I don't think I certainly feel qualified to judge how long this is going to go on for in terms of this resumption of hostilities and how it's going to end, but it underlines that this is going to be an unstable process for the foreseeable future. Now energy prices have come down as of a week ago. They were sitting a bit above where they were before the crisis. They're now somewhat further above, but they're still obviously crude oil prices are well down on their peak. We are also seeing, I think, continued fairly soft evidence on the pass-through into UK prices, but we'll get another inflation number next week. The one other caveat I would add, which I don't think gets enough coverage, is that although crude oil prices have come down, the prices of refined products have not come down as much. So we're talking about things like gasoline and diesel at this point, which of course are the end products. So those are the things that matter in terms of the end products. And one or two of the reasons for that in the global context are that there's a story around China and obviously a story around Russia. China has substantially reduced its imports of crude over the last month or couple of months. That's been interpreted therefore as a sort of softening of the market and a sort of reduced demand story. But they've also, as far as we can tell, reduced their exports of refined products substantially. So in a sense, actually they haven't necessarily changed their balance, and that is tightening the market for global refined products. And the other thing, of course, obviously, and this is obviously good news in other respects, that obviously Russia's had a serious blow to its production capacity from what Ukraine has done. So there is, I would make that caveat, that we all spend all our time quoting crude oil prices, but you have to be a bit careful because I don't think refined product prices have come down as much.
And one of the challenges, of course, is the damage to the infrastructure in the Middle East, which can take eight to well, eight months minimum to get, you know, once there is a ceasefire that holds, it's going to take things to get things back on track. What modeling is the bank doing to look at the impact on the UK economy in the short to medium term?
I mean, we obviously talk a lot to people in the industry, and we obviously talk a lot to our counterparts in the Gulf area. I spend a lot of time talking to my counterparts. I think the story there is, take oil and gas separately. On the front, there hasn't been as much physical damage to the infrastructure as the supply production infrastructure. Obviously, the blockages in the Gulf are another matter. So I think the message we get from the Gulf States is that if they can ship the stuff out, then they will resume production very rapidly, and they have, well at least up until last week, they had resumed production rapidly. They are also have got quite big plans which they're already executing for building new pipelines to get round the Strait of Hormuz, to do that, to get it to ports which are south of the Strait, but that will obviously take some time to do. On gas, I think the story certainly we get from the Qataris, who are the people who matter obviously in that market, are, I mean, they're quite precise. I think they say about 80, I think they say about if I remember rightly, about 83% of the supply is intact. The 17% that was hit by the Iranians in the attack some months ago now will take longer to bring back. They have, again, too, have got quite big plans for increasing their overall output of gas, but that again they're talking about sort of 2029, 2030, I think for that. So I say they're clearly very determined to get supply back onto the market, but obviously what we're seeing in the Strait now is going to impact that.
Okay. So it's a long, rocky period ahead. I'll come to some other witnesses on that in a moment, but we're about to have our seventh prime minister in 10 years. We've had a lot of change at the top there. So, you know, we're talking about internationally, but domestically though, do you think those changes and all that upheaval is good for financial stability? Well, I'm not going to comment on obviously on what's happening in politics.
Well, I suppose I mean, well, let me say about the stability point.
No, but two things which are important. One, as the last few days have demonstrated, the big driver of moves in financial markets is actually not what happens in the UK, it's global. It's the global setting. What I would say however is that I think what the evidence does indicate is that the UK situation is sort of supported by, on our side obviously monetary stability and financial stability, and I think on the other side is the fiscal framework. And obviously you did see a bit of movement in markets briefly on the fiscal framework, but that came back quite quickly.
If you were to be, you can't give private advice to us in public, but we've a new prime minister, a new, well, a new government, a refreshed government I suppose you could say, coming in next week. What would be your top tips in order to make sure that we have financial stability?
Or their best chance of maintaining financial stability in the UK?
Well, I think that the overall message I would give is that I think the big issue is growth in the economy. So I think we can do all we can on financial stability. I do actually think there are signs of a very resilient financial system. We described them in the Financial Stability Report and in two respects. One is, I think for instance the core banking system is resilient, and I'm sure we'll come on to discuss that. But also when you look at debt levels in the economy, if you look at debt levels in both the household sector and the corporate sector, they are not stretched actually at the moment. So that gives us an underlying picture of resilience. What I think is much more challenging is that we've had low growth in the economy now for the best part of probably 16, 17 years actually. This is not a story about any one government by the way. This is a general story. It's not a political story in that sense, but it is a story about UK growth. I've made a number of speeches recently on this subject. I think it's important because it's the critical structural issue. And as far as I will go into fiscal policy, which is not far, what I have said is look, it is interesting that if we did a simple naive counterfactual and said imagine that we'd had the growth rate for the last 17 years that we had for the preceding period, which was a potential and actual growth rate of around 2.5% a year. So we've been around one and a half for the last 17. So imagine you add that 1% back in, you've got the same shocks. So you have exactly the same fiscal policy for every government, not changing fiscal policy. You've got the same shocks at COVID, Brexit, Ukraine, Gulf, they all happen. Where would we be naively? Where would we be today on the public sector debt level? It would be about, I think that number was about 10 percentage points lower now. Therefore, you haven't solved all problems, but I would argue it would be a very different debate.
Okay, that's very helpful. And one of the, there was a strong drive here in the UK for deregulation of the banking sector to promote growth, and you know when we meet with those financial institutions they're keen to see that and constantly stress that we're a long way from 2008.
