Oral evidence - Completing Europe's Economic and Monetary Union

Members present

Baroness Falkner of Margravine (Chairman)

Lord Butler of Brockwell

Lord Haskins

Lord Lawson of Blaby

Lord McFall of Alcluith

Lord Shutt of Greetland

Lord Skidelsky

________________

Examination of Witnesses

Sir Jon Cunliffe, Deputy Governor for Financial Stability, Bank of England, and Andrew Bailey, Chief Executive of the PRA and a Deputy Governor for Prudential Regulation, Bank of England

Q186 The Chairman: Good morning, Sir Jon Cunliffe and Mr Andrew Bailey, and thank you for agreeing to give evidence to us in our inquiry into Europe’s economic and monetary union. You have a list of interests that have been declared by Committee members. This is a formal evidence-taking session for the Committee, and a full transcript will be taken. This will be put on the public record in printed form and on the Parliamentary website. You will be sent a copy of the transcript, so you will be able to revise it in terms of any minor errors. This session is on the record; it is being webcast live, and will be subsequently accessible via the Parliamentary website.

I wonder if I can kick off by asking you, in broad terms, what your assessment is of the Five Presidents’ Report, the short‑term actions envisaged in its later paper of 21 October, and the 24 November proposals on banking union. I wondered, to kick off, whether you would like to start, Sir Jon.

Sir Jon Cunliffe: I am very happy to. Thank you for the opportunity to give evidence today. I find the Five Presidents’ Report reassuring, in that it is a very clear statement of recognition by the euro area of the things that need to be done. From a Bank of England perspective, the stability of the euro area matters very considerably to us. We put out a report that explains some of the impacts on our objectives of financial and monetary stability when things go wrong in the euro area, so the recognition is very valuable. It is good that immediate action is being taken.

It is quite an honest description of the political and other difficulties that the euro area will have in moving forward, and that pressure to move forward needs to be maintained. The short‑term actions go a little bit further than I expected, to be honest. When you read the document, it suggests doing more within the existing framework, and the deposit guarantee proposal pushes further forward than a cynical observer might have thought, so there is something real there. Of course, that is a very difficult and sensitive issue. One last thing I would say about the report is that the area where one might have wanted to see more—although I understand why not—is a timetable. There is a timetable in there, there is an end date, but Europe has always worked by setting timetables and moving towards them, et cetera, and the timetable is, of necessity, quite broadly defined. That is one area that we would hope in future to see more on.

The Chairman: Just on those points you have made in terms of the paper, as compared to the previous one—the Four Presidents’ Report—do you think they made a mistake in not going for debt mutualisation, as the four Presidents did?

Sir Jon Cunliffe: I read the reference to the fiscal stabilisation mechanism, which “could be financed in various ways”, as a way of leaving open some of those possibilities. The stabilisation mechanism is not defined—it is going to be one of the most difficult things for the euro area and the states to agree—but it could be financed by debt, and there could be mutualisation underneath that. I did not think it closed any doors completely.

The Chairman: Mr Bailey?

Andrew Bailey: There is not much to add. As we make clear in the report that we published, and that Jon referred to, our overriding view is that further integration in terms of economic policy in the euro area is necessary to complete the currency union.

The Chairman: Do you think that there are things that are missing from the paper that should have been there, apart from the timetable? The timetable says that they will produce a White Paper in 2017 and then hopefully come to an end point by 2025, but do you think there are things they should have said that are not there, in terms of policy?

Sir Jon Cunliffe: From the Bank of England’s perspective, we believe further integration in the euro area is necessary to make it sustainable and stable. We have said that publicly, and we have explained why in the report we published in October. If we could have our preference, that would be the reality tomorrow. We acknowledge the difficulty of working these things out. Clearly, the further and the faster they can go towards that stability within the framework of the European Union the better, from our perspective. Yes, one would have liked to have seen a lot more things but, as a statement to drive them forward, I thought it was positive and, as an honest recognition of what needed to be done and the problems, I thought that was very positive as well.

Q187 Lord McFall of Alcluith: Mr Cunliffe, I have one question for you, and one for Mr Bailey. You mentioned about the further integration of financial union, which is in the interests of this country. I want to explore the extent to which further integration may affect the UK’s ability to influence macroprudential supervision, and whether the European supervisory risk board is successfully acting as a counterweight to the ECB’s inherent incentive to act in the interests of the eurozone. I well remember that the then Governor, Mervyn King, was very proud of the fact that he was number two on the European supervisory risk board, and there was a crucial role played there by the Bank of England. In light of that, could you give me your comments about how the ESRB is functioning just now, and whether you were surprised that macroprudential concerns did not feature much in the Five Presidents’ Report?

