Treasury Committee 

Oral evidence: Bank of England Financial Stability Reports, HC 681

Wednesday 16 January 2019

Ordered by the House of Commons to be published on 16 January 2019.

Watch the meeting 

Members present: Nicky Morgan (Chair); Mr Steve Baker; Colin Clark; Mr Simon Clarke; John Mann; Alison McGovern; Catherine McKinnell; Wes Streeting.

Questions 115 - 176

Witnesses

I: Dr Mark Carney, Governor, Bank of England; Richard Sharp, External member of the Financial Policy Committee, Bank of England; Anil Kashyap, External member of the Financial Policy Committee, Bank of England; Alex Brazier, Executive Director, Financial Stability Strategy and Risk, Bank of England.

Examination of Witnesses

Witnesses: Dr Mark Carney, Richard Sharp, Anil Kashyap and Alex Brazier.

Q115       Chair: Good morning to this morning’s witnesses. Please bear with us if we have people coming and going. There are various meetings and conversations going on. I am going to ask witnesses to introduce themselves. As I say, there is a lot going on and it will not surprise you to hear if I say short answers will be appreciated, on the basis that we can then whip through the session and move on, and everything else. Can we start with introductions, Governor?

Dr Carney: Mark Carney.

Richard Sharp: Richard Sharp.

Anil Kashyap: Anil Kashyap.

Alex Brazier: Alex Brazier.

Q116       Chair: Thank you all very much for being here. I thought I would start with a general question. Governor, in light of last night’s events here in Parliament, I am not expecting you to comment on the politics and the vote but, if there is anything that you wanted to say about market sentiment or where you think the City is on developments and the fact that we do not have an agreement in place, that would be helpful.

Dr Carney: As the Committee recognises and we have discussed before, market sentiment across a range of markets—foreign-exchange markets, the gilt market, the inflation-swap market, bank funding and equities—is affected by developments with respect to Brexit and particularly developments in Parliament. Yesterday was no different. A broad interpretation would be that the views were most clearly expressed in the foreign-exchange market, where there was a sharp rebound in sterling following the vote. In public market commentary, also consistent with our market intelligence, that rebound would appear to reflect some expectation that the process of resolution would be extended and that the prospect of no deal may have been diminished. I am not giving my opinion; I am giving the market’s initial take. That is both public and how it was expressed.

But that is in the hands of Parliament. The markets, as the country, are looking to Parliament for direction and one would expect continued volatility. In the very short term, there has been, consistent with what I just said, a small rally in gilts and some tightening in UK bank funding spreads. That would be consistent with that but I would not put much weight on these very short-term moves.

Q117       Chair: So the market is waiting to see what happens.

Dr Carney: The market is waiting.

Q118       Chair: I raised this yesterday with Andrew Bailey of the FCA. As you know, the Government are laying secondary legislation in relation to onshoring of EU legislation, if I can put it like that, to do with financial services, but there was also a paper published back in October last year about a temporary transitional power to be exercised by UK regulators in the event of a no-deal scenario. I asked Andrew Bailey about this yesterday. Those powers can be pretty broad. It would be helpful to know—you or colleagues—if the Bank has had discussions with the Treasury about the powers required to manage a no-deal Brexit and if there are any additional powers that you, as a regulator, would need in that scenario.

Dr Carney: There are 16 of the 600 statutory instruments that are of relevance to the Bank. The majority of those that have greatest relevance to financial stability have been made. A few remain outstanding that are particularly important from our perspective with respect to the over-the-counter derivatives, counterparty and trade repositories amendments, an amendment related to Solvency II, and an amendment with respect to contractual continuity. This crosses over with your exchange with the CEO of the FCA, Mr Bailey. This is relevant particularly for firms that are winding up. In other words—and you know this but just for the record—EU firms that would have continuing operations we can address with the temporary recognition regime, and that SI has already been made. But for those that are winding up, this would be relevant.

We do not know the exact numbers there because it is a question of who has come to us to approach for future recognition. We can make some estimates of those and there are potentially some insurance contracts here in the UK that would be affected by that. We are in regular discussions with the Treasury about ensuring that the minimum authorities are given to us and, by extension, the FCA to make sure that this market runs smoothly. If it is of use to have an offline briefing or a subsequent communication on that, we would arrange it.

Q119       Chair: As a last question on this, does the Bank have a view on when it needs to put those no-deal powers, if I can describe it like that, in place before 29 March? Have you said to the Treasury, “If no agreement is in place by 10 February, you have to get this on”?

Dr Carney: In this case, to be candid, it is before 29 March.

Q120       Chair: So it can be done right up to that date.

Dr Carney: When I go back to the Bank, there will be some stern looks at me for saying that but I am testifying and I think, in this case, before 29 March. For firms that are coming to us, getting the temporary recognition was important because that is a clear signal to EU firms that want to have continuing operations here. For those that are running off, they need to know. If I may put it this way, the intent of the Government and not the details but the predisposition of Parliament are clear in this respect that the UK is looking to facilitate ongoing commerce. But if you are running off a business, you just have to know what happens in advance.

Q121       Chair: Moving away from that, back to your Financial Stability Report, I want to start with the transition from LIBOR to SONIA, which is a great acronym. I wonder what progress has been made so far in amending existing contracts to reference SONIA. I should say it is great to hear from you but we are very happy to hear from other witnesses as well.

Dr Carney: It is a great acronym. We worked a long time on it and the industry is working on that transition. The good news is that it is very robust. There are more than 350 transactions per day that underpin SONIA. New issuance referencing SONIA is over £5 billion. All floating‑rate issuance in the last several months has been SONIA linked. On the flow side, it is good news. We still have, as I think you are alluding to, 80% of the cleared swap activity referencing sterling LIBOR, so that is the stock problem. There are some new, longer-dated contracts—contracts after 2021—that also reference LIBOR.

We are working with the FCA, which is very much taking the lead on this—welcome, Mr Baker—and ISDA. There are two issues here: one is the risk-free-rate fallback on existing contracts. We want those existing contracts to have a reference rate. That reference rate or fallback rate is not likely to be SONIA based but more likely to reference OIS in determining some sort of fair spread between what was LIBOR and OIS, so the market can continue to use OIS, which will continue to function, plus a spread. But that needs to be done with industry. There is huge commercial interest on both sides on this. ISDA completed its first consultation last year. We expect further progress in this half.

The second thing we are doing on the cash markets is working with industry on a term reference rate, instead of spot but out to, let us say, three months.

As a last point on what we have done—when I say ‘we’, I mean, in this case, the PRA and the FCA—a “dear CEO” letter has been issued to raise awareness of the importance of this transition. I would expect—I will close with this, and I very much welcome the question and the profile on this—that this will happen. We will work to make it happen. We will work with industry to make sure it happens in an orderly way and in a fair way, but it is going to happen. It is not going back. We have made initial progress but we will look to accelerate it.

Richard Sharp: If you look at the beginning of the year in terms of sterling capital markets, a lot of the issuance has been by supranationals. A number of those have been doing SONIA transactions swapped. That is an incredibly encouraging sign that the capital markets are starting to base transaction activity around SONIA and it is what you would look for as the first sign of some development in the market progressing.

Q122       Chair: What are the key risks of the transition? What about those who get left behind and what will happen if the legacy contracts still reference LIBOR? It is a question of that change. What about the laggards?

Dr Carney: The issue, as my predecessor said, is that LIBOR is the rate at which banks do not lend to each other. This is not a transaction-based market; LIBOR reference rates are opinion. They are interpolated by staffs of financial institutions. In many cases, they do that because they have been encouraged to do so by regulators in order to have an orderly transition. At some point, that is going to stop, so you are going to have a contract that references a fiction and a contract that has real economic value. It is very important that this transition proceeds. As Mr Sharp just alluded to, we have something that is working, and having supranationals—the most sophisticated borrowers in the world, in many respects—come in to issue floating-rate SONIA is a very good sign. We have something that works and is based on underlying transactions. You have a choice of moving towards reference of that or, increasingly, referencing an orphan fiction, if I can put it that way, at a potentially large economic cost.

As a last point, from a financial-stability perspective, which is why you are raising, it is hugely important that this is an orderly and fair transition. I would commend the CEO of the FCA, Mr Bailey, for his leadership on this. It is hugely important that London, as, in many respects, the home of LIBOR, leads this transition.

Q123       Chair: Finally from me, what are the impediments? What would prevent people from making this move? What would the Bank, the FCA or others need to do to tackle any impediments, Mr Sharp?

