and October. In November, which I think is the most recent evidence, that level of sales had reduced; there was still a net sale, but it was considerably lower. That is reasonable evidence, and it probably suggests that it is taking a bit longer to work its way through. It will be interesting to see what we get in successive months, to see where that has got to. There is evidence, yes. But the good news is that, in the interest rate curve, that risk premium has gone.

Jonathan Hall: Just quickly on that, in the report, we said at the time that the interest rate curve had returned pretty much to normal, but that things like bid-offer spreads, the liquidity in the market and the volatility of the market still remained in a position that had not recovered fully. The good news is that, since then, that has continued to recover. It is not only that the interest rates have stabilised, but that depth and liquidity have returned to the market and volatility has declined, so we are now pretty much, from a market perspective, back to where we were at the end of the summer.

Q268       Alison Thewliss: Have you any way of assessing how robust foreign investors’ appetite is and whether they are more nervous now than they were before? Is having had a shock of that kind more likely to put people off?

Andrew Bailey: Obviously, market pricing is one way of doing it, which we have just commented on. As I say, that has really undergone quite a lot of reversal, so that is back to where we were before. Look, I have to be honest: it is going to take some time to convince everybody that we are back to where we were before. I don’t doubt the current Government and I am not in any sense trying to be negative; it’s just that there is obviously something of a hangover effect that takes place, I’m afraid.

Q269       Alison Thewliss: The report says that gilt market liquidity has yet to fully recover since September, and chart 1.2 shows that gilt liquidity here is markedly worse than that in the United States or Germany. Are there particular reasons for that, by way of comparison, and other risks for the UK?

Andrew Bailey: We certainly did go through a period of very illiquid markets, and obviously we had to take action in that period. I will draw on two pieces of evidence to suggest how it has turned round; I think last Thursday was the last time I looked. We have regular, daily monitoring of the gilt market from that point of view, and one measure is bid-offer spreads in the 10-year gilt, which is a benchmark gilt. I think last Thursday it was somewhere around a 60-odd percentile of the distribution, which is within our normal part of the distribution. For us, that means we are back into a normal area of the distribution.

The other piece of evidence that I would draw on—this is true for other countries’ markets as well—is that we quite often tend to get some elements of stress in markets over the year end. That is not to do with anything we have just been talking about; it is sometimes to do with technical trading conditions. Interestingly, this year we had the best market conditions at year end that we have had for quite a few years. I would say those two things are reasonably encouraging.

Q270       Alison Thewliss: Will there be any impact on households with mortgages or loans as a result of illiquidity in the gilt market?

Andrew Bailey: I think we discussed before, probably at the monetary policy hearing, the question of the relationship between the gilt curve and mortgage rates. Obviously, the predominant mortgage now is a fixed-rate mortgage over two to five years, and they are priced off the curve. I did say that, as has been widely observed, mortgage rates went out and the number of mortgage offers declined dramatically during that period. I spotted a mixture of hope and prediction that we would see those mortgage rates come down, and it has happened. We have seen that new fixed-rate mortgage rates have come down since, both for the lower-risk end of the mortgage market—I am talking here about sub 75% loan to value—and the higher-risk end. We have seen correction in that respect, and that benefits people seeking mortgages.

Jonathan Hall: On that point, we have also seen the number of mortgages that are being offered recover as well.

Andrew Bailey: Products.

Jonathan Hall: Yes, the number of products. This links to something we might talk about later, which is the capital levels of the banks. Because they are in a good position, the competitive dynamics within the mortgage market are playing out such that, although it is with a lag and although there are other elements such as volatility that play into the actual mortgage that people see, that is recovering back as the swap rate does, and the margins look similar to what they were, for example, pre covid in 2019. It does not look as though there was any permanent damage done at the end of last year.

Q271       Alison Thewliss: Could I ask you, Mr Hall and Dame Colette, if the failure to prevent double-digit inflation damaged international perceptions of the UK’s macroeconomic policy framework?

Dame Colette Bowe: Can you say the beginning bit again?

Alison Thewliss: Has the failure to prevent double-digit inflation had an impact on perceptions of the UK as well?

Dame Colette Bowe: I find it a bit difficult to answer that question, because, as you know, inflation and its causes and consequences is not a primary topic of discussion for the FPC. I think your question is really about whether the performance of the central Bank has been negative or positive for perceptions of the UK. I am going to be rather boring here and say that it is a bit difficult to have an evidence-based answer to this. Probably everybody has a view. The one thing I would say from talking to colleagues in other jurisdictions is that the difficulties that all major central banks have had—including the Fed and the European Central Bank—in managing both inflation and inflation expectations are pretty widely understood. I think it is important to have that as your context for thinking about the performance of the Bank of England. That is a very long-winded way of saying no to your question.

Q272       Alison Thewliss: That is fair enough. We have talked about the impacts and some aspects of recovery—that things are going pretty much back to where you would expect—but you did say that it will take a longer time to recover in some aspects. How long would you estimate?

Andrew Bailey: I suspect that is conditional on what happens. What I hope and expect is that we will have a period of stable UK economic governance. I really do expect we will have that. There are signs of it. I think international partners will understand that we are back where we were, as it were, and things are restored to normal.

Q273       Chair: Thank you, Alison. On the pensions regulator, Sam, presumably they are taking steps to prevent this happening again. Are you happy with the steps they are taking?

Sam Woods: Yes. We are in a sort of stopgap situation. The pensions regulator with the assistance of the FCA and, crucially, regulators from other countries who directly regulate the funds we are talking about here have put in place and are urging, with agreement between the parties, an expectation that the level of resilience that was built up during the window that the Bank’s operation was running will be maintained. So that is at about 300 or 400 basis points of stress in that part of the gilt curve right now. We think that is okay for now. The recommendation we have made is that that needs to be maintained for the moment, but we need steady-state expectations as well. That is the next stage. Although it is great that we have the stopgap, I think the real test here will be whether those steady-state regulations do the job.

Q274       Emma Hardy: Good afternoon, everyone. I am just looking at your financial stability report from December 2022, in which you said, “the sharp transition to higher interest rates and currently high volatility increases the likelihood that MBF vulnerabilities crystallise and pose risks to financial stability.” From reading that, it seems your first preference is for international action. Is that right, and is there any chance it will be implemented this year?

Andrew Bailey: I should declare an interest at this point: I chair the global supervision and regulation committee, so—for full transparency—I am transferring the risk to myself, as it were, in a slightly weird world.

Many NBFI risks are global or cross-border. The LDI was probably a particular case of a domestic risk, but many non-bank risks are global. That is the first reason it is important that we tackle them globally, but there is a second reason, to which Sam just alluded. Let me return to LDI for a moment. There are two sorts of LDI funds and 85% are segregated funds: one pension fund, one LDI fund. Those are mostly UK domiciled. They were not really the source of our problem. It was the 15% of so-called pooled funds—the smaller defined-benefit pension funds that pool together into a pooled LDI fund. I think there are about 175 pooled LDI funds, representing about 1,800 underlying pension funds; it is about 10:1. All of those are domiciled outside the UK, in parts of the European Union. That illustrates why we have to have international progress on the issue.

I will give you another example, which we are working on very actively: money-market funds. We had issues with money-market funds in the global financial crisis, and again during the dash for cash. Very few sterling money-market funds are domiciled in the UK. They are mostly domiciled in parts of the European Union. That emphasises why it is important that we do this work internationally. I could go on. Look at the Archegos issue, for instance, with hedge funds and banks. Again, that very much had international dimensions.