Sir Jon Cunliffe: No, I was not surprised that they did not feature much. The macroprudential architecture for the European Union was set quite well some years ago. It is an interesting example of how other areas of the banking union and the euro developing within the European Union might work. The ECB is there, but all the national supervisors and authorities are there as well. It is the only table that brings all the people concerned with financial stability in Europe together, and the UK plays a very large role, and the current Governor is Deputy Chairman of the ESRB. It is a place where we can look across the European Union, because we do have highly integrated financial sectors, and look at risk. It has worked. It has taken some time to get off the ground, like most new institutions, but it is actually working well.

Lord McFall of Alcluith: What do you think are the most urgent issues it has to attend to?

Sir Jon Cunliffe: It is looking now at real estate risks across the European Union, both in commercial property and housing. It has looked at insurance, and has produced a report.

Lord McFall of Alcluith: It is work in progress.

Sir Jon Cunliffe: It has produced a number of reports on risks across the European Union area, which we find useful, and it also has the ability to make recommendations to individual jurisdictions. The one point I would make, though, is as far as the banking union is concerned, they were given macroprudential top‑up powers at the ECB level, so the national authorities have powers and the ECB has top‑up powers within the banking union, and that is all very much settling down now. We will have to see how that works in practice, but, generally speaking, it has been quite a good model for the way the UK can work within the European Union framework alongside the ECB and the banking union.

Lord McFall of Alcluith: Mr Bailey, congratulations on your new job, and good luck. I do not know which one I want to put the emphasis on.

Andrew Bailey: That is very kind of you.

Lord McFall of Alcluith: I am interested in your role there, particularly the interaction of the home regulator with the euro area, because the view has been given that all of the standards are made in Europe, and there is limited influence that the home regulator can have. Could you look at that? Also, you will be taking over at a time when there has been a plethora of scandals in the banking industry, but if we look at it, it could be reduced to one: namely, that the customer’s interests have been at the bottom of the pile. However, we now have a system of regulation that is more complex, and rather than a customer‑focused approach, we could have a tick‑box mentality applying to the rules. You know I have mentioned this issue before to you, but given the muddle that the Senior Managers Regime is in—in fact, I was talking to a senior banker last night who said that the old system’s regulations are up in March; the new system’s start in September, so there is an interregnum for six months—that is one big thing that is waiting for you.

Andrew Bailey: That is quite wrong.

Lord McFall of Alcluith: That came from a senior banker from a bank that is in the news this week. I can say that to you.

Andrew Bailey: That does not narrow it down much.

Lord McFall of Alcluith: That is a problem with the industry that you have: they are all in the news. But the issue of duty of care is very important, and I would suggest that if there were a simpler approach to this, with duty of care on the senior personnel, then it could aid the reduction in the plethora of complex regulation. What do you feel about that as you take up your new role?

Andrew Bailey: That is a very interesting point. First of all, I am afraid that the banker you spoke to is quite wrong. The Senior Managers Regime is being introduced at the end of the first week of March, so I am afraid that if they think there is some sort of interregnum, they are wrong. The handover is quite clearly from one to the other, and there is not a gap. What you point to, of course, is the key feature of the Senior Managers Regime, which, to my mind, is the word “responsibility”. As you know from the investigations you have been responsible for in the past, it is a fact from the history of the crisis, the way the Approved Persons Regime operated, and the fact that action on approved persons in the current regime really hangs on the concept of culpability, rather than responsibility. There has been a tendency, therefore, to say, “I delegated that responsibility to somebody who made the loans, or did not make the provisions, even though I am the most senior person in the institution”. I have said it many times: you cannot delegate responsibility.

The Senior Managers Regime is crucially important, both in prudential and conduct, and it is all about getting the incentives right. We have tried very hard, and we will have to go on trying very hard, to construct a regime that has the right incentives in it. Everything we are trying to do on remuneration has the same feature to it: it is about getting incentives right. If we can do that—I will give you an example in a moment—then I would like to think we would get more towards the promised land that you outlined, and, as you rightly say, we come away from the idea that you can do something that is more tick‑box.

The example that I was going to give you is the Fair and Effective Markets Review, because that has rightly raised the question, which is an old question in this country, about the balance between what the regulator does and what the industry is responsible for itself. In history, we have been backwards and forwards on this concept of self‑regulation, but self‑regulation is not, “Here you are; off you go” and it is all a bit of a free‑for‑all after that. The really important thing in the Fair and Effective Markets Review is to hook what we want to do in terms of industry standards and codes up to the Senior Managers Regime, and say, “There is real responsibility behind this. Off you go and put the codes into effect. You can do that in your firms—it is not for us to be in there at that level of detail; we frankly cannot do it—but there has to be a hook of responsibility to hold you to account.”

The Chairman: Before I bring in Lord Lawson, I just had a small question for you, Sir Jon, to do with the European system of financial supervision. You placed a lot of importance in your opening remarks on deepening eurozone integration. Would the deepening of eurozone integration result in us losing this pivotal number two slot? Would it reduce our influence in financial supervision? As the deepening takes place, why would they want us sitting at number two?