Dr Carney: Maybe I will start. I referenced the fallback. Getting that right is hugely important, so there is a judgement about what spread and what underlying reference one would use. That is why ISDA has been very deliberately conducting a consultation. There will be follow-up consultations. It is ongoing right now. That is an impediment because there are trillions of sterling in contract, and an analogous amount, so a much bigger amount, in the dollar market. There are big economics in this, so it is important that it is done in a fair process and that we get the right answer.

In the end, like in many complicated and difficult things, someone has to make a decision, so you have to come together to make a decision about a complex issue. I am confident that, in this case, that is what will happen.

Q124       Catherine McKinnell: I want to ask you about some of the assumptions in the 2018 stress test, which include GDP falling by 4.7%, higher unemployment and house prices falling by 33%, combined with a bank base rate of 4%. In the circumstances described, why would the interest rate be so high compared to the current rate?

Dr Carney: It is important here to distinguish between assumptions and outputs in the stress test. In the stress test, we take a series of judgments about real economic shocks and then we propagate those shocks through to the economy and financial markets. Then there is a response of policy. We make a mechanical response of monetary policy, so we use a decision rule for monetary policy. In the jargon, the Taylor rule is the term. Effectively, we are trying to minimise the deviations between inflation relative to our inflation target, which, as you know, is 2%, while keeping unemployment as close as possible to the natural rate. The first is more important than the second, because we have a hierarchical target. There is a mechanical rule that drives the response.

Your question, in some respects, is about the order of magnitude of rate increases. Said another way, it is entirely natural or it can be expected, in a situation where inflation rises above target, that interest rates may well be higher than otherwise in order to bring inflation back to target. The issue in the stress test is that we introduce a risk premium on UK-based assets and so, in some respects, there is a behavioural response of financial markets on not just UK assets but a broader risk-off tone to markets that persists.

If I can just recap, there is a fundamental shock in China, in fact an outright recession in China; there is a broader global slowdown that cascades through to the United Kingdom; and there are large misconduct costs on UK assets. All of that works, in conjunction with a fall in sterling, to slow the UK economy and push up inflation quite substantially, and interest rates respond, bringing inflation back to target.

There are lots of ways in which one can look at that and ask, “Should the Bank look through it or would the order of magnitude of the shock be less?” The point of the stress is that it is an extreme event. It is a severe event. It is a tough event. We do that in order to make sure that the banking system can withstand something like this.

I would add that the experience in the United Kingdom—and it is a full credit to the people here—is that people pay their debts. They pay their mortgages, if they can, including, as much as possible, even if they are unemployed. It becomes very difficult, though, if they are unemployed and interest rates rise. It is something that is done if it is necessary but it is that combination—a slower economy, unemployment and higher interest rates—that drives defaults. That drives the stress on to the banks.

To bring it to the bottom line, though, it means that banks are well capitalised for that extreme event. It means that, as we sit here today and we are talking about the Financial Stability Report, we can talk about risks in China, risks globally and risks closer to home, and have confidence in the financial system. Individually and as a committee, we have confidence that the core of the system is resilient to the types of shocks that we could see.

Q125       Catherine McKinnell: That covered quite a lot of what I want to ask you about but I do want to challenge some of the mechanical processes—which I appreciate they are—that arrive at the outcomes. The Financial Stability Report says, “The assumed rise in bank rate to 4% in the stress helps banks to widen the gap between what they are able to earn from interest on loans and what they are required to pay out on deposits”, which is what you have said, to ensure the banks are sufficiently capitalised. The high interest rate is very helpful to the banks. Is there a concern that that is why it has been included in the stress test, rather than it being the mechanical response to those events?

Alex Brazier: Absolutely not. In fact, we have done a number of stress tests over the years now, some with falling interest rates and some with rising interest rates. The reason for that is that the interest rate effect has these two sides to it. One is the one you cite, which is that, as interest rates rise, at least from current very low levels, banks are able to expand their net interest margin, and we document that in the report. But the other, of course, is the one the Governor mentioned, which is that rising interest rates lead to more impairments on their credit books.

The net of these two things for the banking sector is that higher interest rates are generally, overall, bad for the banking system in a circumstance like this. The impairments effect outweighs the net interest margin effect, so that is another reason that it makes the test tougher to put those higher interest rates into the scenario. As the Governor said, we make no apology for how severe the stressed scenario is. We saw, 10 years ago, the costs of having a banking system that was not strong enough to survive a bad economic situation. Now, partly because we have been doing these tests, we have a banking system that is more than strong enough to survive even this highly unlikely but still plausible economic scenario.

The big thing that has changed over 10 years—and there is a chart in the report that documents this—is quite how far the capital base of the banks has built up over time. This is a stress test in which the scenario is, in some respects, tougher than the financial crisis. The loss rates they incur are pretty similar to the financial crisis. They make £100 billion of losses on their loans and trading books. The differences is that, whereas, 10 years ago, those loss rates made £200 billion of losses and they had £100 billion of capital—they made losses twice their capital base—now they make losses half their capital base, so they have more than enough capital to survive a circumstance like this. This means that, even in a very difficult economic situation, the banking system is not the contributor to making it worse. The banking system can be an absorber rather than, as it was 10 years ago, an amplifier of the effect on the rest of the economy.

Q126       Catherine McKinnell: I appreciate that, and that is a helpful explanation, but I guess one of the concerns is this. Even if the banks have the capital reserves to lend, in the scenario you describe, is there not a concern that they would not necessarily do so? Are they going to be lending to companies or housebuilders when there is serious economic turbulence and headwinds?

Anil Kashyap: Remember they are in business to make money. The reason they would not lend is that they would not have enough capital to expand the balance sheet to meet these needs. There will be lots of people asking for money, and businesses asking for money, in that kind of scenario. The worst case, from our perspective, is that they do not have the balance sheet resilience to be able to grant those loans. They would want to lend. They wake up every day wanting to make money, and that is the way they do it.

Q127       Catherine McKinnell: This is the issue. Would they be making money? If we have high rates of unemployment, are they going to be happy to lend to households? Is this much more high-risk lending? They will make money from that but there are also risks.

Dr Carney: The issue is that we need to put them in a position where they have the ability to lend, and lend in size. The demand for loans is determined by households and businesses in the country. As we all know, in a downturn or in a recession, people buy fewer houses, and businesses tend, at least initially, to invest less, pull in their horns, right their balance sheets, and then they spend. But what we are looking to avoid, and we are confident we are in a position to avoid, is that the financial system makes that worse.

What happened post-crisis was a dramatic illustration of this. This can happen in other jurisdictions to a lesser but still significant extent. The banks could not lend. Young couples starting out and who should have been able to buy a house could not get a mortgage, people with a good idea for a business could not get financing, and businesses could not expand because our system was not working. That is not going to happen. We are highly confident about that, but that is not the same thing as saying there would be very strong credit growth if an event like this happened, because fewer people would be looking for that.

Can I make one other point, though? One of the consequences of this stress test is that we, as a committee, sat and determined the level of something called the countercyclical capital buffer. We have raised that gradually, over the course of the last two years. It is now at 1% and that binds. That is something that we can take a decision to release in the event that there is a downturn. That gives the banks more room to lend. In the case of a 1% buffer, that gives them about £11 billion more of capital to support lending. Theoretically, if you gross that up, that—£11 billion grossed up and £250 billion of capacity—is about four times the size of the lending that took place in 2018 in the UK economy.

The system has been set up so that there is a lot of capital but they can use that capital and these buffers to meet demand. Then the question becomes how much demand there is going to be. That is determined by other factors.

Q128       Catherine McKinnell: Have you stress tested those other factors?

Dr Carney: Let me answer that in a slightly different way. You started, rightly, with where interest rates went, and then went through the channel of what that does to profitability, and Mr Brazier gave the balance that they lose more on their loans than they gain on the interest.

Another type of stress would be to imagine a deflationary scenario, where interest rates go down and the banks do not make that extra margin on the loans that are coming good, but also the economy slows into a recession because of deflationary pressure. That is what we did in 2016. We have looked at this in a variety of ways and we will continue to vary the scenarios in order to isolate certain potential vulnerabilities in individual bank business models or the sector as a whole, to make sure that they are resilient to a range of shocks.

Q129       Catherine McKinnell: You say you tested that scenario in 2016 and you have tested this scenario. As you have said, the demand in the economy will depend on other factors. You have not specified what those factors are but have you stress tested this model against those factors? I presume you are talking about Government interventions, potentially, and other market responses. Have they all been sufficiently stress tested such that you are confident that this model will work?