However, I stress that the global Financial Stability Board, whose supervision and regulation committee I chair and which Sam is a member of, puts out guidance—we will be putting out quite a lot of guidance this year on this matter—but it is then for national jurisdictions to implement it, usually via the so-called standard-setting bodies, such as the Basel Committee. The UK will move forward, and I think the Bank and the FCA will come out with their own proposals this year on what we do on the money-market funds front. But going back to the point I made a moment ago about domicile, we need the European Union to do it and they have not done it yet.

Q275       Emma Hardy: The second part of my question was whether there is any chance of it being implemented this year. You do not think that anything will be done particularly urgently this year.

Andrew Bailey: No, no; there will be a lot of progress this year. It is critical, frankly. The areas that we are working on include, as I have mentioned, money-market funds and open-ended investment funds. The issue that sits behind quite a lot of this is what is called leverage in the non-bank sector, which is important because some of this leverage is quite hard to spot. Leverage in banks is a relatively easy thing to measure. It is much more what I might call strategy and structure-specific in the non-bank world.

If you don’t mind me saying, the big challenge we have with the non-bank world is that it is a vast landscape. One of the things the LDI incident really demonstrates to us—it goes back to the 85%, and the 15% segregated and pooled funds—is that the work we initiated in 2018-19 and took on with the Pensions Regulator focused on the 85%. That judgment was made because they are much bigger. The problem was in the 15%, as those funds have a much more complex structure because they are pooled. They have limited liability, and they have to because of the liabilities that would otherwise occur to the pension funds. That illustrates the need for a lot of breadth, but depth as well. That is pretty challenging globally, frankly.

Q276       Emma Hardy: What domestic action do you expect from the regulator. You have outlined clearly why action needs to be international, but what happens domestically?

Andrew Bailey: We will—I say “we will”, but it is predominantly the FCA—act on money market funds and regulation. There will be some revision, I suspect—there needs to be—to the standards on open-ended funds coming forwards. There will be some probably less dramatic but further work on margining requirements, for example. I will give you those three prominent examples.

Q277       Emma Hardy: Moving on to interest rates and how they could have played a part, between the financial crisis and now, there has been concern that ultra-low interest rates and ample liquidity could be building up financial stability risks. Might the blow-up of LDI funds in September be only the first case of parts of the financial sector struggling to adjust to non-zero interest rates? Are you expecting more?

Andrew Bailey: The point I would make there is that—some will not agree with me when I say this—the adjustment of interest rates that has been going on for over a year now in our case did not put stress on, for example, the collateral requirements and the collateral and margining process of the LDI funds. We were following them closely over the summer, and our markets desk was getting a lot of information back. There was a lot more emphasis, because they were having to put more collateral up, but it was being done. We talked to the Pensions Regulator, and it was very alert to that point. So, it was not that; that was manageable—in the case of LDI, the transfer of liquidity from the parent pension fund to the LDI funds was happening—but the massive spike in rates that happened in late September created the unmanageable stress for the pooled funds.

Sam Woods: May I just make one quick point? One bit of this is of course that we have banks at the core of the system, and we have a job to do to make sure that they get better at managing the risks coming out of this sector, given all the things that we have just been talking about. As Andrew said, there has been a series of events, such as the Archegos blow-up the year before—which we spoke about briefly and was a $10 billion hit coming from a single family office—to strain the core banking system. In that case, it was not UK banks, but certainly some entities we have here in London. We also had the issues around Greensill, which the Committee has been interested in, LDIs and stuff in the nickel market. The common factor in all of those is a lack of sufficient probing and testing of the risks to which counterparties are exposed. That is something that we can take forward, some more immediately as bank supervisors. The other big supervisors are doing it too—the ECB published a “Blog” today and the US is doing stuff—and it is a bit more tractable than what is going on outside the perimeter.

Q278       Emma Hardy: Staying with interest rates, do you think that financial stability problems were inevitable once the UK exited from ultra-low interest rates?

Andrew Bailey: No. As I said, I don’t think the adjustment of interest rates in that way has created financial stability risks of its own, in that sense. No, I would not say that.

Jonathan Hall: May I just jump in there to emphasise the point? What causes the stress is the sudden liquidity demands and the ability of operational management planning lines to meet those demands. Those demands are most stressful when they come suddenly. That happens not necessarily when rates are rising—or falling—but when they are rising extremely rapidly in a highly volatile market. That means, if they are rising rapidly, that the variation in margin that you have to put up against the moves is quite sizeable. There is also, however, initial margin, which is calculated as a function of volatility, so if that rises, that increases as well. The real stress that comes is not from merely the level of rates, but from the speed of them. When you have a very rapid—unprecedented—rise, that is when you have the stress, which is what we saw.

One other thing to say is moving slightly to the problems with NBFIs and LDIs in particular. The structure that has been built up is good at dealing with very large, concentrated positions—large entities. However, what we are having here is many, many small individually unimportant but highly correlated entities doing the same thing at the same time. I know that a lot of these are domiciled outside the UK, which is why it is harder and why we are pushing the international response.

Q279       Emma Hardy: Finally, you explained that the rapid interest rate rise was part of the concerning reaction to the situation. Do you think in hindsight, therefore, that looking at raising them over a longer period or looking at delaying raising them would have been a better solution, or do you feel that, with the circumstances being as they were, the only option was to raise them as rapidly as you did?

Andrew Bailey: I do not think the path of interest rate rises has been in and of itself a difficulty in this respect. Just going back to the LDI situation, I think what you get is that there are really three things in there and it is three things coming together.

First, as Jon was just saying, it was obviously a very abrupt movement in rates. Two, leverage. The LDI model does not necessitate leverage; it is a way of managing the assets and liabilities of pension funds. But it has become more leveraged over time.

Then the third thing is this point I made about the 15% point, namely that down in the detail you have some really difficult structural problems that became exacerbated with these other two things going on, so that these pooled funds in particular became forced sellers as a result of the combination of these three things. It is unpicking those things that gets you to the answer.

Q280       Chair: Governor, I think you have left out a fourth thing there, which was that you had made the shift, and made it very transparent to the market, from quantitative easing, where you were buying lots of Government gilts, to quantitative tightening, where you were going to be selling them, and that was also a factor.

Andrew Bailey: Can I push back on that, because, as is well-known, we have just sold £19 billion of gilts into the market? We have sold all the gilts that we bought during that period. And in my view, we have not caused a disturbance in the market as a result of doing so. Indeed, beyond that, our QE stock is now approaching £50 billion less than it was this time last year.

However, the £19 billion is quite interesting, because obviously we can isolate the relatively short period in which that happened; we started selling in late November and we finished it last week. And it hasn’t moved markets in that sense.

Q281       Chair: So it was completely irrelevant that that was happening at the same time as the gilt market had this very bad attack of indigestion?

Andrew Bailey: Yes, because actually we weren’t selling—well, at that point we had stated an intention to start selling, which we then delayed because of the disruption to markets.

Q282       Chair: You must have thought it was relevant then.

Andrew Bailey: It would have made no sense for us to be both buying and selling—doing two things at once. That would have made no sense at all. So, it clearly was not sensible for us to start QT during that period.

By the way, when we announced the QT plan earlier in the year, we made it clear that it would be state-contingent, so we have always reserved the right to stop the process if we were in a period of disruptive markets. Therefore, we were only really doing what we said we would do at that point.

Q283       Chair: We will come back to liability during investing when Dame Angela returns. However, on the profits that you have made on the gilts that you bought during that intervention, what are your plans for those?

Andrew Bailey: For the profits?

Q284       Chair: Yes.