Sir Jon Cunliffe: I think not. As the deepening takes place, it may reduce the roles of the national authorities of the euro area, but the UK is the largest financial centre, arguably in the world and certainly, by far, within the European Union. We have a range of responsibilities, knowledge and influence within Europe, so the need to have the UK at that systemic risk table continues. In a way, what happens is that in the euro area, more goes up to the single supervisory mechanism, to the European Central Bank. The recognition of the UK’s role in financial stability within the European Union is reflected in the deputy chairmanship. I would not expect that to be affected. There will be issues about how future European regulation is built and conceived, which Lord McFall referred to. We set some of those issues out in our report, but I do not think the importance of the UK within the European Union on these issues will change.

The Chairman: It is recognised, and it will prevail.

Sir Jon Cunliffe: It is certainly recognised, yes.

Q188 Lord Lawson of Blaby: Since we have got on to the subject of prudential regulation, although there are other things we want to talk about, may I go off‑piste, just for a little bit? Mr Bailey, I think about a year ago you made a very strong comment about Solvency II, which gave you cause for concern. Can you update us on the position of that, and can you also, apart from the specific recommendation, draw any general lessons from this difficulty?

Andrew Bailey: Yes, I can. First, the update is that after many years, Solvency II came into effect on 1 January, so we are now in a world where it is in effect. There was a huge amount of work to get it over the line. We are now in the important phase of not only putting it into effect, but also, frankly, that huge amount of work to put it over the line—some of the issues with such a wide‑ranging piece of legislation and the experience that we have already in implementing it—gives cause to say that some pieces of it need rethinking. Last week, as a response to the European Commission’s call for evidence on European financial regulation, we published our own response, and in there are a number of points on Solvency II that we think need attention.

The point I made a year or two years ago was that Solvency II is a good example of European legislation, warts and all, as it were. I do not know how many years it took. There were varying accounts of this, but it was at least 12 years from beginning to end, and there were several false dawns, where it looked like it was about to be agreed and it was not. The point I made was all about the costs of it. Cost to us is one thing; cost to the industry is a much bigger thing. There was a degree of leading up the path, to say, “It is going to be implemented. You have to be ready”. No, it is not, and there is probably little doubt that that put quite a lot of cost on to the whole process. It is important to bear in mind that when these pieces of legislation are done, there is not only the process of agreeing it, but also a very big implementation task that comes afterwards. You sometimes see that there is a huge amount of very important work in agreeing the legislation, and it gets thrown over the fence, and there is an assumption that it will be implemented very quickly. That is what lay behind it, because some of the false dawns undoubtedly added to the bill of doing it.

Lord Lawson of Blaby: But you did give the impression—I am sorry; it was about two years ago; time flies—that you felt many aspects of it were undesirable.

Andrew Bailey: We have raised a number of quite important points in the call for evidence response that we put in. As Jon mentioned earlier, in the context of Europe, there is a very real issue about the lack of macroprudential tools in Solvency II. You can say that most of the macroprudential attention so far has been on banks rather than insurers, but we have case histories from the quite recent past where, in the context of large movements in financial markets that affect the value of assets held by insurers, industry‑wide interventions were made in the UK—this happened just after 2000, where we had the dot‑com equity market fall—to prevent what you might call systemic effects by the rules, to cause the dumping of assets into the market. In our reading, Solvency II does not yet have the sort of provisions you would like to take those actions, which not only were thought to be sensible at the time, but history shows they were sensible as well. That is one point. There are then several other points to do with the interest rate sensitivity of some of the provisions in Solvency II.

The other point I would make, which I have made a few times—and this is really true of life insurance; it is not so true of general insurance—is that it remains, pretty much, a series of national product markets. That has a huge effect on the business models of the providers, the firms, and if you thought honestly that Solvency II was going to lead to an apples‑and‑apples comparison of the positions of firms, it does not, really. Some of that should be dealt with, and we have highlighted some points in our response. Some of it is about educating the market—analysts, rating agencies, and so on—to say that these are quite different national markets.

The Chairman: Thank you. We are getting slightly sidetracked. Can I come back to Lord Haskins, and banking?

Q189 Lord Haskins: Just as a general point before I ask my question, this Five Presidents’ Report seemed to have a very ambitious heading—“Completing Europe’s Economic and Monetary Union”—when there are all sorts of obstacles that are not addressed in it, such as the need for treaty change and the need, fundamentally, for some progress towards fiscal and political union. To me, it seems a step that may be in the right direction, but is a long way away from completion. However, within that, we have been told that banking union and capital markets union are possible without treaty change. We are also told that the UK could join banking union if it chose to do so. What would be the obstacles, as far as the UK is concerned, to a banking union, whether we are in it or not in it? What would be the problems?