Dr Carney: The balance of our stress testing should originate in real factors, so real shocks to the economy. For example, I do not want to oversimplify it but at the heart of this is a very sharp global downturn that originates in China and cascades through emerging markets and more broadly though the global economy. There are other big factors as well. This is a very open economy, so what happens to global demand? What happens to balance sheet repair, whether for households or businesses? Yes, Government policy can play a role but the core drivers, more often than not, are the real drivers. Real demand, businesses creating new ideas, different investment, demand from abroad, innovation and competition will be the drivers. We play a role in helping to stabilise this, as the Government do, but it is not just the policy setting that rights things.

Q130       Catherine McKinnell: You have stated that these responses are based on demand remaining in the economy. This relies on demand remaining in the economy.

Anil Kashyap: It is important to have an internally consistent scenario. We would not want to assume that demand is collapsing when people are not losing their jobs and when the economy is growing. We have to make sure that this whole thing adds up and that we are not confronting the banks in their lending decisions with a scenario that is completely implausible. We think of the demand as emerging in the scenario based on the other assumptions we make, where we are using traditional patterns in the data and historical evidence to say, “If this was to materialise, this is a reasonable assumption for what demand would be”. We cannot know for sure but we have to make sure that it is not way out of line with what would happen, given the assumptions made.

Richard Sharp: Can I add one thing, which is how this links into investment decisions by, let us say, SMEs? If we look at the post-crisis environment, well-run SMEs were then facing refinancing risk with uncertainty because the banking system was not adequately capitalised. They were concerned about the availability of refinancing and the price of refinancing. That impinged on investment decisions and was, if you like, a negative pro-cyclical phenomenon. This process capitalises the banks so that the SMEs themselves, and some of the medium-sized companies, can feel more confident that the banking system is open and available, and that can flow back into them continuing to make investment decisions, which they would not have done otherwise.

Chair: Mr Brazier, did you have anything you wanted to add briefly?

Alex Brazier: On the previous question, I do not think we are reliant on, as you put it, demand increasing in the economy, as you set out.

Catherine McKinnell: Maintaining.

Alex Brazier: This is a situation in which GDP is falling, unemployment is rising and house prices are falling. Demand is falling a lot in the economy. We do not allow the banks to assume that they could pass this test by simply restricting credit to the economy. We want them to have the strength to pass this test without doing that, and that means, on the basis of the international evidence and as the Governor said, we can be confident that they would not do what they did 10 years ago, which is to be forced into a position where they have to cut lending. The international evidence on this is quite strong. Banks only really cut lending when they have to, to survive, and they did it 10 years ago because they made £200 billion of losses on £100 billion of capital. They had to cut lending.

Dr Carney: I know you want to move on but I just want to make one other important point. What also happens internationally and we do not want to have happen here is that you go into a recession and the regulators, us, tighten policy. That is pro-cyclical and it makes it harder for the banks, so everybody pushes in the same direction.

Chair: We are going to move from the domestic to the global economy.

Q131       Colin Clark: You have already alluded to it. Two weeks ago, Apple issued its first serious profit warning since 2002, largely because of growth in China. Is a downturn in China on the horizon or is it merely lower Chinese growth? Make a prediction.

Dr Carney: There is a variety of indications that growth momentum in China is slowing. It has been decelerating over the course of the last 12 months and probably is going to decelerate further during this year. The Chinese authorities have responded. The central bank has made a number of easing measures, including over the course of the last month.

There are a few things going on here. One is, again, a real effect, which relates to the trade tension particularly with the United States, and that is introducing some caution on the corporate side, with less business investment. The Chinese trade numbers came out yesterday and we are seeing that there appears to have been a pulling-forward effect in trade, so there were more exports before the tariffs came in to affect imports, and now there is a fairly sharp adjustment in trade in the most recent numbers.

Q132       Colin Clark: How exposed is the UK economy to China slowing down?

Dr Carney: Could I make one other point and then get to that? The other important thing that is happening in China, and which is necessary but difficult, is that they are reforming and reining in their shadow banking sector, which has provided a tremendous amount of support to that economy over time, but also raised risk. We saw in 2018 that the reduction in lending in shadow banking pretty much offset the increase in lending in the conventional banking sector, so credit conditions there have tightened and that is why the Bank has reacted.

In a direct sense, UK exposure to China is relatively modest, with single-digit trade exposure. Indirectly, through China’s impact on global supply chains and global demand, it becomes more important. We have very large and welcome financial exposure to China through some of our leading banks, which have some of the largest operations in Greater China. If I can put it in these terms, just quickly to go back to the stress test, we are talking about a deceleration in Chinese growth from the high 6s through 6.5, down to low 6s and potentially into the high 5s. That is material for an economy that is now 15% of global GDP, and we feel the effects. It is one of the reasons for a broader global deceleration that appears to be underway.

In the stress test, we do not go from 6.5 to 6 to 5.5; we go from 6.5 to an outright recession and negative 1.2, so GDP falls in China. That impact cascades through the bank balance sheets in the UK but also to the global economy.

Anil Kashyap: The number we have is a 3% shock to Chinese GDP would reduce UK GDP by 0.5%. In the most severe version of this, where we have a 10% shock, we can get that up to maybe a 3% loss. A 10% shock in China would be cataclysmic.

Q133       Colin Clark: That underlines the whole point of a stress test: it is a stress test as opposed to a prediction.

Dr Carney: You are asking me for a prediction. May I add one other thing in terms of the numbers that Dr Kashyap referenced? In order to get those types of numbers, you do not just have the real effect of Chinese growth slowing; you have an impact on global risk premia, financial markets and financial conditions here in the UK.

In terms of expectations, we expect the Chinese economy to decelerate. I should caution here that the most recent forecast for China is of the MPC in November and we will update in February. However, on the evidence, I will give my personal opinion that I would expect Chinese growth to move towards the low 6s this year. In many respects, the markets have anticipated that. I know the Chinese authorities are aware of the softening, and that is why they have put in place some considerable stimulus. One caveat is that stimulus in an environment when you are reforming a large part of your financial sector does not always pass through directly to the real economy.

Q134       Colin Clark: Moving on from that, is global debt vulnerability in China and Italy, for example, a bigger threat to the UK economy than Brexit, considering some of the predictions and suggestions that have been made? Anybody else can dive in if they want to. This is crystal ball stuff.

Anil Kashyap: Which form of Brexit is it?

Richard Sharp: You have to look at tail risk events, which we capture in our stress test, versus present issues. Brexit is a present shock issue. We watched very closely when Italian 10-year yields moved up to 350, 360; they are now about 280. When they were moving up to 350, that was a potentially present, real vulnerability, given public sector debt there being 130% of GDP. We monitor it carefully and we took action at the time of the euro crisis, looking at the exposures that the UK banking system had to the eurozone, and that leaves us comfortable that the kinds of tail events we are talking about are well covered by the capital in the system.

Anil Kashyap: Our banks have 10% of their capital exposed to Italy.

Alex Brazier: They are both very important. When you look at our stress test, it has both in. The Governor mentioned this earlier. We have a deep China slowdown or an outright recession, and we have a shock in the UK, with rising risk premia and a closing current account deficit, which we may come on to later. By stress testing them both, we can ensure that a banking system that has half its exposures in the rest of the world and only half in the UK is resilient to shocks wherever they arise. We do not really rank them. They are both very important and we stress test both of them.

Anil Kashyap: On the internal consistency, because Germany is so exposed to China, when China slows, that feeds into the German situation in our scenario as well.

Q135       Colin Clark: Is there anything more that the Bank of England could or should be doing, realistically, to make the banking sector more robust in the face of global debt vulnerabilities, or are you saying that we are already very well placed?

Dr Carney: Let me give an example. We may come on in more detail, so I will just give the headline. One of the things in the Financial Stability Report and one of the focuses of the committee over the course of the past year has been the rise in global leveraged lending and the rise in leveraged lending in the United Kingdom. We have done a detailed analysis of this to assess how exposed the UK banking and broader financial system is to this, and what the knock-on effects of that could be and, ultimately, the global impact on the UK economy. I will not go into all the details—others may want to drill down—but we have determined that UK core financial institutions are some of the least exposed to leveraged lending. I do not have the page number in front of me but there is a useful chart in the report that captures that.

In any event, we have stressed their exposures to anywhere from 10% to 22% loss rates, depending on the nature of that exposure—well above what happened in the crisis—to assess the robustness of their capital positions.

That is a specific. The general point is that our job is to continue to refresh our analysis and look for issues that are emerging, because when you think you have done everything you need to do is when the risk is building.

