The House will want to discuss the events in the international financial markets this summer. To assist this debate, I am making this written statement to set out a summary of what has happened and the action taken in response. I will make an oral statement later this week.
International Financial Markets—Recent Developments
Over recent years, the world economy and global financial markets saw an unprecedented period of stability and prosperity. This has been accompanied by: lower average long-term interest rates in advanced economies than at any time over the previous three decades; low default rates on borrowing; investors seeking higher returns; and lower premiums for riskier lending.
Since late July, global financial markets have suffered disruption and turbulence, triggered initially by problems in the US sub-prime mortgage market. Uncertainty over institutional exposure to potential losses on sub-prime mortgages caused reductions in liquidity across a range of financial markets. This uncertainty has been exacerbated by the fact that assets and liabilities have increasingly been managed off-balance sheet in complex structured investment vehicles and conduits.
In these circumstances, a range of asset-backed securities could no longer be sold or traded. These problems spread to money markets and funding costs increased for banks, with inter-bank lending spreads rising by up to 100 basis points in major financial centres and terms of lending shortened significantly. Bond, equity, commodity and foreign exchange markets around the world were affected as investors lost confidence and a re-pricing of risk began that is still continuing. In this way, even institutions with no direct exposure to sub-prime mortgages have been affected.
These developments have affected economies and institutions across the world. Many banks and funds have suffered losses due to direct exposure to sub-prime mortgages and associated securities. For example, in the US a number of sub-prime mortgage lenders have had severe difficulties and funds holding large quantities of mortgage debt instruments were also affected. In Germany, two banks had to be helped after suffering from similar exposures. Banks elsewhere in Europe suspended the activities of funds after exposure to sub-prime products left them unable to value them appropriately. Funds in other countries, including Australia and Canada, have also been affected.
Impact on the Financial Sector
The UK entered the recent period of turbulence in the global financial markets in a strong position. The UK economy has seen 60 quarters of growth—the longest and most stable period of growth since records began—and is expected to continue to grow.
Moreover, the banking sector in the UK has benefited from a period of strong growth which helped it build up healthy balance sheets and capital positions. Most major UK banks reported good profit results for the 2006 financial year and continued to report increases in pre-tax profits in their interim results for the first half of 2007. Throughout this period of growth and stability, the Financial Services Authority (FSA) continued to set capital requirements for all banks above the minima required by EU law and international standards.
Direct exposures in the UK to losses from sub-prime mortgages have been less significant than in some other countries. However, because of the broader impact of the turbulence on global markets, some financial institutions have found themselves under funding pressure due to the seizing up of asset-backed commercial paper markets and the drying up of liquidity in the inter-bank markets.
Northern Rock Plc
Northern Rock Plc faced specific difficulties in these circumstances. Its recent problems were not caused by direct exposure to sub-prime mortgages in the US or the UK: indeed, it has a good quality loan book. Rather, its problems have been associated with wider conditions in the wholesale funding markets. The market for new securitisations had largely closed as investors’ demand for such assets fell across the world. Furthermore, the market conditions in August and September resulted in liquidity in the wholesale money markets drying up, with a shortening of duration of funding and an increase in its cost. The combination of these factors contributed to serious liquidity problems for Northern Rock Plc.
Following advice from the Governor of the Bank of England and the chairman of the FSA that the position of Northern Rock Plc, given market conditions at that time, constituted a genuine threat to the stability of the financial system, I concluded that it was appropriate and necessary for the Bank of England to provide liquidity support to Northern Rock Plc. Northern Rock Plc issued a profit warning on 14 September. At the same time, the authorities issued a statement about the provision of a special liquidity facility to Northern Rock Plc.
On 17 September, to put the matter of security of deposits beyond doubt, I announced that, should it be necessary, the Government, with the Bank of England, would put in place arrangements that would guarantee all the existing deposits in Northern Rock Plc during the current instability in the financial markets.
Throughout this period the Treasury, the FSA and the Bank of England have worked together, and, as appropriate, with Northern Rock Plc, in line with their respective responsibilities, and continue to do so.
Global issues demand global responses, so the Government are working closely with their partners in the EU and internationally to ensure a coordinated international approach to financial market developments over the last two months. I made proposals to EU finance ministers that we must remain fully engaged, acting with the wider international community, in strengthening arrangements for ensuring financial stability. I will also be making proposals at the meetings of the G7 and International Monetary Fund next week on the international response.
The UK has a system of depositor protection based on the Financial Services Compensation Scheme (FSCS). Under the previous scheme only the first £2,000 of people’s savings and 90 per cent. of the next £33,000 were guaranteed. As a first step in improving the level of protection for depositors, the FSA has decided that, with effect from 1 October, the FSCS will cover 100 per cent of deposits up to £35,000.
We must learn the lessons from recent events and reinforce our systems appropriately to meet our objectives of maintaining financial stability, competitiveness and confidence. I will therefore make a statement later this week bringing forward proposals on further reforms to give consumers confidence that their savings and deposits are accessible, safe and secure, and to handle banks facing difficulties.
We will balance any need to make improvements as quickly as we reasonably can with the need to consult as fully as possible. Financial sector regulation will remain effective, proportionate and risk-based, protecting investors and consumers appropriately and ensuring market integrity whilst encouraging innovation and keeping pace with market developments.