Sir Jon Cunliffe: I would separate the questions. A lot has been done without treaty change, and a lot has been done quite imaginatively during the crisis. The Five Presidents’ Report reflects that, but it also makes clear that some things that were done without treaty change should really be changed in future by putting them back into the treaty. My own view on this is when you are dealing with things like mutual funds to support different countries in times of crisis, or where you put the supervisor, et cetera, in the end you want that in heavy‑duty constitutional law, depending on your system, which for the European Union and for the euro is the treaty. I would expect a number of the things that have been done without changing the treaty, in the longer term, to be put on a treaty basis, because there really are quite big things about who has responsibility for supervising financial institutions, who contributes to funds, and how the money is used. That is reflected there.

The obstacles to all of this are pretty large, and maybe it is a bit hubristic to talk about “completing” in that sense. Monetary union is interesting; I do not mean to be pejorative in my use of the word “interesting”, but it is a fairly novel and ambitious construction, so it may take 20 or 30 years before you might call it complete. Just to go back to the point I made at the beginning, though, if you or I had said in 2006 to the euro area, “You need a lot of action to complete this project”, they would have said, “No, this is done, and it works”. That recognition of what needs to be done is undervalued. You could say it took a very large crisis to get there, which is also true, but I sense that there really is a tectonic shift in the way it is thought about, which—as we live next door to it—is very important to us.

Lord Lawson of Blaby: It did not need a major crisis, although that is what happened. It needed just a little knowledge of history.

Sir Jon Cunliffe: I am not a historian, I am afraid.

The Chairman: The interesting point that many of our witnesses have raised is whether this can move forward in the absence of another crisis, in terms of the end point that they want to get to.

Sir Jon Cunliffe: It is an impossible question to answer, because one cannot read the future. Some European luminary did say that Europe is built by crises. My guess is that it is quite difficult to move forward at a time when you are coming out of a very bad financial and economic crisis. If I looked at the Five Presidents’ Report and this question of obstacles, it goes to the question of what you can do. The area that is least mapped out is the last one, about political union, and that is the area where you have to have the political support to make the changes in sovereignty, which are referred to explicitly in the report as changes in sovereignty. You have to have the political support of the electorates of the single currency member states to make those changes. Are you likely to get that support in crisis? Are you likely to get that support when you can convince people that this is the way forward for those that have chosen the single currency? I do not know the answer.

Andrew Bailey: There is an obvious tension between risk‑sharing and pooling of sovereignty of policy. That is, at the high level, the obvious tension.

Lord Haskins: What about banking union, and the way it might impact on us if it happens?

Sir Jon Cunliffe: The first point is that an awful lot of it has happened. There is now a single supervisor that supervises the large European banks. There is now a single resolution board that we would deal with as our partner, if we ever had to resolve a problem with a cross‑border bank within the European Union; I hope we do not. There is an awful lot there already that just did not exist two years ago.

In a number of different jobs, I have always supported banking union, because when you have a single central bank and you have a single currency, then your financial systems are linked together. They transfer risk, and we have just seen that happen in the crisis. It is a necessary move for a single currency, which perhaps could have been anticipated in advance—I do not know—but I am glad that it has at least been recognised. For us, it is the possibility of having a strong partner with similar concerns, the ECB, with whom we can build a relationship. The issue, which again is recognised in the Five Presidents’ Report and is now generally recognised, is that some of the rules and the things you need to operate a single currency and a financial or banking union are different to, or go further than, what you might need to operate a single market. The issue for us is that that is recognised and properly reflected.

Andrew Bailey: Just to be clear, we have had over a year now of experience of working with the ECB in this new role as the Single Supervisory Mechanism, and it has been a good experience. We obviously had one quite large event and problem in the euro area that they have had to deal with during that time—that is Greece—and I can say, from my own experience of having been involved in previous episodes of crisis, we welcomed it being put into place and we have welcomed it now it is in place. As Jon said, it gives us a natural counterpart, from the point of view of the supervisory process, and that is good.

Lord Butler of Brockwell: If I may just continue Lord Haskins’s theme of testing your view of the Five Presidents’ Report, a good deal of the evidence we have had states that for one reason or another—some of which are political reasons—it is actually really rather unspecific. It may be there is a recognition that much needs to be done, but the Five Presidents’ Report does not carry us much further in what needs to be done. Sir Jon mentioned, in particular, the deposit guarantee proposal, which is one of the specific recommendations in the Five Presidents’ Report, and yet that has immediately run into opposition, particularly from Germany. It looks as if not much progress will be made on that. Would you like to comment on that, and then I will come on to one or two questions specifically about it?