Alex Brazier: If I may add one further, general point, building on that, the point of macroprudential policy is to ensure that regulation keeps up with the way the world is evolving. Over the past few years, we have been in an environment where the global economy has been very supportive to growth. The level of UK GDP is, because of this, about 1% higher than it would have been otherwise. As is so often the case, when things look good, that is when risks are building. During that period, we have been making sure that we have been responding to those building risks. The stress test has got tougher in terms of China, as debt levels there went up, and the test has got tougher on the United States, as corporate-debt levels have risen as well, so the loss rate banks are incurring in the stress test has been going up, and the same for emerging markets.

As things have been developing, we have been making our tests tougher. When times are good, normally people respond by thinking, “Things are less risky. We need to do less”. The point of macroprudential policy is to flip that on its head, and that is one of the things we have been doing through stress testing. While times looked good and risks were building, as the phrase goes, we were fixing the roof while the sun was shining.

Q136       Colin Clark: One of these huge risks is protectionism. How can the UK banking sector and economy be affected by increases in global protectionism? I know the Governor has given evidence on it before. You can carry on. You were speaking about the macro risk.

Alex Brazier: I would say two things. The first is about the central outlook for the global economy, which is obviously affected by protectionism. So far, the effect, as far as we can tell, has not been great, but as the Governor laid out in a speech recently it could be bigger. As the Governor said just now, that is, at least within bounds, a central outlook issue. It is an issue about whether the global economy slows from one path to another path that is different but not completely different.

The issue for us is whether something like a slowdown in growth could play into the other vulnerabilities that have built up, such as, for example, debt levels in China or debt levels in the United States. If those economies experience any slowdown on the back of increased protectionism, there is a question about whether then you play into debt levels becoming less sustainable, and households, companies and Governments, in some cases, needing to deleverage, which amplifies the shock.

For us, as the Governor described the China issue, it is not so much about the central outlook; it is more about whether those things could play into the debt vulnerabilities that we have identified in the Financial Stability Report.

Q137       Colin Clark: Has the UK been impacted so far by the tit-for-tat trade war going on between China and the US? What should we be looking for in the economy, or are we? You said back in July, Governor, that the direct threats to the UK are relatively modest.

Dr Carney: One of the things is that, to the extent that the trade war is isolated—between the United States and China bilaterally—third countries are relatively unaffected, provided there is not spillover through to financial markets. In some respects, we have seen spillovers to financial markets in the latter part of November and through December. Some of that has come back as there has been interpretation of better news on the trade negotiations there. It is important what happens in financial markets.

There is the possibility, over time, of some trade diversion to those third countries that are not directly involved so, to some extent, you can benefit from it. Of course, that does not happen overnight; you need to have the capacity and you need to fit into supply chains and others. The modelling we have done has suggested—again, with a heavy grain of salt here—to the extent that it is a bilateral dispute, that the direct effects on the UK are relatively modest.

Q138       Colin Clark: Are you optimistic that that dispute is reaching some sort of conclusion? I do not read the President’s tweets, but where are we?

Dr Carney: It is hard to say because the core negotiations are not being conducted in public.

Colin Clark: The President thinks they are.

Dr Carney: There are some in public and there are some in private. The dispute has shifted from the early stage, when it began around overcapacity in steel and aluminium, to much more fundamental issues, if I can put it that way, around intellectual property protection and, effectively, a range of broader issues around the trade and investment relationship.

If I can just finish the thought, I guess I would caution that, in that type of dispute or, to put it more positively, discussion, it is possible that there will be an ongoing series of discussions and there may be progress on a specific arrangement, but these more fundamental issues will take some time to have a meeting of minds about, because the two sides start from very different positions.

Richard Sharp: We should not overlook the capital flows. We need to finance our deficit and we have been a beneficiary of Chinese foreign direct investment. Clearly, as China’s demographics change and it moves to be more of a savings country, and given its overseas holding of foreign currency assets, good cross-border activity should also encourage better capital flows. Portfolio allocation to the UK is quite significant in reducing our cost of capital.

Colin Clark: That was one of my other questions. Chair, I will hand over.

Chair: We will come back to the current account deficit point because there was more to say on that, but I am going to bring Simon in.

Q139       Mr Clarke: We touched upon leveraged corporate loans and it is, indeed, now time to drill a bit more into those. You can hear the ghosts of subprime mortgages clanking their chains when this topic is brought up. It is relieving to hear that the UK is less exposed than most other jurisdictions. The FSR explains that the share of loans where investors do not require borrowers to maintain certain financial ratios has reached record levels. Borrowers are also increasingly indebted. There has been growing use of adjustments to how earnings are calculated at the point a loan is made that assume potential future earnings improvements are realised, which may overstate EBITDA and, therefore, understate leverage. That sounds pretty serious, a bit like the subprime crisis. How concerned should we be?

Dr Carney: We are concerned, which is why we have spent a lot of time on it, and I commend you for quoting that part of the report because this is very clear evidence of a steady decline in underwriting standards. You have all the hallmarks, in particular once you start adjusting cash flow. What happens in financial history is that they come up for a new term for these types of adjustments. The term of art at present is “add-backs”, and there is a chart in there that gives a sense of the scale of add-backs, but they are quite substantial add-backs to underlying, actual cash flow, which adjusts for future events, whether they are synergies in a merger, cost cuts or other things. That is the first point.

Secondly, we are now up to near 80% of covenant-lite. It is drifting, to keep with the subprime analogy, which is not perfect, along the road to no-doc underwriting, which happened 11 years ago.

There is another concern. One of the protections we have in the UK is that, if you securitise a loan—you originate the loan, you securitise it and you sell it off—there is European regulation here, which we would retain, requiring the originator to retain a portion of those loans, so they have skin in the game. That had been the case in the United States. It was struck down on a legal challenge about 18 months to two years ago, so they have now lost that incentive alignment. We are concerned, and we are also concerned just because the pace of growth has been quite rapid for some time.

If I can go back to the subprime analogy, subprime was a form of financial inclusion when it originally began, brought lots of people into the housing market and was quite a good thing. It kept growing at double-digit rates, while underwriting standards kept deteriorating. Once you got to 2006 and 2007, that is when virtually all the damage was done. Those subprime underwritings were really poor. When you look at something like the leveraged loan market, you get worried that, latterly, we will be in trouble.

Q140       Mr Clarke: Are we at that stage in the cycle?

Dr Carney: We were getting to that stage, which is, again, why the FPC focused on it, and an increase in leveraged lending was happening in the United Kingdom.

We have—and I will not go through all the numbers—dimensioned the exposure of UK banks to this: how many CLOs do they have? How much do they have in the pipeline? How much do they have on their books? We have applied various loss rates through the stress test and we have stressed them harder than in the global financial crisis, because the underwriting standards have gone down, and we are satisfied. There is also supervisory guidance on top of that.

Richard Sharp: If I could put a slightly different spin on it, first of all, leveraged lending properly executed is a good source of capital and an important source of profitability to UK banks. London is a European centre of leveraged lending, so the issue is not that leveraged lending should not take place. Leveraged lending is typically defined as six times EBITDA. When large corporates take these loans, they often put interest rate protections in there, so they are protected. As the Governor said, there can be failures in judgments about future profitability, but six times EBITDA gives a substantial amount of coverage in current interest rates.

The other point I would make is that it is not surprising to see leveraged lending growing. If we go back five, six or seven years, there was much more doubt about interest rates. We have had lower for longer and, therefore, it is a significantly lower cost of capital. I just want to put it in perspective: it is not all bad. It is a source of major employment and profitability here; it lowers the cost of capital for investment. The issue is that it should be well managed and carefully managed, and the banks’ capital should be appropriately matched against their risks.

Q141       Mr Clarke: On that point about careful management, Mr Brazier, on numerous occasions in the FSR it says that figures are based on bank staff estimates of where the risk lies, and that is pretty integral to managing this whole phenomenon.

Alex Brazier: That is right.

Q142       Mr Clarke: Why do you have to rely on estimates, and does that suggest you do not know fully who holds these debts?

Alex Brazier: We did not know fully who held these debts but, as you said, as a result of observing something that has the ghosts of subprime jangling its chains, we did a pretty thorough deep dive. The fact that we had to do the deep dive is indicative that no one else has put the numbers together, but we felt the need, given what we were observing, to put the numbers together. Interestingly, our counterparts in other jurisdictions are now consumers of that and are very interested in what we have put together. The Governor referred to the so-called waffle chart on page 45, which breaks down who holds these packages of leveraged loans. We are the only people to have done that.

That means we have a much better idea of where these loans are than we did, say, six months ago, and everybody else does too. For some people, our conclusions should ring alarm bells. For us, they allowed us to be moderately reassured about UK banks’ exposures, which we have been able now to stress test fairly thoroughly.

