THURSDAY 10 JANUARY 2008

RT HON ALISTAIR DARLING MP, MR JOHN KINGMAN AND MR CLIVE MAXWELL

  Q1860  Chairman: Chancellor, you mentioned that you do not want to stifle financial innovation, and I think that is a working aim, but we are in this situation because of reckless financial innovation in that the bottom line is that no-one any longer trusts the rating agencies' judgment or the creditworthiness of complex structured instruments, and that in itself some are suggesting is putting a hole Basel Pillar I. Is it not the case that forcing the rating agencies to clean up their act is a necessary condition for Basel II to get on track again?

  Mr Darling: There are two things would say about credit rating agencies. Firstly, they should always be regarded as a source of advice rather than the final word as to what you do. I think there may have been some cases where people have taken the word of a credit rating agency and that is it, but the second thing is, of course, questions have been raised in relation to how effective, how diligent they have been, but if you take the root cause of the present crisis in America, for example, in the housing the market in particular, the root cause is institutions, on advice (and we do not know, obviously, how much they relied on credit rating agencies, substantially or not), lending money to people who, frankly, were never going to be able to pay it back when the interest rates went up, and it must have been within their contemplation that interest rates at 1% were going to go up at some stage.

  Q1861  Chairman: But at the core of that is complex structured products?

  Mr Darling: That is right. One of the issues that needs to be looked at, for example, is that credit rating agencies do advise companies in relation to the very instruments they are then going to raise, and these are issues that need to be sorted out, particularly at an international level.

  Q1862  Chairman: It would be reassuring if you were to give us an undertaking in terms of Basel II that this issue is going to be looked at.

  Mr Darling: It is. It is being looked at at the IMF level, it is being looked at the Forum for Financial Stability as well.

  Q1863  Nick Ainger: Chancellor, you were talking just now in response to the Chairman about the root cause of this problem being the miss-selling of mortgages in the United States which then spread throughout the whole financial community, through CDOs and SIVs and so on, but in fact it should not have been a surprise, what happened in the summer, because both the Bank of England and the FSA gave specific warnings that there was a threat to a liquidity problem. In January the FSA quite clearly said that "market liquidity remains abundant at the moment, but it is still important for market participants to consider how they would operate in an environment where liquidity is restricted". The Bank referred specifically in its Financial Stability Report in April to impaired market liquidity, all as a result of the subprime mortgage problem. It would appear, possibly other than Goldman Sachs, that virtually no bank appears to have taken any cognisance of those two quite clear warnings in the UK and it would appear from our meetings in Brussels and in Frankfurt that, in fact, European banks did not really take note of similar warnings that they were given. What can you do in the work that you are planning ahead now to address these problems?

  Mr Darling: One of the things that I think we can do is to strengthen the role of the IMF in relation especially to these international global problems, that there is a more formalised way of bringing to people's attentions that there are problems mounting and that people ought to start making plans against the situation deteriorating. You are right that the Bank of England has issued general warnings; the FSA itself has. The questions that arise from that are twofold: at an international level, how do you make sure that a report or a speech by a central bank governor that actually is beginning to sound warning bells is acted on? The second thing is, of course, enforcing regulation. You need to ensure the FSA, having flagged this up in general, then starts to look, in particular, at institutions that they were concerned about.

  Q1864  Nick Ainger: Presumably the risk committees that banks have could formally look at the report that either the central bank or the regulatory authority has provided, flagging up a particular warning and then they would have to formally respond to that warning. Is that a way that it could be done?

  Mr Darling: I think that is something that you would have to think fairly carefully about. For example, suppose that the Governor of a central bank made a speech in which he said, "I think there is trouble ahead", are we then saying risk committees of banks all around the world would have to look at the speech and then say, "Do we do something?" or are we saying that there would be an expectation, a supervisory requirement, only if it is something slightly more formal than that?

  Q1865  Nick Ainger: I am not suggesting that. On these two occasions, in January it was in the FSA's financial risk outlook. It was not a speech; it was actually there: a carefully worded report. The same was true of the Financial Stability Report of the Bank of England in April, again, clearly identifying this problem, and yet nobody reacted, it would appear, other than one or two institutions.

  Mr Darling: One of the things we need to reflect on is how do supervisors, having expressed a general concern or even a particular concern, then make sure that it is acted upon? I suspect that is an issue here, it is an issue around the world, but for the past few years, as you know, we were talking about these things, as you say, you refer to specific warnings. The question you ask yourself, if you were to go back to American where the immediate problems stem from, why was it there that someone did not start asking questions about their exposure to these houses where it was quite obvious that the house was not worth what people thought it was and there was no income to go with it?