Sir Jon Cunliffe: The hardest issue here is that in order to move sovereignty up to the next level, and have risk transferring within the monetary union, you have to have collective discipline, and then you have to have collective support, or solidarity and discipline; these things go under different names. To me, that is the central bargain that has to be struck at the heart of the euro area going forward. How much collective discipline? How much do you give up national rights over budgets, et cetera? How much collective support? How much risk transfer? You are very right to say that that bargain has not been struck, and until it is struck, it is very difficult to move forward on anything that shares risk, because the moment you do, people say, “There is not enough collective discipline”, et cetera.

There has been a very interesting article by the President of the Bundesbank and the President of the Banque de France this week trying to take that forward, but in the end it ran into this. If the question is, “Can the larger pieces move forward without that bargain having been made, without a view about where the balance should be between collective discipline and collective support?” then the answer is “No”. It will continue to stop short until that question can be answered. My sense is that the question will not go away, and it is recognised in the euro area that it cannot go away, which is what leads me back to timetables and the fact that this report recognises it.

Lord Butler of Brockwell: But in the absence of that, can there be progress? In particular, we look as if we are going to have two of the pillars in place, but not the third. Can we do without the third pillar if that proves so difficult to achieve?

Sir Jon Cunliffe: It is better to have two than none, and I talked about resolution and supervision, which are the other two that exist. It was possible to do those, and there is an element of risk‑sharing in those as well. I would not rule out progress on the deposit guarantee scheme, but even the deposit guarantee scheme starts with reinsurance, with deposit guarantee schemes supporting each other—one supporting the other when the other is exhausted. It is a relatively small step, so it may be possible to make progress there. On the bigger issues of real risk‑sharing that involve those questions of collective discipline and collective support, the political bargain has to be made first, and it has not been made yet.

Andrew Bailey: It is probably worth tracing through for a moment our own experience of what the effect of that is. In many ways, if you look at big banks, the deposit insurance is there, but it is not the tool you use when the bank fails. That is why resolution is so important. It does come into play with smaller institutions, when you effectively want to use an insolvency tool, and you are not sure whether there is enough effective protection in the balance sheet. If you trace through the missing one, and ask what the effect of that would be, at the moment it is probably more likely that it would lead countries to wish to use public money to support small institutions, to avoid, if it comes to it, triggering the problem with the deposit protection scheme. If the problem with the bank then goes through into a problem with the state, that would need to bring in more than one small institution.

Q190 Lord Butler of Brockwell: We have had some evidence that the single resolution mechanism does not actually carry much conviction. Are you confident that without the deposit guarantee schemes, in the present state of banking union, the single resolution mechanism would be sufficient to deal with the failure of a major European bank?

Sir Jon Cunliffe: Let me preface my answer with one point. In terms of sufficiency to deal with the failure of a major cross‑border bank, the European Union and the UK are generally well advanced along that agenda, but we are not there yet, because although we now have the powers and the institutions to do that, building up the loss‑absorbing resources that you could use in a resolution is going to happen over the next four years. We are all moving forward.

I would say two things about the SRB. The SRB could work without a deposit guarantee scheme; you could resolve an institution without that, but, of course, you would be going to national schemes there, and the question then—which is why we have the joint one—is, when you go to national schemes, can the sovereign stand behind the scheme in the end? Even if it is only bridge‑financing it, that will probably be for a very long period until the industry can repay that. That would perhaps be an issue, but resolution would be much better than it was before, even though we do not have that.

The second question is one that is acknowledged in Brussels and in the SRB. The architecture is quite complicated, because responsibilities and authorities are divided in quite a complicated way within the euro area. If you look at the number of people that would have to come to the table to deal with a resolution on the Single Resolution Board, it is quite a few, and the wiring diagram, as I say, is quite complex. It could be made to work, and in a crisis, you find ways of making things work. The Single Resolution Board has only just been born, but they need to work through those issues as to how those different responsibilities and authorities would interact in a crisis. There is more work to be done on that side.

Lord Butler of Brockwell: Perhaps I could ask Mr Bailey, as he faces the prospect of moving on from the PRA. Are you satisfied with the degree of co-operation between the PRA, the bank itself, and the single resolution mechanism?

Andrew Bailey: The PRA are our primary point of interfacing with the single supervisory mechanism, because they are what I call the going-concern supervisor. In the Bank of England, Jon is responsible for resolution. I used to do resolutions, but I have very happily passed it on to Jon. It is the resolution part of the bank that has the primary relationship with the Single Resolution Mechanism; the supervisors have some relationship, but it is primarily a resolution‑to‑resolution issue.

Sir Jon Cunliffe: Unfortunately, or fortunately, I have this responsibility, because there has to be a division between the supervisor and the resolution authority, because the objectives are different, so we sit across a Chinese wall.

Andrew Bailey: We have not brought it with us today.