I would add one other point, though. Unlike the subprime episode, it is clear, when you can at least find the data, who holds the exposure. One issue with subprime was that, on the face of it, it was off banks’ balance sheets but, in many cases, it was not; it was in an off-balance sheet investment vehicle—a SIV—that was funded by the bank and, when push came to shove, it all came collapsing back to the banking system.

One thing that is different here, partly as a result of post-crisis regulation, is that we do not have that shadow banking. Where this is held in banks, it is clearly held by banks and you can manage that and stress test it. Where it is not held by banks, it is held by hedge funds, investment funds or other sorts of funds, where the risk is on their balance sheet and they are more able to absorb it. That is one of the big differences with subprime. Even though the growth rates look the same and the underwriting standards have some disturbing similarities, it is either in the banks or not in the banks. There is none of this shadow banking activity.

Q143       Mr Clarke: In terms of what the consequences would be were there to be a sharp fall in the appetite of overseas investors for these products—and, of course, the mere fact that we are having a discussion like this today may be part of the process whereby some people start thinking about whether they are such a clever thing to be holding on the scale that they are holding them—what does that risk for both the UK and the global economy?

Dr Carney: Let me start with the UK economy. First, there has been an average readjustment of 70 basis points in the spreads for leveraged loans in the last two months globally, including here in the UK. It is probably directionally right but that is a market that is still functioning, with issuance. That is welcome and I certainly associate myself with Mr Sharp’s comments about the value of the market as a whole.

In the UK right now, there is not deep demand for corporate borrowing, given the temporary uncertainty. Secondly, UK corporate balance sheets have re-levered in the last few years but they are still in a pretty good position, particularly from a debt-servicing perspective. When one looks at their profitability relative to their interest and principal repayments, they are still in a reasonable place.

To put in a bit of a forward-looking position, my personal sense is that the market is undergoing an adjustment. There is greater focus on underwriting. That is healthy. As greater certainty comes to this economy through your process, good UK corporates will be in a position where, if they are a lower investment grade or sub-investment grade borrower, they would be able to access this and help grow this economy.

Mr Clarke: Does anyone else want to supplement that?

Anil Kashyap: Back to leveraged loans, when the committee first started talking about this, we were quite worried about the pipeline risk and what would happen if the appetite dried up, they were not able to place these things and they had to take them on to their balance sheets. We have dimensioned that and the numbers are pretty modest. Importantly, there is almost no wholesale funding behind any of this, so the odds of getting stuck with something where your funding is running away is another difference vis-à-vis subprime.

Dr Carney: As a final point, to give you some reassurance, in looking at that pipeline risk, the loss rate we applied in the stress test was 22%. A bank got caught underwriting something that they ultimately—

Q144       Mr Clarke: That is pretty high.

Dr Carney: That is very high. It is higher than during the financial crisis. We took the higher end, in part because of the deterioration in underwriting standards, but it is a pretty severe, tough number. That gives us some comfort.

Mr Clarke: That is really helpful.

Mr Baker: Governor, I apologise. My failure to send you a Christmas card was entirely part of a general failure, so thank you for your Christmas card. I can announce you are on my Christmas card list.

Dr Carney: Apology accepted. It is a tremendous relief.

Q145       Mr Baker: You are all on my Christmas card list. Thank you very much for your generous note too. I want to turn to the capital treatment of sovereign debt, because you will all know that the Government’s no-deal plan is to remove the preferential zero rate on European Union sovereign debt. Can you tell me: was that an FPC request, Governor?

Dr Carney: No, we made no specific request regarding the adjustment of the risk weighting. That is a mechanical consequence of leaving the European Union. I would add the caveat, which I suspect you know, but just for the record, that it is relevant for sovereign debt that is rated below the equivalent of AA-minus. To put a point on it, for the reverse into Europe, provided our ratings of gilts are recognised, the United Kingdom is rated AA-flat at all the agencies. You are not necessarily asking this question but it would not apply to the United Kingdom for European holders of UK gilts.

Q146       Mr Baker: That is most helpful. Do you think it helps or hinders the work of the FPC in setting capital requirements to have this, as you put it, mechanical removal of the zero risk weighting?

Dr Carney: If I can go first to the theoretical—and colleagues may want to jump in—the point of having a zero risk weighting on sovereign debt is within one’s own currency, principally. Sovereign debt is risky, just like any other type of debt. It is less risky in your own currency, for reasons we can get into and reasons you do not fully support, I suspect. The holding of foreign currency sovereign debt having some risk weighting is sensible. It is not something we ask for but it would be consistent with prudent risk management. At some threshold, it becomes less relevant.

Q147       Mr Baker: You mentioned the word “mechanical”. The application of law, of course, should be mechanical, and it is part of the point of the rule of law, but we could have a different choice in our rules, could we not? We could choose to zero rate European sovereign debt, if we wished.

Dr Carney: We could do. As you know, there is a wide range of riskiness of various European sovereign issuers. From a prudential perspective, it is not necessarily desirable. I would add further, if I may, that there is a question of the capital charge applied, but there is also a question of concentration limits and other things. One can introduce real distortions. People can risk up because they think a certain sovereign is much more creditworthy relative to its rating, particularly if they do not have to apply any capital. Now I am really stretching the analogy but I appreciated the previous exchange on leveraged lending and subprime to remind us what happened in the past. In the past, so-called “leveraged super-senior”, the bits that the SIVs would buy, the top of the credit stack—they were AAA—had very low risk weighting and people loaded up on that, and then they found that it was much riskier than it appeared. That is the kind of situation you get into over time if you have these capital distortions.

Anil Kashyap: The stress test is a big innovation vis-à-vis 2007. The trading losses flow through, so if there is an increase in spreads because some country’s situation deteriorates, if they have played off of the miscalculated capital charge, it is going to hurt them in the stress test. That is one of the biggest improvements, I would say, relative to pre-crisis.

Q148       Mr Baker: Perhaps one of the external members could elaborate a little on what this means for the banks’ capital requirements and, therefore, their robustness and resilience.

Anil Kashyap: The important thing is that, as long as we have a global component to what our stress scenario is going to be, they are going to suffer losses. If they have zero capital charge against it, that is going to drive them closer to the minima. To the extent that they understand that they have to survive one of these stress tests, that is an important constraint on how far they can load up on these things. It is very difficult to know what to do with the risk weights. We do not want to go back to a world where the credit-rating agencies can create risks by fiddling one notch. That is not great. You could try to use things like credit default swaps. Those markets are thin. Our stress test strikes a nice balance because we put this through. The losses we assume are consistent across all the asset classes, so it does not look like it is discriminatory, and we have to check that they can meet the standard.

Q149       Mr Baker: Mr Sharp, you used the term “real vulnerability” in relation to Italian debt earlier in the session. Is there a case that, at this time, it is wise to have a positive risk weighting on European sovereign debt, or that of any nation, rather than having a blanket preferential zero risk weighting, given that we are outside the eurozone and the political and financial system across European countries is difficult? “Tricky”, civil servants like to say.

Richard Sharp: Personally, I do, yes.

Q150       Mr Baker: Bearing in mind it is your last session, is there any advice you would want to give the Committee or, indeed, the FPC on this particular issue? The Governor is all ears, I see.

Richard Sharp: I have no unique knowledge. I just remind people, if I look back at my career, when I started in finance, Venezuela was AAA, so things change. The Governor has spent a lot of time on analysis in his private sector work on sovereign risk. If you look at the global debt environment, it is salutary to bear in mind that global debt to global GDP is higher now than it was before the crash, and a lot of the burden of that has been borne by the sovereign level. We were talking about China. In 2008, it had non-financial sector debt of $8 trillion. Since then, it has gone up by about $25 trillion and is now about $33 trillion. Some of the numbers are quite significant, and some of the debt-to-GDP numbers are significant. If we are entering a regime of lower global growth, which is one of the sources of sovereign creditworthiness in terms of their tax base, that clearly is a challenge over the next five to 10 years for certain sovereigns.

Q151       Mr Baker: Is this enormous expansion of debt not a mechanical consequence of the policy choices that have been made to try to deal with the global financial crisis?

Richard Sharp: You also have to look at the reduction in poverty in countries like China as a consequence of their growth. They have contributed 27% to global growth. We have not just one engine of growth in the US; we have another of polar growth in China as well. While there are correlations, the fact that they are differentiated is very good for the global economy.

