TUESDAY 4 DECEMBER 2007

MR CHRIS HITCHEN, MR PETER MONTAGNON, MR GUY SEARS AND MR DAVID PITT-WATSON

  Q1400  Mr Mudie: You are a bit more realistic or pessimistic than Mr Hitchen whose submission says there is nothing to worry about whereas you have said there is a lack of transparency and there are real worries.

  Mr Hitchen: To clarify, I was not trying to give the impression there was nothing to worry about.

  Q1401  Mr Mudie: Are you going to be more pessimistic?

  Mr Hitchen: No. Certainly, there are things we do not know yet and in two years' time we will find that more pain is being borne. But what we tried to say in our paper was that pension funds are likely to be less affected than some other investors because of our more cautious and diversified approach.

  Mr Pitt-Watson: Let me also be very optimistic. Capital markets do and have done a fantastic job, but we should learn the lessons from this credit crisis. In my view, we have to learn exactly the lessons that we spent 20 years learning in the equities market, namely that credit markets will not be successful unless you have someone who takes ownership responsibility. In the equity market Mr Hitchen and Mr Montagnon in particular have been leading lights in making sure that in the UK we do have ownership. I think we need to learn that lesson from this credit crisis too.

  Q1402  Mr Mudie: If I were an individual approaching my pension and listening to you I would ask: are we learning just the theoretical lessons or will we have some pain from this? Will there be pain in the pension industry?

  Mr Pitt-Watson: We do not know what the real world economic effects will be from this credit crunch. I was talking yesterday to a retailer who was terribly negative about what was happening. We simply do not know. If you are the Bank of England by how much will you reduce interest rates to try to keep the economy going?

  Q1403  Mr Mudie: That is not very reassuring, is it, because you are in hedge funds, private equity and securitisation and yet you come before us and say you are okay?

  Mr Pitt-Watson: I am sure that people's pensions in 25 years will be okay at the end of the day, but if what we are looking at is what is likely to happen in the immediate term there is a real problem. We do not know. There were CDOs, special purpose vehicles issuing paper and inadequate accounting rules. The economy particularly in the United States bubbled. The bubble burst and we now have to hope to can bring it down slowly without it affecting people's livelihoods and jobs. It could affect their jobs.

  Q1404  Mr Mudie: In the individual areas we have mentioned the fundamental issue is transparency. In your memorandum you talk about a government review and the current tripartite discussion. In the same sentence you go on to talk about whether greater transparency can be achieved in the market for structured investment vehicles. Am I reading that wrong? Are you expecting government to deliver transparency or do you just make a plea for it? If it is the latter tell me how we will get it. It seems to me to be the thing that is missing from the whole exercise.

  Mr Pitt-Watson: I think I am making a plea for responsibility and ownership. To take one example, in the area of accounting rules we have had a momentum towards international accounting rules. Most of the world has adopted American standards which very much value things to market. We have talked about those problems. That move continues. It is up to investors to make sure that we first slow this process and consider what is happening in this country, but also if we have a body called the International Accounting Standards Board should not investors be in the majority on that body? Should we not be asking that pension funds set aside some part of the enormous fees they pay to fund managers for trading, to make sure they have the necessary resources; so that when we do get international accounting standards they are not ones that break under stress? That is the sort of thing we can do and is a good lesson for the future. In my memorandum I make one or two other suggestions about things we could do.

  Q1405  Mr Mudie: When we listened to the banks earlier I am not sure they did not deliberately disguise the risk in these products by mixing them up. I do not know how any analyst can properly advise you when the same banks have the stuff on their books and are scared stiff because they do not know what they have. If they cannot analyse it how on earth do they expect someone advising you to be able to tell you the risk? In other words, it was deliberate.

  Mr Pitt-Watson: I do not pretend that we can make this perfect. What would I rather have in future? Do I want people who start with accounting measures that fundamentally are based on prudence or accounting measures that fundamentally are based on market value? Who would be more likely to protect pensions and savings? I make the assumption that prudence might be quite helpful here.

  Mr Hitchen: You have a good point. I think investment banks will tell you anything you want to know about a product they are selling to you, but ultimately they are in the transaction business and their job is to get the transaction done. It is a fact of life that there are brighter brains working at investment banks than elsewhere in the food chain. That is just the way the economics work, so the rest of us have to be pretty careful about the way we deal with them, but the watchword has always been caveat emptor.

  Q1406  Mr Mudie: Does it not come down to the old saying that if it is too good to be true it is not true?

  Mr Hitchen: There is certainly a risk of that.

  Q1407  Chairman: On the question of reporting, the other day I read an article which said there were five or six different ways to report losses in accounts. It may be that some banks are just drip-feeding this, so perhaps there is a need to look at reporting losses in greater detail.

  Mr Montagnon: One area where we do need more transparency is the reporting of this business in financial institutions. We need to know with much greater clarity what is on, what is off, and what has potential to come back onto the balance sheet than perhaps we did in the past. As investors who hold shares in financial institutions this is something that should be looked at closely. In addition, we also want to have a close look at the role of audit committees and risk committees in managing these risks and deciding how they should be reported. That is one area of transparency that we would like to see improved as a result of this.