Sir Jon Cunliffe: The SRB is just up and running. It took up its responsibilities on 1 January. We have an excellent relationship with this nascent organisation. We know some of the key staff well, particularly the chair, who was the head of the German supervisory authority beforehand, and we have worked very closely with them on the set‑up and on the relationship. It is a good relationship, but it is a complicated thing.

Lord Butler of Brockwell: And across the Chinese wall, you have confidence in each other, do you?

Sir Jon Cunliffe: Absolutely.

Q191 The Chairman: Sir Jon, you have mentioned a particular country. Many of our witnesses said to us that the greatest obstruction, as you have implied, on EDIS was political. Do you think there is going to be movement on the part of the Germans, given that the Dutch presidency have said that they intend to make progress on this?

Sir Jon Cunliffe: To be honest, Chairman, it is hard for me to give you an informed view that is better than the witnesses you have had. My instinct is, yes, there will be some progress. It will be slow; it will be fought through all of the skirmishing and trench warfare of European legislative negotiation, but there will be some move towards the reinsurance phase, probably. That would be my view, but this is conditioned generally by the political environment in the European Union, and other things are going on in Germany and elsewhere, in non‑economic areas, that make European solutions not very popular.

The Chairman: I am conscious of time, but I just have one quick one before we leave the topic of banking union; it is to you, Sir Jon. Many of our witnesses have commented on the absurdity, in a way, of the UK not coming into aspects of banking union, given how pivotal a player it is. Do you see the United Kingdom coming into banking union?

Sir Jon Cunliffe: No. It is a political decision, and it could be taken. My view on why banking union is necessary and exists is because there is a shared currency and a shared lender of last resort. It still has not, to be blunt, solved the problem of where the ultimate fiscal backstop is. That is something that you will see in the Five Presidents’ Report, and that goes to these political issues. I do not think a banking union is necessary to operate the single market in financial services, and so I cannot see, when we retain responsibility for our currency, central bank and lender of last resort, why it would be necessary or, in terms of accountability, desirable to make that step, because we then would be in a rather odd situation. Of course, that could change in the future, and we deal with the world we live in.

Q192 Lord Lawson of Blaby: One of the most important things that the Five Presidents’ Report says is that in order to “complete” the monetary union, there needs to be fiscal union. I take it you would agree with that?

Sir Jon Cunliffe: Yes, although I do not agree that fiscal union necessarily means becoming a complete federal country, but there has to be a much higher level of fiscal integration that includes risk‑sharing and collective support.

Lord Lawson of Blaby: I am going to press this further. Fiscal union is very much akin to what the Germans like to call the transfer union, is it not?

Sir Jon Cunliffe: It can be. It depends how far you go.

Lord Lawson of Blaby: What do you mean by “fiscal union”?

Sir Jon Cunliffe: By “fiscal union”, I mean that some of the sovereignty for taking fiscal decisions is moved up to the supra‑national level, and, secondly, that those decisions that are taken at the supra‑national level would include the fiscal choices that individual members of the monetary union make.

The Chairman: Policy choices?

Sir Jon Cunliffe: Policy choices, yes, which is why the political side of this is very important. But it would also include, as part of the fiscal choices, the transfer—to use that word—of the single currency between member states. When the Germans think of transfer union, I think they think that German taxpayers will be basically supporting southern European budgets with transfers. One would not necessarily have to go to that extreme, but there has to be a way of member states of the euro area supporting each other in times of stress. The mechanism that is sketched out—and it is very sketchy—in the Five Presidents’ Report is one in which you access this mechanism at times of stress and emergency. It is not a normal budget support mechanism, as you might find in federal transfers between states in the United States, or even between Länder in Germany. There are different degrees, but when I said that I did not think monetary union had to go to full fiscal federalism, that is what I meant.

Lord Lawson of Blaby: But that has been the view of every reputable economist who has ever pronounced on this matter, so far as I am aware, from the MacDougall report—which you may recall—onwards.

Sir Jon Cunliffe: I do recall it.

Lord Lawson of Blaby: Donald MacDougall made it absolutely clear that there has to be a fiscal union, which is a kind of budgetary union, in which federal taxes, or European taxes—I do not want to pre‑judge the political thing; the political implications are fairly clear—are of substantially greater size than we have at the present time. Do you disagree, and, if so, why do you disagree with the accumulated view of the economists?

Sir Jon Cunliffe: No, I thought I had agreed with it, actually. The Five Presidents’ Report agrees with it as well, because it says that for a monetary union to function—I forget the exact words—this rule‑based fiscal system of the growth stability pact is insufficient, and we need to take some of these fiscal decisions to the supra‑national level, which is exactly the MacDougall point. The point I was making is how far you go, and whether that means you only have a federal, euro‑area tax—you have no local powers—and you have the sorts of transfer mechanisms that exist with the German Länder, or whether you have something that is only activated in times of crisis. There is a range of choices there.