Dr Carney: Big picture, yes, I would agree with your characterisation and make a couple of points. First, one of the things with financial crises has been—and this is history—that the costs are borne by the taxpayers in the end. They are tremendous and they are borne over a long period of time. Either the losses of the shareholders and debtholders are explicitly bailed out by the taxpayer—and we have seen examples in this country and other countries—or the fiscal cost, the hit to the budget deficit, whether through automatic stabilisers or proactive fiscal policy to lean against the recessionary and, in some cases, depressionary, if I can coin a new word, effects of the collapse of the financial system, is borne over time. Both of those, combined, are driving this extraordinary increase in debt.

I would make two points related to that. First, that is why we are spending a tremendous amount of time on ending “too big to fail”, so that this process is quick, clean, centred on the private sector and centred on those who have supported the activity of the institutions, and making sure they recognise and align it. One thing that happens in our stress test—and it is a little thing but part of a bigger picture—is that some of the holders of so-called AT1 securities get bailed in. That is what has happened in the last few years. They learned from that: they thought they had a guaranteed debt stream but they become equity-holders. That should not be news to them if it happens in the future.

Lastly, as a supplementary point on China, the other thing that has happened in China has been a tremendous amount of financial innovation, much of it good but some of it, in many respects and in hindsight, a replay of what happened in the United States, with SIVs, off-balance sheet vehicles, of banks driving a lot of that debt increase in China.

Q152       Mr Baker: Conscious of time, this is a final question: how does this removal of the preferential treatment of EU debt affect the banks’ competitiveness? What will it do for the demand for UK sovereign debt?

Dr Carney: Quickly on the second, we intend to retain our rating, if not improve our rating. As long as we are AA and above, the consequences of the measure do not bite. This is a narrow plumbing issue but it is important that the ratings not just of the UK Government but also of UK institutions are recognised by the EU in the event of a no-deal Brexit. I alluded to some plumbing-type issues that still have to be brought over the line, and that is one example of them. We are working on it and there is a plan, but they have to be brought across the line prior to Brexit day.

In terms of competitiveness, holding government debt for investment purposes is not a big deal for banks. If you are relying on that for your competitiveness, you are probably in trouble. The nature of market-making and trading is much more inventory-light, which is a good thing. It is there on the margin. Finally, longer-term, assessing risk appropriately and having capital against that risk helps make you competitive for the medium and long term.

Mr Baker: Unless anyone else wants to come in, I will say thank you very much.

Q153       Chair: I just want to return to the issue about the current account deficit, which Mr Brazier referred to earlier on, and the part of the report that looks at that. The report says, “Looking ahead, the ease with which the current account deficit is financed will be influenced by the credibility of the UK macroeconomic policy framework and its continuing openness to trade and investment”. Perhaps you could just unpick which potential UK Government policies could make the current account deficit harder to finance.

Alex Brazier: Let me start with one important piece of background. The UK current account deficit is 5% of GDP, the biggest in the G7. We are reliant, as the Governor said a few years ago, on the kindness of strangers.

Q154       Chair: That has been disputed, so we might come back to that.

Alex Brazier: We will come back to that. I am firmly behind it. To mix my cultural metaphors, when we talk about the kindness of strangers, we are not tilting at windmills. The point is that the current account deficit has been financed by capital inflows from abroad. Over the past year, 60% of that can be, on net, accounted for by people buying UK commercial real estate and buying leveraged loans issued by UK companies, as Mr Clarke alluded to earlier. Those have financed the fact that the UK, overall, is spending more than it earns.

For that to continue, we need to rely on the risk appetite of foreigners for buying things like commercial real estate, corporate debt and other things. It is not difficult to imagine a number of things, both external and internal, that could change that risk appetite.

Q155       Chair: Let us concentrate on the internal.

Alex Brazier: Fine. I would say a number of things, and they are all captured in the stress test. The first is a question mark about the UK’s free trade policy in the future. The issue there is that, depending on our trade arrangements, the sustainable current account in the future could be much lower than it is today. If you look at our estimates of our sustainable current account today—that is, the level of the current account that does not result in our net international investment position deteriorating over time—they are a bit below but not far off 5%.

If you change those trading arrangements and, for example, introduce tariffs and non-tariff barriers in the way we do in some of the scenarios in our response to this Committee, the sustainable current account deficit falls considerably. To get there, you have to have a period of adjustment, with funding costs for the UK rising, the exchange rate falling to crowd in net exports, but saving rising and investment falling. That is a painful adjustment.

Ultimately, the UK has the mechanisms—a flexible exchange rate—to make that adjustment, but getting from A to B is not straightforward. As the Governor mentioned earlier, one of the things in our stress test is exactly this: foreigners losing of some of their appetite to invest in UK assets and, as a result, funding costs rising for the UK, domestic demand falling and the exchange rate falling. You can see the consequences of that in the scenario.

The fact that you can imagine some things driving this is why we have felt the need to put these sorts of things in our stress test scenario. We do not try to forecast what the precise trigger for such an event would be; we just ask ourselves, as with so many things, the question: could it happen? Is it possible to imagine it happening? The answer is yes, and that is why it is in the stress test scenario.

Dr Carney: I have one other institutional point, if I could make a short commercial for the Bank of England, the Monetary Policy Committee, monetary independence and commitment to low, stable and predictable inflammation. It is a serious point: the predictability of the macrofinancial policy regime is one of the determinants across all countries of the sustainability of inflows. It is not the only one but it is one of them, and it is one of many reasons why the UK is an attractive destination.

Q156       Chair: That attractive destination has been cited by many as a good thing, and it looks like people still want to invest from overseas in the UK, but the report noted that, over the period from 2012 to 2015, the current account deficit was financed by UK investors selling overseas assets at a faster rate than foreign investors selling UK assets. That position has reversed since 2016, so foreign inflows have been substantial, which is pointed to by some saying that this is a good thing; people want to invest in the UK. What caused the reversal of that position in 2016?

Alex Brazier: It is difficult to say precisely what caused it at that point in time. A lot of these things with the current account are very volatile and they have a habit of changing rapidly. I would just highlight that, while it is good that foreign investors seem to have had that appetite for UK assets over time, it is reliant on the things we have just been discussing, and the Governor mentioned the institutional framework in particular, but it also creates the risk that people lose that appetite at some point in time.

Q157       Chair: You are vulnerable, then.

Alex Brazier: We are vulnerable. As a nation, we are spending more than we earn. It is good that people are willing to invest but that means the onus is on the UK to retain that attractiveness as a destination for foreign capital flows, unless we want to go through the sort of adjustment we just discussed. The important thing for us is to make sure that, if such an adjustment does occur, the financial system is resilient and able to deal with it.

Dr Carney: I have two points. First, some of the 2012 to 2015 period was UK bank deleveraging and shedding foreign assets. That was some of the element there. Secondly, in terms of the quality of inflows, one always gets a little concerned when a lot of something is classified as “other”. In this case, 45% of the inflows to the capital account are “other investment”. One has to caution a bit with the data here; they move around, but “other investment” can range from interbank borrowing to short-term portfolio investment. It tends to be, in the hierarchy, a little lower quality and easier to repatriate as an inflow than, for example, foreign direct investment.

We have seen on the foreign direct investment side a shift from investment in plant and equipment to an investment, almost exclusively, in commercial real estate. The majority of, for example, commercial real estate transactions in London and the south-east are financed from abroad; 80% to 85% of leveraged lending is financed from abroad, as another example.

It is not surprising, again, that there is less FDI into plant and equipment, given the deliberations in Parliament and where the future is going. For all the reasons that the UK is attractive, one would expect that to start up again, once there is greater certainty.

Q158       Chair: Finally, “property crash” might be too strong, but we have seen the London property market slow down considerably. Any nervousness in the property market is a source of particular vulnerability. You are nodding.

Dr Carney: It is a vulnerability. Again, I know we spent a lot of time on stress tests but Dr Kashyap made a point about consistency. One of the things is that, as the current account in our stress test reduces, with fewer inflows to commercial real estate and a bigger impact on commercial real estate prices—they are down by about a third in the stress test—there is a knock-on effect, to the extent that our banks have exposure. As a central point, UK bank exposure to UK commercial property is at decade lows.

Chair: That is very interesting.

Wes Streeting: Good morning. Sorry I missed the first part of the session.

Dr Carney: It was fantastic.

Wes Streeting: I have no doubt. I look forward to reading the written record.

Mr Baker: Your evidence, Governor, was especially fantastic.

Q159       Wes Streeting: Now you have said that, I will watch it back, not just read it back. I cannot wait. I do not want to talk about Brexit; instead, I want to talk about the concerns that the TUC has raised about the levels of household debt, to begin with.