Andrew Bailey: They all go to the Treasury. [Laughter.]

Q285       Chair: That is just automatic.

Andrew Bailey: That would be a fantasy—no, they all go to Treasury. Actually, they were bought under the terms of the asset purchase facility—

Q286       Chair: And what is the amount valued at today?

Andrew Bailey: It is around £3.8 billion. No, the Bank of England does not get to keep that. [Laughter.]

Q287       Danny Kruger: I want to ask about the countercyclical capital buffer, if I may. If I can take us back to December 2021 and your report then, in Parliament we were coping with the advent of omicron and worrying about whether we would ever get out of lockdowns, but it was pretty apparent then that the pandemic was ending and the expectation was that a year from then—December 2022—the economic outlook would be much more positive. Presumably therefore, and perhaps with anti-inflationary measures in mind, you announced that you would raise the buffer to 1% in December 2022, rising to 2% in June 2023. This was confirmed in July last year and has just been confirmed again. Can you talk us through the thinking in terms of why you have confirmed this plan? I understand why it was made a year ago, but the reason for a countercyclical buffer is that the expectation is that you will be lending into a downturn, rather than restricting borrowing, so why has this decision been maintained?

Andrew Bailey: I will start and I am sure the others will want to come in. The CCyB is not in and of itself a countercyclical policy tool in the sense that it is used to manage the macroeconomy. The purpose of the tool is actually to vary banks’ capital buffers where we see evidence of pressure building that restricts the supply of credit into the economy. You can see that coming, obviously, through their lending decisions, but you can also, obviously, see it through the returns they are earning.

To be clear, we have not yet seen evidence that there is a strong stress on the banking system in that sense and, with the rules that we have in place nowadays, we are likely to see that early—even earlier than we may have done in the past—because the provisioning regime is now more forward looking. We are not seeing that at the moment; that is not a feature of the banking system. Certainly—I have picked this up from our regional agents—it is true that there is both a reduction in demand for credit and the banks are assessing their credit risk assessments so that they are taking those decisions, but that is in what I would call the normal course of events. So the answer to the question is: we have not yet seen the conditions that we think would justify, therefore, reducing the countercyclical buffer, but as we have said, and we said in December, we stand ready to move it, should we do so.

Q288       Danny Kruger: I would be interested to hear what those circumstances might be. I understand that in theory it is not a policy lever for managing the macroeconomy, but it has effects in the real economy. You presumably accept that it is going to make debt harder to obtain for some firms at least. Do you accept that? If so, on which sectors do you think the pressure will fall on?

Andrew Bailey: No, I do not think in and of itself it is going to do that. Let me be clear: the banks are not having to build up the CCyB: they have actually got it. So we were locking in something that was there.

Sam Woods: The important fact is that we are tracking back to this 2%, which we regard as our neutral rate setting for this instrument. As Andrew was saying, the banks have sort of internalised that point already and have that capital there. The question for us was: is there a reason not to track back up to that at this point? The answer was no, for the simple reason that banks have plenty of capital headroom above that and are not yet facing the pressures—they are not really facing credit strain. Therefore, we thought it was better to get back up to it and then, of course, we can vary it either way, going forward. You asked about the conditions that would be relevant; I think the discussion would become much more finely balanced and difficult at the point at which big credit impairments were actually coming through on to the banks. I think that is really the point at which you would expect the balance potentially to change.

Dame Colette Bowe: Could I follow up a point with you, Danny? What always seems to me really important about the CCyB is that we communicate very clearly why we take whatever decision we take, be it to maintain it, raise it or lower it. As a person who has worked in the industry, I know how important that communication is. May I ask a question of you? Do you feel that the communication around why this buffer is as it is isn’t clear enough? Is that what is behind your thinking here?

Q289       Danny Kruger: It is, to a degree. I accept the value of long-term—of giving foresights to the industry about what the impact is going to be. The concern is that a decision was made in very different economic circumstances and has been maintained when everything seems to be different. I was glad to hear you, Sam—or maybe it was Andrew—say that you are open to changing it, which of course you should be. In July, as I understand it, you made it quite explicit that if conditions deteriorate, you are open to change, whereas that indication or commitment was not repeated in December—

Andrew Bailey: It was.

Q290       Danny Kruger: Okay. I am sorry if I missed that. But to Colette’s point, it is about long-term plans, so how quickly, and under what circumstances, might you adjust the plan to raise the buffer? Would you do it in advance of July, do you think?

Sam Woods: I think it is very unlikely in advance of July, partly because it is actually unhelpful if we are constantly moving this stuff around at a very high speed—of course, it is always possible, and we review it quarterly—but also for the reason that I gave, which is that a turn in the economy that was coming through in credit impairments would be a salient change for us to take into account. Just based on what has happened so far—and we have put in the report our expectations around what is going to happen during the course of this year—it strikes me at least, based on the evidence I have seen, as unlikely that that could turn in a sufficiently violent way to make it sensible to change course. Of course, if it did, then we would be open to that, and we always maintain the ability to go up or down. But the fact that we are tracking back to what we think of as the neutral rate is a relevant point here, because we are trying to get to the starting point that you would want to be in before going into such a situation.

Q291       Danny Kruger: Just for the record, I understand that at 2% it would be the highest ever buffer. I accept that it is theoretically neutral, but this would be a very high buffer historically.

Sam Woods: It would be, but only for the reason that we have constantly been deterred from getting back to it by changes around us. Covid was actually the most major one: that really was big enough to make the change. As I say, it is deeply baked into banks’ expectations, and that is why they have got it currently.

Andrew Bailey: We will take another decision on CCyB. As Sam said, we do it every quarter, so there is another one coming up in two months’ time. Just for the record, paragraph 55 of the December record has the same language in it.

Q292       Danny Kruger: Lastly from me, if I may—this is somewhat relevant or related—you were speaking quite optimistically about the state of the mortgage market. I recognise that there are some of those positive indicators, but we just had a letter from the FCA warning of 750,000 defaults. It might be that new products are flowing again, but people who are locked in are at significant risk—we are looking at 800,000 people who are facing a tripling of their payments this year. I appreciate the FCA was assuming slightly higher interest rates than we are now hoping for, but still, how do you see the risk of default in the mortgage market at the moment?

Andrew Bailey: I would just say on the FCA number—perhaps we should come back to you on this—that there are a number of different numbers that go around, and people use them legitimately for different purposes. I think that number captures every payment that is late.

Q293       Danny Kruger: I think it is about 200,000 already in default, and there are people who are at risk of default because their payments are now such a high proportion of their income.

Andrew Bailey: Yes. The point I was going to make is that there are several measures: there is a measure that captures payments that are more than three months in default, and there is one that captures payments that are more than six months in default, but the one the FCA uses is any payment that is later than its contractual point, which will always be a higher number, I suspect. We do not have the record, but we can—well, as I say, I want to be very clear that I realise the difficulty that this causes for those households that are affected. Rising interest rates are difficult in this respect.

Where I think we start is that it is a mixed picture, in terms of what is going on. Overall, mortgage debt service levels are lower than they were at points in history when we had stress—the early ’90s and pre-financial crisis. However, I do recognise that one of the big distinctions between now and some of these points in the past is that we are in a cycle of rising interest rates, as you said, whereas in those periods it turned out that it was a cycle of falling interest rates.

I would also say two things. One is that fewer mortgages are at high loan-to-value rates than they were in the past, and that will have an impact on what should feed through into repossessions.