  Mr Sears: Some of the investment banks said they might take this back on because of reputational risk. If we start to go to reputational risk as being the reliance for a covenant, in the past people may have relied on that reputational risk because things have been too big to fail. I think there are things out there that are too big to rescue. That is the real risk. In other words, if it is just reputational risk banks will not step in at that time because it will be too big. We have already seen a distinction in the approach of some investment banks.

  Q1408  Peter Viggers: Following that precise point, it might be better to be an investment bank that has survived having sloughed off its non-attributable, non-balance sheets assets rather than one that still finds difficulties having taken on board those liabilities.

  Mr Sears: It is an invidious position for them. I do not suggest that I would like to sit in their seat but that in designing the structure going forward we have to take account of the fact that we should not be in this situation be making such decisions at a time when there is lack of clarity.

  Q1409  Peter Viggers: I asked questions of the investment banks about the securitised assets held on their balance sheets which had been through various stages of collateralisation. I was reassured by bankers who said that there were recognised models for testing a section of these CDOs as assets and it was possible to evaluate them. Are you similarly sanguine? Do you believe it is possible to value such securitised assets? First, is it possible to put a value on them? Second, does liquidity affect their value?

  Mr Sears: I do not believe that in the end the models work. You heard from others who gave evidence this morning. They talked about the long tail and the unexpected event, so there is a breakdown. You just have to look at what has happened to see that the models could not cope with working out all the complexities of the things connected to them. As another example of models, the interim results of Northern Rock—I make no criticism of its board—give their Basel II statement. That is entirely proper, but in that statement the waiver they get on 30 June which allows them to move onto internal models and such like would result—to be fair, they say there is some asset realisation as well—in a release of £300 million to £400 million to shareholders over the next three to four years. That was the projection of moving onto the internal models. They may have been used utterly properly; I do not suggest otherwise, but I think that raises questions about what the internal models are and how much you are allowed to rely on them in these risky areas at the end of the day. I believe that in certain other areas the modelling is very good, but for the new frontiers the models do not work. I believe that this morning we have heard from very responsible investment banks that they feel the same.

  Mr Hitchen: The models do not deal very well with the world from which the data which populate them have come. They may very well reflect the past five, 10 or even 20 years depending on the model. I always try to remember as a sense check that maybe these instruments did not exist in the 1930s, but what would have happened if they did? Think about a scenario which could clearly happen in the real world but which might not have been so evident in financial markets in the recent past and therefore not modelled.

  Q1410  Peter Viggers: To move closer to your areas and look at the risk associated with private equity and highly leveraged deals, have lenders to private equity been exercising due diligence in respect of loan issuance and have they been alert to the risks associated with weaker loan covenants? Is this an incipient risk?

  Mr Hitchen: To be candid, we invest with a number of general partners and often take the equity piece of private equity deals. Those partners have in the recent past until the summer found it increasingly easy to get loans for the deals they want to do. I do not go as far as to say that the providers of those loans have not been doing due diligence, but it is certainly the case that credit has been very easy over the past two or three years and it is now markedly more difficult. The same general partners now have to accept more difficult terms for loans or in some cases do equity-only deals. There has been a complete turnaround in the way underwriters look at private equity deals.

  Mr Montagnon: In a seller's market—it is a seller's market—it is quite difficult for the buyers to demand the kind of covenants that they might wish. We have been through a period until quite recently when better protection might have been wanted but it has been very difficult, if not impossible, to negotiate. If you seek such protection you will not get any investment.

  Q1411  Peter Viggers: If investors in the past have perhaps been over-reliant on summarised risk assessments by other organisations what can they now do to be more specific and certain they are taking risks that they fully understand?

  Mr Montagnon: One thing we have done at the ABI together with other bodies it to talk to the credit-rating agencies about putting into their own assessments more reference to the covenants and greater explanation in shorthand terms of what is there, not necessarily their evaluation which would present them with legal problems. We would need and hope to go further in that direction.

  Q1412  Peter Viggers: I raise a specific point on pension fund investment. A recent Citigroup survey showed that 85% of pension fund managers plan to raise their allocation to alternative assets in the next three years, with private equity being the most popular area of prospective investment. Do you think that figure still carries weight or has there been a rethink?

  Mr Hitchen: I am sure that the figure still carries weight because pension funds tend to operate in quite a gradual way, but we go back to a point I made earlier. Pension funds are looking to diversify into as wide a range of assets as possible. That is really our primary defence against any particular problem that emerges in a section of the market. I am sure we would like to invest not a large but significant amount of our assets in private equity, hedge funds, property and various other alternative assets. I suspect we will find it quite hard to build our exposure to private equity in the near future because I do not believe that as many deals will be done in that sector of the market.