The TUC analysis said that total unsecured debt has risen to £428 billion. At 30% of household income, this is higher than before the financial crisis. Does the Bank concur with those figures and do you agree with Frances O’Grady when she says that household debt is at crisis level? Maybe, Governor, we could begin with you. I am keen to hear views across the panel.

Dr Carney: First, we welcome the TUC’s analysis and profiling of this issue. The Committee has focused on it in the past. Big picture, UK households have worked hard to pay down debt. Since the financial crisis, the overall level of household debt, secured and unsecured, has gone down by almost 20 percentage points relative to income over the course of the last decade. Overall—and there are different cohorts, and I am going to come to the specific question—in terms of the ability to service that debt, the cost of that debt in interest and principal repayments relative to income is now quite low and, relative to history, almost two standard deviations below historic averages. But there are cohorts.

There are some differences in the way we look at household debt. To be specific, the TUC analysis looked at unsecured household debt, which is 12% or so of the overall stock of debt, so it is looking at 12% of the overall stock. It comes up with a figure on a per capita basis that is about twice our figure, so about £15,000 per head, and we are at about £7,700. What is the difference between the two?

Some 60% of the difference is accounted for by student loans. I will say up front that student loan debt—lots of students are people who have graduated and we have lots of them working with us—is an overhang on the individuals. As you know, as they get to certain thresholds, they begin to have to pay that back, it affects their consumption and it has other effects on those individuals. However, from our perspective, it is not strictly debt because it is, in effect, an income-contingent tax. As you know, once you get to certain thresholds, you start to pay it back, so it can have an effect on behaviour, but it is not outright debt. For example, if someone loses their job or shifts down to a less well-paying job, it falls away.

Then, in terms of the proportions, they have included two things that we just would not include. First, about 13% of the difference is lending to the so-called NPISH sector, which is non-profit institutions, schools and hospitals. Those are not households. They have used ONS numbers that happen to include those in a bucket but that is not household debt or unsecured debt. The second is lending from foreign institutions to households. The reason we do not include that is that it is just an estimate by the ONS. The ONS takes all foreign institution exposure to the UK, takes average exposures across various liability classes and just says, “There is this percent that should be for households”. Since we go from the other side and look at actual balance sheets and exposures, they do not line up, but we are pretty confident, having gone to the balance sheet and exposures that way.

It is clear that you take that out, in our view. It is also clear that you do not include the debt of non-profit institutions, schools and hospitals. Both of those are clear. You can have a debate about student loans and we are doing some research on how that student loan overhang affects marginal propensities to consume and invest as a longer-term project, but that accounts for the difference.

If I could put it into the big picture, again, we are talking about 12% of overall borrowing. As a last point, lest anyone does not think we look at this, we do look at this on a regional basis and on an age cohort basis. We are well aware that, for example, in the north-west, the burden of unsecured debt is much higher relative to the national average, whereas, in terms of overall debt, the highest burdens of overall debt, because of the high price of house prices, is greatest in London and the south-east.

Q160       Wes Streeting: That was very helpfully comprehensive, not least because you have now knocked out all my questions on student loans and why the Bank does not account in those ways, so that is very helpful. As a slight digression, the work that the Bank is doing on the impact of student loans on a whole range of issues, including consumption, would certainly be personally interesting to me, so I would be grateful if you would not mind sharing it when it is available. I am sure it would be of interest to the Committee.

Dr Carney: It is at an early stage but we will definitely share it.

Q161       Wes Streeting: When you are ready to share something, that would be interesting. I will bring you in, Alex, but also broaden out the question slightly. Taking into account what the Governor said about how the Bank views this in a historical context, how concerned should we be about the level of unsecured lending that is currently taking place, and the risks both to households from the Bank’s point of view but also the wider risk to the economy. Alex, I will bring you in now.

Alex Brazier: I have two points. First, building on what the Governor said, the overall level of consumer debt in the economy is around 15% of household income. That is in line with its historical average. We strip out things like student loans, which, as the Governor said, are a very real burden, and we need to think about, in particular, what the income-contingent tax liability they create means for not just consumption but also the ability to service other debts. That is the financial-stability issue we are going to focus on. As the graduate population that has been through this student loans regime increases, that issue will become more and more important, hence the importance of this work.

While we do not think the level of consumer debt, as we look at it for financial stability purposes, is at an unusually high level, it had been growing extremely rapidly, at annual rates of about 11%. That was troubling, not because it was necessarily a direct macroeconomic issue. The flows of new consumer credit are about 1.5% of consumer spending, so they are not big from a macroeconomic perspective. The wider risk was that banks and other lenders were looking at the performance of these loans in the recent past, when write-off rates had been coming down, and thinking, “Great, our underwriting standards now must be excellent. These things are less risky. We can do more of it”. As a result, you saw interest-free periods extending, interest rates coming down on these types of loans, and general supply conditions loosening.

That troubled us because, had it gone on too far, it could have compromised the resilience of lenders. This is an asset class that accounts for only 7% of their UK lending but accounts for 40% of the losses they take in the stress test. That is because, in contrast to mortgages, which the Governor described earlier, people are much more likely, in the scenario we have described, to get into difficulty and default on this type of debt.

Because we saw that, we had a thorough look at banks’ exposures and concluded that, even though write-off rates had fallen, that was not so much to do with the quality of the loans they were making and the creditworthiness of the people they were lending to; it was due to a relatively benign economic backdrop of steady employment growth and low but steady wage growth.

On the back of that, we increased the losses they thought they would make in the stress. We increased the loss rate on these things from 13% to 20% and, as a result, the banks had to put aside £10 billion more capital against these exposures. At the same time, the PRA issued guidelines to banks about their underwriting standards, effectively to say, “Do not just look at credit ratings. Please look at the underlying ability of the borrower to repay this loan”. That is not just a conduct issue; that is a prudential issue.

Who is to say whether it is coincidence or not? But, at around the same time, the growth rate of consumer credit seemed to slow very sharply. It has come down from about 11% a year to, in recent months, an annual rate of around 5%, which is much closer to household income growth. Just to loop back to where the question began, the level is not at a historically unusual level as a percent of household income, and the growth rate has now come down to more normal levels. Maybe that is due to our interventions, maybe not, but when it looked like it was growing rapidly this was a serious issue for us and we intervened.

Q162       Wes Streeting: That is a point of consensus. Finally, conscious of time, following on from the Chair’s earlier questions, I want to quickly ask about mortgage lending. The FSR notes, “The share of advertised products available to finance a 90% loan-to-value mortgage increased from 13.8% in September 2015 to a post-crisis peak of 17.3% in September 2018”. How concerned are you by this trend? Is this something we ought to be concerned about?

Anil Kashyap: The loan-to-income guidance that we give is one source of reassurance. We see some bunching right below our threshold of 4.5%, and we think that that is indicative of the fact that the policy is working. It is very important that we also have these affordability tests built in to the mortgages. While that credit is growing, we are accounting for it, and checking that the borrowers can support those levels of debt and will be able to continue paying. Then, of course, our stress test checks. As we know, even during the crisis, the mortgage losses were modest because people will do everything they can to keep their house, keep paying and stick with that. It is something we watch all the time. It is why we have the housing tools that we have in place, and they are working as we would hope.

Dr Carney: There are two things. First, from a constituent level—your constituents, not ours, although they overlap perfectly across the country—for first-time buyers and people who moved to regions where house prices are higher, high loan-to-income and high loan-to-value mortgages may be necessary. In most cases, it is a very sensible decision, with younger people who are going to grow into these mortgages. Our first responsibility is financial stability but we are trying to take into account these dynamics in the market and monitor accordingly.

Secondly, we are conscious—and this is also very true of the PRA—that the housing market has slowed. The amount of capital dedicated to mortgages has continued to increase and the process of ring‑fencing the domestic operations of banks may be having some impact on competition in this market. In other words, banks with considerable capital liquidity and a deposit base, where maybe not the only game in town but the principal game in town is mortgage lending, could create dynamics where, certainly, banks are going up the risk curve.

The first thing we want to check on in that regard is whether the banks, their boards and their risk managers know they are going up the risk curve or whether they are just backing into it. From a supervisory perspective, there is greater supervisory intensity around this, what risk rates they are applying and how well this is being managed. For openness, that is one thing that is happening here, but we very much start, from a financial stability perspective, from where Dr Kashyap was in terms of the protections that have been put in place.

John Mann: Good morning. In these turbulent times you will be delighted to know, Governor, that the Christmas card you kindly sent me was not put with the “politicians and other curiosities” display. It went on the main mantelpiece.

Dr Carney: Thank you very much.