The second thing—sorry, there are three things I want to say. The second thing is that I do think the FPC’s mortgage tools, particularly the flow limits, have beneficially limited the number of households with very high loan-to-income ratios, which would be much more likely to be experiencing problems.

The third one comes back to two things. One is the fact that the banks have more capital, and the second is that they are under an obligation now to handle customers with payment problems very differently to the way they did in the past, which is why we are seeing fewer repossessions. I would expect to see fewer repossessions going forward because the banks have an obligation now to treat customers differently, and they have the capital resources to do so. One of the problems we had with the financial crisis was that they were absolutely up against the wall, let alone the borrowers. All of those things are important and I hope will help those households that are affected.

Q294       Chair: Sam, to clarify on the capital buffer, when it was loosened it was alleged that it would potentially result in £160 billion more; I just wondered what the outcome was.

Sam Woods: In effect, the meteorite didn’t hit, because of the action that the Government and central banks around the world took to stave off the impact of covid. We published a chart in the report, where you can see what has happened to actual bank capital levels: they are basically tracking up a long march since 2008, which is the reform coming through—the tripling in the level. Then there is a step up for covid, because precautions were taken by us and by firms, and then they have come down again a bit because of some regulatory changes, and also because of some payouts that have been made. So in the end it didn’t bite. That is why we are in the position we are in at the moment.

Dame Colette Bowe: If I may, Chair, going back to the questions on mortgages, the impact of the cost of living and all that, there are quite a lot of different ways to understand what is happening in the market at the moment, and I would like to suggest, Andrew, that we write to the Committee and explain some of the work that is being done inside the Bank—for example, on looking at the ability of households to service their debts after you have taken account of the cost of living pressures on them. As we know, cost of living pressures on different households are very different. If you are going to make sense of who might be at risk at the moment in terms of mortgage defaults, you need to really focus in on that. Chair, if we may, I suggest that we write to you about that, because it could maybe give you a more holistic picture of what is going on and what the risks are.

Chair: If you have done that kind of work, we would be very grateful if you would share it with the Committee.

Q295       Mr Baron: I want to explore the extent to which global debt vulnerabilities are a risk to financial stability. What do you say to the charge that when it comes to combating inflation central banks globally have been behind the curve from an interest rate policy point of view? That in effect has not just meant that inflation has risen to the levels it has now, but low interest rates encourage debt, so we have a situation of rising debt and rising inflation, which surely cannot help financial stability, can it?

Andrew Bailey: We also went through quite a long period of low inflation when, in many ways, central banks were trying to stabilise inflation upwards rather than downwards, which is obviously different from historically. That was a period where QE was used.

Q296       Mr Baron: Yes, but there was a long period when interest rates remained very low relative to inflation, with clear signs of inflation ticking up. It did not suddenly jump from 2% or 3% up to 10% or 11%, but still central banks—not just the Bank of England—were well behind the curve. This has encouraged rising inflation and high debt levels, so I don’t take your point. Yes, there was a long period of low inflation, but when inflation did start ticking up, interest rates stayed pretty stable for a long time and ignored all the siren warnings about inflation, and are now playing catch-up.

Andrew Bailey: Actually, it was not that long a period, if you don’t mind my saying so. We had the covid period and then 18 months or so of coming out of covid—two years at most. So it was not that long a period, if you don’t mind my saying so. Over that period, we have had a number of shocks that have affected the world economy and contributed to the pattern and pace of adjustment. The first big global shock that I would draw out is what we tend to call the global supply chain shock, which was the coming-out-of-covid shock. That really reached its peak a year ago and has been declining since then—probably declining at a more rapid pace as last year went on. We see that in traded goods prices, shipping costs and other things. The second, much bigger, one is the tragic war in Ukraine, which has had a huge impact.

Q297       Mr Baron: Can I push back slightly? Before the supply-side shocks, or the global supply chain shocks, and even Ukraine, there were clear signals—for example, money supply figures going through the roof—of pockets of inflation around the place. There was no shortage of economists warning that inflation was there, and was coming around the corner in some measure, yet banks—the Bank of England included—kept interest rates very subdued. I raise that because it encouraged high debt. When interest rates are low, people take on debt: it is a natural phenomenon. We have a situation now where we have debt levels still going through the roof—they are very high by historical standards—and inflation, as we all know, at 10% or 11%. That cannot be good for financial stability. I am not just laying this at the Bank of England’s door; I am laying at the door of central banks generally. Have you been sleeping on the job?

Andrew Bailey: In my view, QE was used during the covid period—this was very well set out by Ben Bernanke in his recent book—to stabilise rates further along the curve, and particularly to stabilise rates for corporate borrowers during the covid period to help them deal with the shock of covid. That had a beneficial effect.

Q298       Mr Baron: Can I push back even further? There is a view that this policy of ultra-low—artificially low—interest rates was deliberate. In the absence of growth, the best way of eroding debt levels is to encourage inflation.

Andrew Bailey: Oh come on!

Mr Baron: I don’t expect you to agree with that.

Andrew Bailey: No.

Q299       Mr Baron: I do not expect you to say, “This is what the policy was,” but look at how it played out. There was a theory: how is it that central banks can allow inflation to jump to 10% or 11% when they had most of the tools at their disposal? It is a little convenient, isn’t it, that when you have inflation at that level, debt gets eroded pretty quickly.

Andrew Bailey: Can I push back on that? I’m afraid the biggest single reason that inflation has risen to that level is the war in Ukraine. It is also the most likely reason that we are going to see a rapid fall in inflation in the year ahead. We are not seeing energy prices rising further—in fact, they are coming down.

Q300       Mr Baron: History would suggest that once inflation exceeds 5%, it takes many years to get it down to around 2%. I know there are these forecasts saying that it is going to halve, but history does not suggest that that will happen. Once inflation is endemic in the system, it gets built into wage claims and everything else, and expectations rise. Am I being unfair?

Andrew Bailey: We are in danger of having a monetary policy hearing. Let me make one point. I think that, going forward, the major risk to inflation coming down in the way that—this is my central case—I think it will is the supply side, and in this country particularly the question of the shrinkage of the labour force. I’m afraid I do not remember people saying during the period when we were coming out of covid, and particularly while we were still in the furlough scheme, which we were until the end of September 2021, “You know what? The labour force is going to shrink in this country.” I really do not remember people saying that.

Mr Baron: We are going to have to agree to disagree.

Andrew Bailey: We should continue the debate. We have another hearing next month, so—

Q301       Mr Baron: Let’s move on to ultra-low interest rates, certainly relative to inflation. There has been a misallocation of capital, to a large extent. For example, some estimates suggest that 10% to 15% of companies in the US are so-called zombie companies. In other words, if interest rates were to rise much more, you would have a lot falling out of the system. That would be a danger to financial stability. To what extent do you subscribe to that view—that one example of this misallocation of capital is zombie companies?

Andrew Bailey: I don’t particularly subscribe to a more structural view of it. I think that one of the things that we do look for—I think this is more of a risk in the US than elsewhere—is the risk that comes from excessive leveraged lending, which creates more leverage in the corporate sector. It is something that we have been highlighting for some years now and that I think we probably need to be more focused than ever on. The numbers would certainly suggest that it is more of a US phenomenon than a UK phenomenon.

Q302       Mr Baron: Moving on to the broader picture, we have got high inflation, which some of us believe will be stickier than central bank forecasts, and eye-watering debt levels—not just in this country, but globally. Where do they fit in on the risk profile, with regards to other threats to financial stability in this country? May I ask you to include the deteriorating economic system in China in that list? Where do high debt, high inflation, China, and any other threats come in? Give us some sort of general view as to where the dangers are, from your point of view.