Lord Lawson of Blaby: Yes, but are you seriously saying that this second option, by which you just have an agreement to help each other out in times of crisis, is satisfactory? It is not what the five Presidents have in mind, and they are right; it is much more the model of the German Länder, which you have talked about.

Sir Jon Cunliffe: You could have a fiscal stabilisation fund that would act as a fiscal stabiliser but that would not necessarily have to be acting all the time.

Lord Lawson of Blaby: If there were this eurozone tax system for this purpose, how would it impact on this country?

Sir Jon Cunliffe: It is part of the general question of how the UK functions in a European Union in which a group of countries have gone for a tighter integration. That is the reality at the moment. The fiscal integration that would lead to transfers and supra‑national decisions on budgets will make that group tighter, and then the question becomes, “Can the boundary of the single market, and the things that we are involved in, be different and broader than the boundary of the single currency?” That is possible; it has been possible up until now. There is a recognition now that that issue needs to be addressed, and it is being addressed at the moment in the renegotiation that the Government is having. It is not axiomatic that the single currency and the single market have to share the same boundary, but it is necessary that if one group is going to integrate more tightly, we think about how the relationships are governed between those who are in that tighter integration and those who are not. That is a big task, but I do not think it is an insurmountable one.

Andrew Bailey: Jon makes the absolutely right point that this is hugely subject to the boundary issue but, setting the boundary issue aside for a moment, is something within the euro area that led to faster decision‑making and faster outcomes in times of crisis. You saw this with Greece. Of course, those incidents can have wider spill‑over effects; that would be a positive thing.

The Chairman: Thank you. In this particular area, you have touched on the tension between deepening integration for the eurozone and keeping the single market intact. I have a lot of sympathy with your interpretation, by which it does not necessarily lead to an EU/EMU treasury function. It may do, but it may well not.

Q193 Lord Shutt of Greetland: The subject of the European Deposit Insurance Scheme has been alluded to quite a bit, but we understand that an expert group is being asked to work it up, and that something is to be reported in March. Where do the current risks need to be reduced, and what are the implications for the UK and the wider single market of the group’s focus on reducing national discretion? Would they differ if these rules were applied specifically to the 19 eurozone members, or if they were applied to the 28?

Sir Jon Cunliffe: The reason why there is, alongside the deposit guarantee proposal, a risk reduction agenda comes back to this point that if we are going to share risk, then we have to reduce the risk, because otherwise we are all responsible for each other but we have no guarantee that the other person is actually reducing risk. The risk reduction agenda is a direct consequence of the proposal for a euro area deposit guarantee scheme, and it is looking at a number of areas. Some of those areas are relevant to all European Union members, and we would like to see progress in them, so there is pressure to implement the resolution directive, which, from our point of view, would be a good thing. We would like all European Union member states to implement that law.

There is a requirement to implement the work that is going on in Basel now to complete Basel III, which Andrew might want to talk about. There are other things there that are relevant to those who are going to share the deposit guarantee scheme, but they are not necessarily relevant outside of that. We have to make sure that those in the euro area who need to have the deposit guarantee scheme get what they need, but it does not necessarily have to extend to those who are not in that scheme. The question of national discretion is very important there. It is quite difficult to run a banking union with 18 separate jurisdictions and national laws, and I have a lot of sympathy for those who have to do that, so they may need to agree to have less discretion, because they cannot operate in that way. That should not mean that countries within the single market that are not in the banking union should have those discretions removed. I think the Five Presidents’ Report actually says, “We will need more uniformity”, so there is a recognition that it has to be done. It is important that it is done properly as this negotiation goes forward.

Andrew Bailey: Could I just give a practical example of how this affects us directly? Where a bank branches from a country in the euro area to the UK, as it can do under the passporting regimes in the single market, the deposit protection for the depositors in that branch in the UK comes from the home state, which is wherever it is branching from. It does not come from the UK. We have had cases in point where we have become quite nervous about this, because the solvency of a national deposit protection scheme depends upon the solvency of the sovereign of that country. They are inevitably inextricably linked. We have had incidents where the solvency of the banking system of the home country is a direct product of the solvency of the sovereign, and when both of those are called into question, you then get a situation where you say, “Do the depositors in the UK really understand where their deposit protection is coming from?” The worst thing is for the thing to go wrong, and then they say, “Well, I never knew it was coming from wherever. I thought the UK was providing it”. We have had to go through an exercise of some sort to say to branches, “You have to tell your depositors where it comes from”, but you can never rest easy that the depositors really have got it, frankly.

Lord McFall of Alcluith: Is there still not a gap there? Sir Jon mentioned about the deposit guarantee scheme, and the host countries could undertake that, but we had our very own problem with Iceland.

Andrew Bailey: Yes, we did.

Lord McFall of Alcluith: I think we used the Terrorism Act at the time.