  Mr Pitt-Watson: If you ask what investors can do, it comes back to how it is investors will ensure they are providing that ownership discipline. We have the principal/agent problem and we keep passing the security on and on. By the time it has been passed to a hedge fund that is trading in derivatives, of some CDO originated from wherever, there are several principals and agents. Somehow we have to get investors as a group to work together, for example as Mr Montagnon would do for the ABI, on a much more significant scale than historically, to make sure that the ownership disciplines exercised by the old-style bank manager who said, "Yes, I think you will repay the mortgage", are there. We need that more urgently when dealing with alternative investments because once you have them in your hedge funds what you are investing in is quite complicated.

  Q1413  Peter Viggers: Might there be the emergence of new forms of vehicles with much more emphasis on transparency and certainty?

  Mr Pitt-Watson: That is certainly something we at Hermes would be keen to promote for ourselves and among other investors as well.

  Q1414  Chairman: That reminds me of an inquiry we conducted into split capital investment trusts a few years ago. We had before the Committee one of the architects of such trusts. He admitted to us that he really did not understand the model. It was good for the environment in which he used it but when it went into the outside world it blew up.

  Mr Pitt-Watson: That is exactly the sort of problem. Clearly, there are lessons to be learnt from this issue, but if we think about what may be the problem in the next war it will be the same thing happening again. People will be trading but not owning and we will have lost control of where the ownership function is. Then everybody, right across the market, loses out. Ultimately the railway and BT pensioners suffer.

  Mr Sears: However good the model is, one will always have human fallibility.

  Q1415  Chairman: But it is frightening when the architect of the model says he does not understand it, is it not?

  Mr Sears: I do not disagree with that.

  Q1416  Jim Cousins: I want to turn to the insurers. The Governor of the Bank of England made it very clear that he wanted a change to the solvency arrangements for the banks to prevent retail depositors from being trapped, as he expressed it. Do you favour that?

  Mr Montagnon: We believe that we need a robust system of deposit protection but we think that it needs to be very carefully crafted in such a way as not to distort the savings market as a whole. The danger is that if there is over-protection of depositors it will act as a disincentive to other forms of saving. How one gets there is quite complicated. It may be we need to look at the way the insolvency laws operate to ensure that savers can get their money or deposits out of banks quickly in the event of a bank failure. One of the problems with the present system is that it seems to get a long time to get the money out. That may mean it is probably helpful to have some adjustment to the insolvency arrangements.

  Mr Sears: While this is not particularly an IMA view, like Mr Pitt-Watson I am the author of two chapters of Tolley's Insolvency on regulated bodies and financial market insolvency. I worked on the Credit Institutions Reorganisation and Winding Up Directive in Brussels. I think the issue is not whether or not depositors ultimately get their money back. The innovative thing people can consider in looking at it again is whether or not there is a way to ensure people can keep getting their cash notwithstanding an administration or collapse. Given that most people take money through a cash point I presume it is not beyond the wit of man somehow to plug into the cash point system so people can still withdraw money while there is an insolvency up to the limits of the protection. A lot of the discussions have been about how much money people should get. As your constituents will know far better than I, telling people that for example after Christmas they will get their money back if there is an administration of Northern Rock is not something they need. Many of us use cash points. I can go to one that is not provided by my bank and I presume there must be a way of plugging the Bank of England into it at moments of crisis up to some limit.

  Q1417  Jim Cousins: Of course, the implication of that is that rather more banks will go bust because it will be easier to make them go bust if retail depositors are protected. I want to ask the insurers about Mr Sears' earlier point about toughening the reserving requirements on banks with the idea of preventing them going bust in the first place.

  Mr Montagnon: Clearly, it is better if banks do not go bust in the first place. The problem with Northern Rock was essentially a matter of liquidity. I believe it is generally agreed that not enough attention was paid to the liquidity risks facing that bank in the run-up to the crisis. I therefore presume that in future people will be paying such attention. Even if you have the best protection or prudential supervision in the world sometimes there will be cases when you have problems. If when a problem arises the retail customers know that their own money up to a given limit is safe and they can have access to it when they want at least you are spared the risk of a run because there will be less need for customers to go immediately to the bank to try to take everything out. It is from that point that one gets the risk of contagion.

  Mr Sears: Equally, the bank is put into administration if it needs to be.

  Q1418  Jim Cousins: I have understood the written evidence of the insurers to mean that they would not favour much higher limits of depositor protection than we currently have.

  Mr Montagnon: That is correct. The question is not whether the limit needs to be increased but rather how the system works and whether one can have confidence in it. If one takes a limit of £35,000 that covers 98% of all savers who have their savings only in cash and about 80% of all individual savers, so one will capture the bulk of the most vulnerable people in that protection. If one increases the amount one tends to distort the market for savings because in view of the guarantees one makes bank deposits more attractive relative to products that do not have the same guarantees. That is not necessarily good for the savings industry and the country's overall propensity to save.

  Q1419  Jim Cousins: Where does that leave the so-called bank assurance model in which the bank is also a portal into other kinds of savings products?

  Mr Montagnon: I do not believe it necessarily affects the model. What we would like to see is a market for savings where choices are not distorted. If we can offer products across that range we are very pleased to do that. One of the things we are concerned about in terms of bank deposits is that the way the protection scheme is funded should not involve cross-subsidisation from insurance to banking deposits to protect the latter because that would tend to distort the position.