Andrew Bailey: We do have to keep a close eye on debt levels in this country. Going back to what I was saying earlier, it becomes a bit mixed, frankly. Both corporate and household debt levels are still below where they were pre global financial crisis, but we are, as I said earlier, in a period of rising rates, so we have to be aware of that. Now, on the corporate side, in this country, the evidence is that the debt level is rising more in small firms than it is in large firms, so again we have to be focused on that. I have also just mentioned leveraged lending, which I think is more of a US phenomenon than a UK phenomenon.

As far as China is concerned, yes, we do have a very close watch on that, not least because, obviously, as you will know, our financial system is more exposed there, due to the historical connection, than other systems are. That is why, in all the stress tests that we do of our banks—Sam is doing one at the moment—we have to give a lot of thought to the “China shock” that we put into them, because of the impact that it will have.

On the economic outlook for China, my view is that, first of all, it is quite likely that we will see a negative impact on China in the short run, from what is going on at the moment, in terms of the release of the covid restrictions and the impact that is having. I am not sure that that will be very long lasting, though. I suspect that they will come through that. I think, then, how they manage credit in the system is important. My sense is that the property sector continues to be under stress, but they are managing the supply of credit into it. However, you are right: we do have to keep a very close watch.

I am afraid that the other risk is that we are still living in very difficult conditions, given, obviously, the potential for any further impact from the war in Ukraine.

Mr Baron: Thank you very much.

Chair: We will now go back now to the liability-driven investment issue, and Dame Angela.

Q303       Dame Angela Eagle: Governor, what was the cost of the problems in pension funds caused by the mini-Budget and what happened with liability-driven investments? What was the cost of the fire sale of assets? Have you—

Andrew Bailey: So, the cost to pension funds?

Q304       Dame Angela Eagle: Yes, to pension funds—the fire sale of assets caused by the run on the economy.

Andrew Bailey: I do not have numbers for that. One of the reasons why I do not have the numbers is that pension accounting has quite a distinctive form of accounting. My understanding was that the pension funds themselves were actually, if anything, not recording a decline in their net liabilities. That is due to the accounting framework that is used, so you cannot use that way to get at it. So, I do not—I am afraid we are not a pension regulator, as such; we are not a micro-regulator of pension funds. If you would like, I will take the question away and we will see what we can come up with, but—Sam, I don’t have any—

Sam Woods: I think that’s right, Andrew. Obviously, we do have numbers for the volume of gilts that were offloaded. We have numbers for the volume of capital that was brought into the system. We have put them in a report that could shed some light. So, we have got those, but maybe we can also look at that question.

Q305       Dame Angela Eagle: Could you take us through those now? It’s a secondary way of trying to find out what the cost to DB pensions particularly would have been. There was a sudden and enforced fire sale of assets on the pension funds’ books, wasn’t there?

Andrew Bailey: Yes. The number I remember for the LDI funds during that period from about the last week of September through to the middle of October was that they sold something like £23 billion of gilts. That doesn’t tell you the loss, of course; that is the gross sale. And as I say, it is clouded by the accounting treatment of these things. But if you like, we’ll see whether we can come up with something; we can also ask the other parties involved whether they can add any—

Q306       Dame Angela Eagle: The Pensions Regulator was also encouraging DB pension funds to invest in these kinds of liability-driven investments, was it not?

Andrew Bailey: Well, I mentioned before you came into the room that I think the origin of LDI investment was as a means of managing asset and liability portfolios and pensions, bearing in mind the future liabilities of pension funds, and the cash flows. I think that makes sense, but what has happened is that they have become more leveraged over time. That’s the change, I think.

Q307       Dame Angela Eagle: You were talking about leveraged borrowing, in some ways, earlier, in answer to a question from one of my colleagues, but leverage, when it begins to build up in these kinds of areas, can be a cause of instability. Are you worried that this kind of build-up of more dangerous investments can happen on your watch and you can perhaps miss it?

Andrew Bailey: I apologise to the other members; I hope they don’t mind my repeating something I said earlier.

Dame Angela Eagle: I am sorry: I couldn’t be here earlier in the session.

Andrew Bailey: No, don’t worry: I totally understand. I was just saying I apologise if members have heard this before. We had what I call an 85:15 situation. The reason I say that is that 85% of these LDI funds were what is called segregated funds: a big pension fund has a single LDI fund dedicated to itself. And 15% were in so-called pooled funds, which were smaller pension funds coming together into a pooled LDI fund. I think there are about 175 pooled funds, representing about 1,800 underlying pension funds.

A lot of the work that was done post 2018—in fact, I think, all the work we had done post 2018—was on the segregated funds, because they were big. So that was the 85%. The experience we had in late September and early October 2022 was that the segregated funds were not forced sellers. They did sell—we saw some of the numbers for what was going on, because obviously we were buying. They did sell towards the end of our window, but they were not forced sellers in that sense.

It was the pooled funds that were the forced sellers, so it was the 15%. I think the reason—or one reason anyway—is that the pooled funds have a limited liability structure. That is obviously essential in that structure because no one pension fund is going to take on the liabilities of every other pension fund that is in the pooled fund.

The problem, I think, with that limited liability structure—I am going towards the limits of my knowledge of pension funds now—is that they had to therefore have triggers in them, because if a single pension fund says, “I’m not going to meet that collateral call; I’d rather walk away”, given the shock, then the pooled fund has to handle it, given it has other funds in it. I think they do that by having triggers that say “You have to start selling that piece of the assets” at that point, and so they became forced sellers. And that triggered a good part of the problem.

I think we must hold our hand up at this point and say that, by looking at the 85%, the 15% remained relatively obscure, and the fact that this legal structure was sort of buried in there was also somewhat obscure. I was saying earlier that the challenge we now have, if I raise it up to the level of the whole non-bank sector, is this. The non-bank sector is a huge landscape, particularly globally, but we have a lot of parts of it in this country, so the challenge we have on our hands—obviously, we need the assistance from the micro-regulators—is how we get both the breadth and the depth of the coverage here. It is a pretty big challenge in that respect.

I will say this. Obviously, it is important that we also have what I call the backstop arrangements in place, so that we can deal with these problems if they occur. The backstop arrangement in this case was the gilt purchases, and obviously we can say this now: I think it worked, in that sense. What we set out to do has achieved its objective.

Q308       Dame Angela Eagle: But we don’t quite know at what cost to the funds yet. When there is a fire sale, there is a fire sale; you offload assets at a cheaper rate, and the implications for those who are relying on that particular pension fund for their retirement are obvious.

Andrew Bailey: Your question is fair enough. I would remake a point that I made earlier: the other challenge we had in this situation was that the movement in long gilt rates was historically unprecedented.

Dame Angela Eagle: Which is what stress tests are supposed to be about.

Andrew Bailey: No, as I was saying earlier, with a stress test you always have to pick your point in the distribution of outcomes. We do this with the banks’ stress tests. Beyond that, in the case of the banks you have a resolution regime and a backstop liquidity regime. You have to make that choice, and you draw on history to some degree to make that choice. This was two to three times bigger than any movement in history.

Jonathan Hall: Obviously the instrument was purchases, but it was a means to an end, and part of that was to give the pension funds time to raise the liquidity. This links the two points—that any fund that has either derivatives exposure or some kind of leverage has to have a plan or operational capability to deal with liquidity demands. What happened here was not only that the stress was larger than anything that had been tested or was historical, but that it was so fast that these very small, inexperienced funds that were not dealing with normal collateral flows had to deal with that in an extremely short period of time.