Sir Jon Cunliffe: We did.

Lord McFall of Alcluith: It was huge, and, to me, that cross‑border problem is not solved yet. That is still a big issue for you.

Andrew Bailey: That is where this whole question about risk‑sharing and the link between the sovereign and the bank sector comes in. In the case of Greece and Cyprus, where we had branches in this country, we were asking ourselves, “Do the depositors understand their position?”

Lord McFall of Alcluith: But that cross‑border aspect is not yet solved, Sir Jon.

Sir Jon Cunliffe: It is necessary in the single market to depend on the actions taken by other authorities and other Governments. In the Iceland case, which I can remember well, the rules and the supervision of the Icelandic financial system were nowhere near capable of dealing with that system. When people say to me, “Why do we need common European rules for financial services?”, that is a good reason why we need much tougher and really high‑quality regulation in the European Union.

Lord McFall of Alcluith: It is important for us not to mislead here. There is still a lot to do in Europe to get a uniform system. That is really what I am interested in getting from you.

Andrew Bailey: That is an example of where having the third pillar in place would help us, because it would take away a residual piece of the problem that can occur.

Sir Jon Cunliffe: Just to make it clear, even if the euro area comes to full risk‑sharing within EDIS, we would still be subject to those risks in relation to a non‑banking union country. That has not changed.

Andrew Bailey: Iceland is different.

The Chairman: It seems to me that you are making a good argument for us to be in EDIS, if it comes about.

Andrew Bailey: No, I was not. It is an argument for why, if you are a host regulator, you welcome that assurance from the home states that are in the banking union.

Sir Jon Cunliffe: But then you will want to make sure that the home states are actually regulating properly with high‑quality law, which is why we are in favour of, in the single market, having the highest‑quality regulation that we can.

Andrew Bailey: It is the argument for having all three pillars in place in the euro area.

Q194 The Chairman: Sir Jon, you will be aware, from the Five Presidents’ Report, of the concern within the eurozone countries that they do not have a single voice on the IMF. We have not quite been able to glean what the detriments of that are, but I wonder whether you would share with us your view on this unified representation, and particularly whether you believe it would have any impact on the United Kingdom’s place.

Sir Jon Cunliffe: First of all, to be brutally frank, I do not think there is necessarily a concern among the eurozone countries that there is not a united voice, but there is a concern among the eurozone institutions that there is not a united voice. If you ask the question in the capitals of the major euro area member states, you might get a different answer than if you asked it in Brussels.

The Chairman: Particularly the ones who are represented already.

Sir Jon Cunliffe: Correct. It is a difficult set of issues, and most of this is not the bank’s responsibility. The difficulty is that the IMF is a nation‑state member‑led institution, and what I thought of the proposals was that that is a level of common representation that requires more integration. You do not have the integration there. To explain that, when you sit around the IMF table, you discuss all aspects of a nation’s economy. It is not just its monetary policy; it is its fiscal policy, and, as Lord Lawson was saying, that would need to move. It is its economic structure and those kinds of issues, and the IMF discussion is a broad discussion. The difficulty is that within the euro area, those responsibilities have been divided between the national and the euro area level, and the only single euro area institution that exists at the moment is the central bank.

The Chairman: Which has observer status.

Sir Jon Cunliffe: It has observer status, and there is heavy co-ordination. The fund look at the member states, but they look at the euro area as a whole, and they try to find a way that they can deal with the euro area institutions as a whole as well, but they are not a whole, because they are not a federal country, and you have to find a way to get all those people who have a responsibility at the table. My personal view is that you would do the single representation when you had moved sufficient of those responsibilities to the supra‑national level to mean that the single representative could cover all those things. That is not a view that is generally agreed to in Brussels, though; I will just point that out.

The Chairman: What are the implications for the UK, if and when?

Sir Jon Cunliffe: I do not think there are big implications for the UK, and the proposal is to do this under a treaty article that applies specifically to the euro area. I do not think there is a question of “Would we join?” or whatever.

The Chairman: And our place would be secure.

Sir Jon Cunliffe: Our membership of the IMF?

The Chairman: The IMF, yes.

Sir Jon Cunliffe: There is a general debate going on about how many advanced economies have a chair at the IMF. “Shares and chairs”, as it is called, has been a huge discussion in the IMF for the last 35 years, along with how the emerging markets are represented. Our position may well change as a result of that, as our economic power in the world relative to China or wherever changes, but would we be part of a single representation, or would it impact directly on us? I do not think so.

Andrew Bailey: It is important to remember that there is a fundamental link back to currencies here. If you go back to Bretton Woods, it was about currencies. That is mainly a national thing, as Jon rightly said, but that is the tension within the euro area.

The Chairman: Thank you, Sir Jon Cunliffe and Mr Andrew Bailey. This concludes today’s public evidence session. Thank you very much indeed.