John Mann: You are between Borussia Dortmund football club and the ambassador of Nepal.

Chair: There is no answer to that.

Dr Carney: There is no answer to that, although you do not want to mention to Tottenham fans that you got one from Borussia Dortmund.

Q163       John Mann: Are there any fundamental disagreements between you and the ECB over the agreement when we leave the European Union on financial services?

Dr Carney: There is a difference of opinion between us and European authorities in terms of the risk. The principal disagreement or difference of opinion between us is about the risks associated with uncleared derivatives in the event of a no‑deal, no‑transition scenario for Brexit.

Q164       John Mann: No, I meant in the context of a deal scenario.

Dr Carney: To be candid, we do not talk about those scenarios, because neither of us are involved in the negotiations, so what we are managing is the current situation, anticipating what the risk would be if there is not a deal and trying to provide advice and put things in place. I would say, with respect—then I will hand back—the co-operation with us and the ECB with respect to preparations for a no-deal scenario is exemplary from our perspective.

Q165       John Mann: I understand in relation to a no-deal scenario, but in the deal scenario are there any fundamental obstacles to having a deal that relates to financial services?

Dr Carney: I cannot put my finger on one, no.

Q166       John Mann: There are some fundamental issues politically in relation to customs here; that is quite evident, but in terms of financial services, if there is a deal here, then, we can be confident that financial services itself would be a smooth negotiation. 

Dr Carney: If I can just reemphasise this, it is not for us to negotiate. I thought the question was specifically with respect to us and the ECB.

John Mann: It is, yes.

Dr Carney: Neither of us are party to the negotiations. From time to time, I am sure both of us might be consulted on technical aspects that would inform the negotiations. As you well appreciate, I know, there are a host of fundamental issues in financial services that would have to be considered in any negotiated deal.

Q167       John Mann: You seem relaxed, or confident, that they could be reached.

Dr Carney: No, I was answering specifically with respect to the ECB and the workings of central banks.

Q168       John Mann: It is important for us to know whether there are any fundamental issues that you and the ECB see, should there be a deal.

Dr Carney: May I broaden it out slightly? You can stop me if you disagree with this. There are fundamental issues in terms of the division of responsibilities and the flexibility of supervisors to take decisions. Many of the decisions we have discussed today we take because we have independent macroprudential responsibilities and powers given to us by Parliament.

Of course, it would matter if, for whatever reason, the nature of the deal either shifted those responsibilities to other authorities or somehow constrained our ability to take those decisions, such as varying the terms in the mortgage market in order to protect longer-term financial stability. My last high-level point is this. For the rules that govern our financial system and the evolution of those rules, how the collective “we”, the UK, participate in their design and implementation is a fundamental point.

Q169       John Mann: Are you confident in relation to what your remit and the Bank’s remit would be, should we progress with a deal into negotiations, in relation to the aspect we are dealing with in particular, relating to financial services, how you will be involved and how you will be advising?

Dr Carney: We recognise that this deal is about everything. Financial services is one component and the Bank is one component of financial services. We do not have good visibility. As a straight answer, we do not have good visibility to the nature of the future relationship and we, like others, take note that a process is being developed to determine that.

We would presume that, as part of that process, before material decisions were taken about the oversight and regulation of financial services, given its importance and risk to the UK economy, perspective would be sought as part of those determinations. We fully recognise that the decisions are taken in a much broader context and then we will implement those decisions as Parliament sees fit.

Q170       John Mann: If Parliament muscles its way into a direct locus in relation to negotiations, how will your relationship with those negotiations alter?

Dr Carney: We are not part of the negotiations and we have not been part of the negotiations in any way, shape or form, with the sole exception of what has been disclosed publicly, which are discussions around no-deal risk and cross‑border risk. We have talked about this many times in front of the Committee. From time to time we are asked our perspective on technical issues. We provide those through the Treasury, as you would expect, and through testimonies, such as these. We are respondent; that is the way I would characterise it. Whoever is driving this process will get perspective if they ask, but only if they ask.

John Mann: Mr Sharp, you have made only three speeches over your time, so we need to get value for money out of you today. That is reasonable and fair, is it not?

Richard Sharp: It is totally fair.

Q171       John Mann: What is going to happen to investment, seeing as Parliament does not seem to be able to make its mind up about anything? What is the immediate impact going to be on investment, in your judgment?

Richard Sharp: As a result of— 

John Mann: Us not making any deals and Parliament not deciding anything.

Richard Sharp: You have to look at the difference in timeframe. In the lead‑up through this process of negotiation, in terms of the data, it seems as though in the liquid markets people are neutral to underweight UK, and you have seen most of that in the equity markets. In the event of a disorderly exit, you have seen in the work produced by the Bank that there are different degrees of severity.

It also then relates specifically, in my view, to the question of the national credibility. If you look at the disorderly analysis that we have done, much of the decline in GDP that comes by 2019 is as a result of the movement in interest rates, which occurs because, as we discussed earlier, we are influenced by external holders of our financial assets, plus spread widening. That is going to be driven by political uncertainty here, the credibility of the Government to manage their financial affairs or the kind of political uncertainty that could come as a result of general elections or other things. That is a very unpredictable but major factor that would then have a circle effect in terms of investors’ willingness to move into the UK or contract assets further away.

There is very high risk. In the short term, you would expect to see the thing that we had around the referendum in play and that we built into our model as well, which is foreign exchange acting as a shock absorber. That allows, then, repricing to take place, so that the risks the UK represents are properly adjusted and we get a balance.

I would say that this is a market that people have stayed away from. There are some great, great attributes, such as the rule of law, underlying strength in the economy. We are continuing to see illiquid investors investing in this market, but the liquid markets will be negative in the short run. Then it comes to the different perspective that this Committee represents in terms of the growth prospects, the trade negotiations and the friction associated with trade.

Q172       John Mann: How will the market respond if Parliament grabs some of the executive power and decides that the 650 Members of Parliament are going to manage the negotiations? What is your view on what the market reaction to that would be?

Richard Sharp: I cannot be precise, but I can communicate that uncertainty and a lack of financial strategy is only a negative, because it adds a risk factor to the outcomes.

Q173       John Mann: How long could we delay article 50 and decisions for before it has, in your judgment, a significant impact on investment and then on jobs?

Richard Sharp: This is a personal view that falls out of my FPC participation.

John Mann: That is why I am asking. You are on your way out, so you are free to speak. I am not going to allow the Governor to interrupt you and he does not want to.

Richard Sharp: I have negotiated many large M&A deals, as the Chairman knows well. The history of negotiation is that, in any event, there is always tension right at the end, and if you put off the end you will still have tension at some point towards the end. Bilateral negotiations between sovereigns and Governments have often reflected that, in the trade negotiations we have seen.  That is my way of answering the question.

Q174       John Mann: I am not asking your view on what we should do. That is a political decision. How big a difference, in your judgment, is our decision or, indeed, non‑decision going to make to investment and job prospects in the country? From where you are seeing it, as someone who will be advising people how to spend money and invest, how big a decision is this? How big is the gulf in terms of direction?

Richard Sharp: As we have already heard, the backdrop is a slowing global economy and that means investment decisions, in any event, are constrained. Therefore, there is more fragility associated with any decision to increase capacity in that environment. Then, if you add another layer of risk on top of it, it makes it a pretty easy decision to hold back. It is quite significant.

Q175       John Mann: As a final question, would you be confident, with your experience now of the Bank, when it comes to financial services, that getting a good deal on financial services is achievable for the country?

Richard Sharp: Yes, I would hope so. We benefit from having a Governor who has strong central banking global relationships. The head of the ECB is a former colleague of mine as well. These are very constructive people who recognise mutual interest at the central bank level and you have seen that activity in global accords, in terms of protecting growth. At the central bank level, which is where some of the regulation of financial services will take place, I am quite optimistic that the individuals involved will be very constructive.

John Mann: Thank you. Thank you for your contribution over the years.

Q176       Chair: The trouble is when the negotiations are left to politicians. The Governor has one brief thing.

Dr Carney: I have one thing, if I may. Sorry, Mr Sharp. In the scenarios, the impact in the short-term is tariff restructuring and dislocation related to customs. It is not the interest rate response. The interest rate response is something that affects the pace of the recovery, and it is important that that distinction is noted on the record. It is just a scenario. It does not mean it is what is going to happen.

Chair: I thank all our witnesses this morning. Can I particularly thank Mr Sharp, who for inexplicable reasons is not going to be in front of the Treasury Select Committee any more, but we wish you very well? Thank you for your work on the committee and we look forward to seeing the other witnesses again in due course. Thank you.