If we turn back to the analysis, we can show not only that some fire sales were happening, but that a significant amount of liquidity was raised within that period, meaning that fire sales that would otherwise have happened did not happen. That saved those pension funds that money. Obviously, going forward it is not just about the question “What should the stress levels be?” or “How large should the buffers be?”; there has to be an emphasis on planning and operational capabilities to raise that liquidity fast enough so that the fire sales do not need to happen and there is no stress on the pension funds, but also no financial stability impact.

Q309       Dame Angela Eagle: Yes, perhaps not to leverage up to the amounts that they did. The financial stability report acknowledges that regulatory and supervisory gaps exist in LDI approaches. What are you doing to learn from this episode and close them?

Andrew Bailey: As I said earlier, there are two dimensions to this. There is a UK landscape, which has a number of regulators in it and the FPC as the macro-regulator. Jon has just made a very important point that relates to our thinking about stress testing and what we would like the micro-regulators to do. I put it in terms of the legal restrictions. Jon rightly pointed out that there were governance issues around how quickly they could do this. That is the sort of issue you have to tease out.

Q310       Dame Angela Eagle: Assembling the trustees, you mean.

Andrew Bailey: Yes. The second point I wanted to make is interesting. I drew the 85:15 distinction between the segregated funds and the pooled funds. The segregated funds are mostly UK domiciled. None of the pooled funds is UK domiciled; they are domiciled in parts of the European Union. You have to further regulate. I mean, we are already doing that, by the way; I know the micro-regulators are, but you have another dimension to the regulatory situation.

Q311       Dame Angela Eagle: You have supervisory and regulatory gaps, and regulatory complexity, so there is a complex and fragmented system, as I think you pointed out, Sam. Is there any way of simplifying this and getting a clearer line of sight in some of these complex, convoluted areas of investment activity?

Sam Woods: We deal with a lot of very complex and convoluted things; the banking system itself is very complex. This specific issue around the resilience of LDI funds to big spikes in gilt yields is a narrower area. It exists in a complicated regulatory landscape.

What has happened kind of through force majeure is that the relevant regulators, which in this case are mostly the Pensions Regulator here with assistance from the FCA and the two main EU regulators who host these funds, have put in place an expectation for a requirement that a fund should be robust to a blow-out in yields as big as the one that we saw. Crudely, we welcome that so that is fine, but we need a steady-state version of it. I think that is what we and the Committee should expect to happen. That itself will be quite a strong mitigation.

What will be interesting to see will be if you have those constraints in place and they limit the extent to which funds can leverage and—it is a bit unfair to put it this way—there is a bit of having your cake and eating it: you keep the returns from the higher returning assets you have and you leverage for the gilts part that you need for matching purposes. Once you have put in the requirement to be robust to that level of movement, is that still a commercially attractive thing for pension funds to do? That is what I think the debate will be about.

Q312       Dame Angela Eagle: Perhaps discouraging leverage might be quite a good idea from a financial stability point of view.

Sam Woods: It is true that if we removed all leverage from the system we would have much less financial stability risk, but we would also have a lot less of other good things.

Q313       Dame Angela Eagle: Some of it; I am not saying all.

Sam Woods: Clearly, they had become too levered because they came unstuck when there was an outsize move.

Q314       Dame Angela Eagle: Is some of this about remuneration incentives? The incentives of the people who run them are for returns, so they will take reward from the activities and results of funds by taking on more risk than perhaps they should in an area such as pensions. Have we got the wrong incentives?

Andrew Bailey: I think what happened is that what started as a means of managing asset liability positions became a means of actually increasing the return to the fund. I think that is what happened—that is the leverage point, really. Then we get exactly to the point you make. It has slight echoes of the discussion we were having on Solvency II at the beginning—where you put the line in terms of the acceptable risk.

Q315       Dame Angela Eagle: If you are investing in some gung-ho investment fund, your acceptable risk might be far higher than you would want your trustees to take for your pension.

Andrew Bailey: Yes, but this is gilts we are talking about. This is not to do with exotic assets; it is to do with interest rate leverage on fairly straightforward assets.

Sam Woods: What we have learned is that there was not enough understanding among the trustees, particularly among those in the pooled funds.

There are really two separate things. One is how big the move could be, but we can all be criticised for that. The move was twice as big as what happened on the way into covid. Sometimes things happen and get worse.

Secondly, on the point that Jon was raising, the speed at which movement might be necessary in terms of getting the right collateral into the right place: that was really the main problem, because the segregated funds could get there—one pension fund, one LDI operation—but these others just could not get there in time. That was not properly appreciated. That is the kind of thing that can be improved.

Jonathan Hall: Normally the problem with leverage is the size of the losses in the assets you hold, whereas here the assets were being held as a hedge to their liabilities so, as has been said publicly, pension funds should have been benefiting from the rising yield, and in aggregate they in fact were.

Even the individual pension funds—I have not heard of any for which this was not the case—that had leveraged holdings were still, net, hedged. The issue with the leverage here is not the fact that the performance was being leveraged up and they were taking risky investments; it was that any leverage always means that you have to have an ability to meet liquidity demands. That capability was not there in these tiny funds with a small number of trustees investing in the pooled funds domiciled overseas. That is the key. If they had been able to meet those liquidity demands, they would still have their hedge and it would have been a net positive thing for them. That is the issue that has to be addressed.

Q316       Chair: Thank you very much. We will move on now to the financial stability risks posed by cryptoassets. I understand, Mr Hall, that you are recused on an ongoing basis from any FPC discussions of cryptoassets, because of a holding that you have in cryptoassets.

Jonathan Hall: Yes, in a company called Guardtime. That’s right, yes.

Q317       Chair: When did you acquire that holding? I ask because I know that when you came in for your pre-commencement discussions with us, it wasn’t mentioned in your questionnaire, and that you have recused yourself from the discussions in the committee since July 2021, so it must have been during the time—

Jonathan Hall: The holding is a long-standing holding. It was reported to the Bank and it was perceived not to be a conflict at the time that I came in here. It’s a company that is engaged in blockchain security, and that was perceived at the time not to be in any conflict with anything the FPC was doing. That was not a static decision but a dynamic decision that was reviewed over time. Relatively soon after I joined the committee, there was a discussion of stablecoins and potentially of CBDC that was tabled, and I went back to the Governor and the team within the Bank and reiterated that I had this holding that I had already told them about but that had been perceived not to be a conflict. It was decided at that time, not only because it might be a conflict but because there might be a perception of conflict, that I should be recused from any conversations and from receiving any papers from that point on about stablecoin, CBDC, cryptocurrency, DFI—anything in that space.

Q318       Chair: It wasn’t in your pre-commencement questionnaire, though.

Jonathan Hall: Well, it wasn’t as a conflict; it was reported as a holding.

Q319       Chair: It has subsequently been viewed as a conflict.

Andrew Bailey: Could I just emphasise the point Jon just made when he said “as of now”? The point was that when Jon joined the committee, we were really not devoting time to discussing these issues, but fairly soon after Jon joined the committee, obviously these issues got larger and we did, and Jon recused himself at that point. So the reason it was not a conflict when Jon joined the committee was not that it wasn’t a conflict by today’s standards; it was that we were not focused on—we were focused at that point in time on a different set of issues, none of which at that time would have presented a conflict in terms of this holding.

Q320       Chair: I think we might start being a bit more explicit in our pre-commencement questionnaires about some of these holdings that external members have. Colette, you wanted to add something to this?