  Q1866  Mr Love: Chancellor, you indicated earlier on that all opportunities are open in regard to Northern Rock, including the possible nationalisation. Right at the beginning the Chairman asked you about the Human Rights Act. What influence will the Human Rights Act have on the way you respond to shareholders' interests in Northern Rock if you have to nationalise it?

  Mr Darling: The Government is legally obliged to obey the law. There is no surprise there. When we introduced the Human Rights Act, I think at the end of the last decade, we were very aware of that and so we have to take that into account, but, as I said to the Chairman earlier, equally I am quite sure that people who have been buying Northern Rock shares since September were fully aware of its present circumstances.

  Q1867  Mr Love: I want to ask you specifically about the consideration that shareholders will receive, but let me put it to you in this way. Can you reassure the Committee, if nationalisation becomes the only option, that when you consider buying the shares from shareholders you would take into account either the market position of their shares or, indeed, what shareholders would have received should one or two of the private sector options have been a possibility? In other words, will you relate what the shareholders receive to the market, rather than to perhaps what some people think would be a generous solution really to the Human Rights Act?

  Mr Darling: We have to give regard to the Human Rights Act, but I will take into account all those things that I am legally obliged to take into account whatever solution we may reach.

  Q1868  Mr Love: Can I ask you about the issue of the intervention of the FSA in the future when a financial institution is in difficulty. I wondered whether you have given any consideration as to whether or not that should be based on the judgment of the regulator or whether there should be specific criteria or rules that they would have to follow in order to justify any intervention?

  Mr Darling: I think there would have to be clear rules because the law can only operate on the basis of certain things happening. As I said earlier on, I am not in favour of legislation which would give the state the arbitrary power to intervene in a bank when there is no possible justification for doing so. Inevitably, you have to have some degree of discretion because you cannot legislate for every conceivable possibility. You can think of 101 reasons why a bank might get into difficulties and pose a systemic risk. I think it is important that we provide as much certainty as possible, precisely because of the point that I think Mr Cousins was making; we want people to be able to invest in this country with certainty, where they know what the rules are, just as if they invest in America or Canada or wherever they know what the rules are there, and they understand that and they are quite happy with that. We do need a degree of certainty. We cannot just give people blanket sweeping powers but, on the other hand, you do not want to get into a situation where you find the one thing that you had not got down in the Act happens and you are back to square one again.

  Q1869  Mr Love: I accept what you say that you need a balance, but in the reality of the situation these are always very fast-moving circumstances. You do not have a lot of time to sit back and make judgments, and therefore following the situation may well be the best judge at that particular time rather than depending on rules.

  Mr Darling: What you need is a legal framework. If you take everything that we have been discussing this morning, whether it is in relation to the lending to Northern Rock or supervision, inevitably there has to be a degree of judgment, especially in relation to supervision. For example if you take Northern Rock as it was, there has to be a degree of judgment as to at what point do you intervene. The FSA accepts that perhaps looking at it now they should have said to Northern Rock , "You cannot carry on in a situation where you have got no plan B."

  Q1870  Mr Love: My final question Chairman. You have indicated that although things have improved, the credit crunch is still having an impact. Is it yet having an impact on the real economy rather than the financial sector?

  Mr Darling: I think it is very difficult to be sure as to what the ultimate effect will be. I can just say this: that last October at the Pre-Budget Report I down-rated our forecast for growth for this year because I was sure that it would have some effect, but my cause for optimism that we will get through this is that our economy is fundamentally strong. This last year it was the fastest-growing economy of any developed country. We have very low levels of unemployment. 1975 is the last time it was as low as this. We have got over 29 million people in work. Crucially we have got low interest rates and inflation is at or near our target of 2%. There are a lot of reasons to be more optimistic. It was a completely different position to the one that we were in 15 years ago where interest rates were high and three million people were unemployed. We are in a very much stronger position. Having said that, we are going through some difficult times. Right across the world there are problems. I mentioned the housing market in the United States for example and whilst, if you look at the money markets, the conditions are better now—and I think a great deal of that was due to the action taken by central banks just before Christmas—I think this year is going to be difficult. However, provided we stick to the course we have set I remain optimistic.

  Q1871  Chairman: Chancellor, we have almost kept to time. We hope with our report to keep strictly to time and that it works in with your consultation exercise. We thank you for your evidence this morning and we look forward to that consultation exercise.

  Mr Darling: Thank you very much.