Dame Colette Bowe: I would like to agree with what has just been said. The way Andrew and Jon have described this is absolutely right. When Jon joined us, we were not talking about these issues, but you never know how things are going to develop, and I think that when somebody joins the committee, you need to have absolutely full—the whole lot out there, just because life changes.

Andrew Bailey: Can I just emphasise, as chair of the committee, that Jon did not withhold anything from us when he joined the committee? That is really very important.

Q321       Chair: But it wasn’t picked up in his pre-commencement questionnaire that we—

Andrew Bailey: That may be true, yes.

Q322       Chair: So I think what we will do, Governor, if you are happy with this, is that, in future for these pre-commencement questionnaires, we might ask for the level and sort of disclosure that we are subject to here in the House.

Andrew Bailey: That’s fine. What I would suggest is probably that the Secretary of the Bank talks to the Clerk and we can sort that out.

Q323       Rushanara Ali: It would be helpful for this Committee to be informed if there are changes, because we weren’t party to this and the Committee did produce an inquiry report on crypto. before Mr Hall joined the Bank and came to this Committee for a pre-commencement hearing,. It was quite an extensive report, so in the Committee’s work this was of interest. And I think, just to avoid a situation like this, it would be better to be kept in the loop—because we were kept out of it altogether.

Andrew Bailey: That’s fine. I totally understand. As I say, it was disclosed, but we certainly understand—we can inform you proactively, as it were.

Q324       Rushanara Ali: Yes, just as a “for info”, because then it makes it less problematic, or awkward for Mr Hall.

Jonathan Hall: Just in terms of the change, immediately that this was perceived to be a potential conflict, it was mentioned in every discussion of crypto and publicly after that, so it has been extremely transparent.

Q325       Chair: Understood. Moving more widely to the stability risks posed by cryptoassets, I believe, Sam, that it continues to be the view of the FPC that the direct risks to UK financial stability from cryptoassets are limited. Is that the view of everyone on the committee?

Sam Woods: It is certainly my view, and I think it is the unanimous view—obviously excluding Jon, who has no view. The reason for that is really that the core of our system has stayed a fairly long distance from most of what is going on in crypto markets and with cryptoassets. That is not entirely an accident: we have been very clear in our guidance to the banks from the PRA with the support of the FPC that they should be very cautious in any activity they undertake in that market, and that we would seek to capitalise things in a prudent way.

We have also been very forward in the Basel discussions. Andrew and I have just agreed with the other governors, and heads of supervision just before the break, a fairly robust standard to make sure that if banks do get involved in this stuff, it does not present a risk. That has been the view that we have taken, and I would say, given the extent of the implosion that we have witnessed over the last year in crypto—both the collapse in asset values from about $3 trillion to $0.8 trillion, and then the individual episode around FTX—there has been really no discernible impact of that on the financial stability of the UK system.

Q326       Chair: You said in the financial stability report that the failure of FTX underscores the need for enhanced regulatory and law enforcement frameworks. Is there not a risk that, actually, more regulation might create some sort of halo effect and make it become more of a financial stability risk?

Sam Woods: You can certainly have that debate. The law enforcement part of this is actually more for the FCA: to the extent that these types of financial asset, whatever your view on their credibility, are being used as an alternative mechanism to get around some money-laundering, anti-terrorist financing controls that we impose on the main system, that should not be allowed to go just because it is outside the system. As I say, I think that is more for the FCA than for us, but we are also interested in the prudential oversight of these things. For the Bank and for the FPC, the most important part of that is around the possibility of the emergence of what we call a systemic stablecoin. If a coin came into usage that was being widely used by people as a means of payment among themselves—which is possible; it might come along, for instance, through sponsorship by one of the major tech companies, or something of that kind—that, I think, is the bit that the FPC would need to be focused on.

As for the speculative bit, people bet on all sorts of things. People bet on horses; they can bet on crypto. I do not think that need worry the FPC too much. It may be an issue for a consumer point of view, but the stability issue is around a systemic stablecoin.

Q327       Dame Angela Eagle: We know that there is kind of an underbelly to the financial system that crypto plays a huge part in at the moment, and clearly it is not regulated—nor should it be. We all want those who dabble in Bitcoin and the various other coins that exist to be aware of how little protection they have when it comes to losing money, but at the same time, loads and loads of people in the country do speculate, and loads and loads of people do take these coins as if they are backed up. It is the source of an awful lot of fraud and conning. Shouldn’t we be taking more of a warning approach to some of this than just saying, “Oh, it’s out there. It’s like betting on horses”?

Andrew Bailey: You are preaching to the converted, if you don’t mind me saying. I have been saying for four years that it has no intrinsic value.

Dame Angela Eagle: You have, Andrew, that’s true.

Andrew Bailey: We talk about crypto. There are two or even three parts to it, and I think it is important to say that when we have this sort of conversation, we are talking about what we tend to call unbacked crypto of the Bitcoin variety.

The second part of it is stablecoins, which are not much in evidence in this country at the moment, but exist in the US and could spread. They are designed to have far more of the characteristics of money. The FPC has already come out—about a year ago, wasn’t it?—with its views on the principles that should govern those, because we take a very strong view that if it is going to have the characteristics of money, it has to live up to them, and one is that it must have assured value. Unbacked crypto has anything but assured value—in my view, it has no intrinsic value. I would make that distinction, because I think the regulatory treatment—I think you are seeing Jon Cunliffe fairly soon—will make that distinction.

The third part, which I will not dwell on much but which is being worked on actively internationally, is what we tend to call decentralised finance, which is one of the ways in which these things are being used and managed. Those are some ways for the application of artificial intelligence and machine learning to financial contracts. There is lots of potentially there, obviously, but it has the risk in there—you see some of this with the well known failures—that it is attempting to put things beyond the reach of jurisdictions by in a sense creating this world that, though I am not an expect, I do not think exists and will not exist, where it is outside human control as it were. I don’t think we will get to there, but it will make our lives more difficult in doing so.

Chair: John, do you want to come in with a quick question?

Q328       Mr Baron: Can I just push back on this idea that it is not a risk to the system? You have millions of accounts holding cryptocurrencies. The figure that I was astounded to hear was something like 3 million. You have the chance of it offering the transfer of money illegally or the transfer of illicit money. You have seen the collapse in the FTX exchange, which has caused problems for many—many people have lost money. How can that not be even a marginal risk to financial stability? It is affecting people’s lives and wealth.

Andrew Bailey: The bar on financial stability is quite high, but I would agree with you. I think the halo effect is a real challenge, don’t get me wrong, but I don’t think it is sustainable to have this world where people like me get our megaphones out and say, “Don’t touch the stuff. It has no value,” because as you rightly say 2 million or 3 million people have got it. The FCA survey suggests that in this country the average holding is probably quite small. For some people I suspect it is a bit of a novelty, but clearly some people are losing money as a result of it, so I agree with you on that. I think we have avoided the worst in this country; the US has a much bigger set of issues. The US regulators are being much more aggressive on it, and that stands because of that. I don’t think we can take it for granted that that would always persist. I agree with quite a bit of what you say in that respect.

Q329       Alison Thewliss: Given the amount of money that people can be paid within this industry, is there a lack of expertise within regulators? Does that become then a financial stability risk if you cannot keep up?

Andrew Bailey: In crypto?

Q330       Alison Thewliss: Yes.

Andrew Bailey: We have had to recruit people, particularly with the technical knowledge. What we are trying to do is combine our knowledge of financial stability and financial risk with people’s knowledge of the technology. The fact is that parts of technology will, hopefully, have uses in other areas. We are very much prepared to see that happen. So, yes, we do have to do that. It is not the first time we have had to do this sort of thing, but I think all regulators have to do this. We have certainly been active in that field, yes.

Q331       Danny Kruger: I have a couple of questions about central bank digital currencies—not crypto. We had the Economic Secretary here, Andrew, and the Treasury and the Bank are working together on a taskforce to look at CBDC. His sense was that we would see a stablecoin backed by the pound arrive sooner than an actual sovereign digital currency in this country. If there were a stablecoin that people could use, do you think there would be any real need for a digital currency in the UK?

Andrew Bailey: That is a very interesting question—fascinating—which gives rise to other questions. As I said earlier, the FPC has already set out its own standards or principles that it should apply to a sterling stablecoin—actually particularly to what we call systemic sterling stablecoin, meaning ones that would have wider use, which is what you are talking about here. As I said, certainty of value is critical, and that gets to the cold question of the backing assets. I think for me a big question here is: can we imagine a sterling stablecoin that meets those criteria and that is anything other than something that looks rather like a synthetic central bank digital currency? The ultimate risk-free sterling stablecoin would be a fully 100% central bank reserve-backed instrument.

Curiously, we have a very traditional arrangement for banks issuing banknotes in Scotland and Northern Ireland that is a little bit like that. I sometimes say that you are in some ways talking about a digital version of Scottish banknotes, which are issued by commercial banks but fully backed at the Bank of England. We revised the rules in my time as chief cashier, because there were some loopholes in them. I think you are going to get to the question: what is the difference between that and a central bank digital currency? I will not get into the Scottish issue—I will leave that to you, Alison. What is the difference, and what is the better way to go?

I don’t want to talk all day about this subject, but there is another important issue. There is a boundary between what we call central bank money and commercial bank money in the system we have now, and that is important. Of course, wholesale central bank money is available in electronic form now—we are renewing the RTGS system to make it more digital, among other things—but it is not accessible to the public. The only way the public can get central bank money is through banknotes, and there is probably a limit on the number of banknotes that any of us want to have, for obvious reasons. The question about how you would imagine limiting the boundary between central bank money and commercial bank money in a digital world is an important one, both in normal times and in stress times, because it would make bank runs easier. That is important, because commercial bank money is lent into the economy. We do not lend into the economy—that is not our job, and we would not want that to become our job. We are not going to get into the business of being a retail bank—that is clear. But we have to think about the economics of that pretty hard, because it potentially changes the boundary.

Q332       Danny Kruger: Very interesting. Thank you. There is a huge conversation to be had, which we do not have time for, but those are some of the issues around it. Can you explain to us what you think the advantages of a CBDC are? We are talking about wholesale, and we will come on to retail in a second. Andrew Griffith was implying that it was because the rest of the world is doing it and that, if we do not do it, the City is going to suffer. Is it just about that?

Andrew Bailey: I slightly differ from Andrew Griffith on this, because—

Danny Kruger: To be fair to him, he said that there are upsides as well, but he stressed the jeopardy of being left behind.

Andrew Bailey: The question of whether we need a wholesale CBDC gets to the question whether that is any different from having a real-time gross settlement system, particularly the one we are building to renew the one that has been here for 25 years, which is a more digitally open and enhanced RTGS system. I am not sure it is, because RTGS settles—

Q333       Danny Kruger: You are not sure it is different?

Andrew Bailey: A wholesale CBDC and a digital RTGS system are different, because a digital RTGS—or, indeed, any RTGS, such as the one we have today—settles in central bank money. It is central bank money.

Q334       Danny Kruger: It is slow. That’s the problem, is it?

Andrew Bailey: The existing system is over 25 years old, but it did its first £1 trillion day recently, so it is a pretty venerable system that works.

Q335       Danny Kruger: The offer of this technology is that you can do massive transaction volumes in seconds—that is the argument.

Andrew Bailey: If you don’t mind me saying so, I think that remains to be seen. I am not saying that as a Luddite, because I am all in favour of technology.

Dame Colette Bowe: You’re not a Luddite!

Andrew Bailey: Thank you, Colette. I sometimes get the payments experts come to me and say, “It’s great to see distributed ledgers, but an RTGS system is faster.” I think it is an open question whether a wholesale central bank digital currency is needed, because we have a wholesale central bank money settlement system that we are doing a major upgrade on—it is the biggest investment project the Bank of England has ever done, actually—in order to enhance it to meet that world, as it were. So I think that is an open question.

Q336       Danny Kruger: I am pleased to hear that you are not absolutely giddy with excitement at the prospect of a wholesale CBDC, because I think there is a bit too much irrational exuberance around it as it is. Do you share my concerns about the prospects of a retail digital currency? If we were to proceed with a wholesale system, do you think we might soon end up with people saying, “We’d like to be able to have our own digital banknote”?

Andrew Bailey: To be clear, we are not trying to abolish cash or banknotes. I do quite a lot of talks on this, and I start by saying—it can come across the wrong way—that we have to be very clear about what problem we are trying to solve before we get carried away with the technology and the idea. I am not convinced about some of the problems that we might be trying to solve. I am not necessarily convinced that the retail payment systems need this sort of upgrade at the moment. We are not trying to replace cash. We meet the public’s demand: if the public want banknotes, the public get banknotes; if they want digital currency, we will consider it.

Frankly, I am still thinking hard about this, and the thing that I come back to is that if there is a demand for retail digital money—if there is a demand for stablecoins—and we must set the standard very high because of the need for certainty of value of stablecoins, is it actually different from a central bank digital currency? Should we make that distinction, or not? It remains to me an open question.

Q337       Chair: Thank you very much, Danny, and thank you, Governor and team. We are going to come back to this over the course of the year, particularly when you make further announcements in this area.

You have committed to sending us an estimate of what the increase of risk might be in the financial system as a result of the Edinburgh reforms. I am going to give you an open-ended question: is there anything else about which you want to use this platform to share with the world what is going on?

Andrew Bailey: We will have a go at answering the pensions question and we will come back to you on managing the disclosures.

Dame Colette Bowe: The only thing I would like to add, Chair—

Andrew Bailey: Mortgage numbers was one—sorry.

Dame Colette Bowe: Yes. You asked at the beginning of this section, Chair, whether the view about the risk to financial stability from crypto was the unanimous view on the committee; I certainly support the judgment at the moment.

The other thing I would like to say is that I am not persuaded that getting the right kind of regulation into this area would give it a halo effect. I understand that there are serious investor protection issues here, but given the potential malign uses of crypto in cases like terrorism, money laundering and other forms of criminal activity, we cannot just stand back and say, “Well, we don’t want to give it a halo.” There have to be other ways we can deter people from taking undue risks in this field. That is the view from an external member of the committee.

Sam Woods: When we were talking about the Edinburgh reforms, we touched only very briefly on ringfencing and senior managers. I think Ms Ali said as an aside that they are both going; that is not where we are and we would not support that. Those two are areas to which it is worth paying close attention as that process plays out.

Q338       Chair: We are going to take further evidence in that area, but I think you have agreed to share with us, if you have any estimate, what the increase might be in terms of the impact on the public purse.

Sam Woods: Yes, I think that was going to be on Solvency II. At the moment there is not really a proposal for the senior managers.

Q339       Rushanara Ali: It would be helpful to know in writing your thinking on ringfencing and the senior managers regime, because we did not get into it. Anthony Browne was going to ask about some of those issues, but unfortunately he could not make this meeting and I did not get into it.

Andrew Bailey: We can do that.

Chair: If there is nothing else the witnesses want to add, I declare the meeting closed.