Do you think that that emphasis on deregulation and growth poses a risk for financial stability? Because sometimes that's the tension that's put to us by other people, that the bank is holding back growth because they don't want to see that deregulation. Is that a fair comment?
My overall view on this is we will not get growth if we don't have financial stability. I mean, I think we can point to episodes in history which support that view. So financial stability and monetary stability are key underpinnings of growth. Does that mean however that every one of our rules in financial regulation is perfectly formed? No. It doesn't. Would it ever be the case? No, because the world always moves on. So do we support a process of review? Yes. I do think that where I do differ from some of the arguments that are put is, let's take the banking system because it's important. The key to actually the banking system supporting the economy is to have a system that is earning returns which cover it more than cover its cost of capital, which means that they can invest their returns to support lending into the economy. And that is the best system we can have. I think after a long period of rebuilding capital in the banking system post the financial crisis, we actually are now in that situation. They earn more than their return on capital, and you can see that in the market numbers, you can see in the price to book ratios. Therefore, it seems to me they have a choice they can make as to whether they reinvest earnings into their own business or they pay them back to shareholders, and that's a choice that should be made in the market. We were not in that position before. The reason I push back is that some of the debates I find, and you read the debate, it's as if we've got this fixed amount of bank capital and therefore we must lighten regulation to allow it to be spread around further, and it isn't fixed. It isn't fixed at all. A healthy banking system will earn its returns and they can be reinvested into the economy.
Okay. Well, they've heard that. Mr. Crossner, you do, I mean from your perspective, let's take a look at the Fed. Does a washed Fed mean? What's it mean really for financial stability globally and in the UK? Do you think there's going to be any changes as a result?
So Kevin Warsh and I went through our confirmation hearing together to join the Fed, and we sat next to each other for years during the global financial crisis. So he has been battle tested in financial stability and he's very aware of and sensitive to those issues. So I'm obviously no one can guarantee that there will not be a financial crisis, but he is aware of and very sensitive to those issues. Obviously, there's a lot of change in financial regulation in the US, and a new proposal related to the Basel 3 endgame which I think is providing much more effective regulation. And I think it's very important not to confuse effective regulation with deregulation. We want to make sure that regulations are effective, that they reach the financial stability goals, but also that banks can intermediate, that they can actually do lending, they can do what they're supposed to do in the economy. And I think that's the key motivation for what's going on at the Fed now in thinking about financial regulation. And I think from the more macro perspective, Kevin is going to be very much aware of those issues, is not going to want to do anything that is going to expose the time that he is at the Fed to a financial crisis. But of course, sometimes events overtake what one wants. And certainly when I was at the Fed, I had studied a lot about the 1930s. Ben Bernanke said a lot about the 1930s. I don't think any of us thought we would be in a 30s-like crisis, but having studied that period, that was very helpful. And I think Kevin, as well as others who have been through that period, will make sure that we're best prepared. We'll be able to respond to try to minimize the damage if there is some sort of shock that causes a crisis.
Thank you. That's very helpful from someone who's so close to Mr. W. Jim Dixon.
Thank you, Dame Meg. Just looking at other risks that we're facing at the moment. We're just at the end of our, well, or sort of in the middle of the third wave of extreme weather of this year. So clearly climate change is sort of front and center for all of us in thinking about the way in which the country and the world is developing. Would you say that climate change is now a bigger risk than you'd previously estimated? I think when the governor came to us previously, you said it was sort of one of a number of risks obviously, but it had slightly receded in terms of the extent to which it was something that you had as one of our primary risks. Would you say the recent focus on climate change has changed your view on that at all?
Well, I was making a relative point. I wasn't making a point about the absolute level of climate risk. I was making a relative point. I'm going back to the chair's first question. I mean, given what we've seen on, for instance, on frontier AI over the last few months, I sort of have to make that point again. I mean, look, I'm not a climate scientist myself, so I'm not going to venture opinion on what we can conclude from what we've seen in the last few weeks, but we've obviously had, you know, Europe has had a very strong period of very hot risks from climate. Yeah.
And either the governor or other members of the panel. Does the sort of climate change we're seeing, does it impact on financial institutions in a way that we should be taking notice of? Would anyone want to, Mr. Benjamin, that?
So the channels in which climate change affects financial stability haven't changed. They remain very present. They are risk to banks, they are risk to insurers, and they're risk to core markets from climate change. This hasn't changed, and part of our analysis is to gradually embed this analysis into the mainstream of how we test financial stability. And we've still got strong teams of staff at the bank looking at those issues and understanding the analysis that you're talking about. Because I think the governor last time we spoke, you said there were now, and you accepted there were now fewer staff perhaps working on those issues, and that might indicate a sort of lesser emphasis on them, which was a bit concerning.
No, again, I make this point. We have to actually allocate our resources to reflect the relative risks as well. And for instance, AI has come up the league table very rapidly.
We'll come on to AI momentarily. Katherine West.
Thank you very much. Today, Meg, on the point of AI, what assessment has the Bank done on the needs around water, particularly internationally, thinking of countries like Malaysia where it's such a big part of the economy now, but the physical needs around water etc. that will, if not handled correctly, could have an impact on economic stability? What assessments?
I'm not sure we're the experts on that one, particularly, to be honest.
This, there's one aspect.
It's always good to have an expert in your organization.
I'm not an expert either. But there is one aspect in which, and it is related to AI, in which the availability of water supply does affect those developments. We've all heard about the very large increases in the infrastructure of data centers that are being planned to develop AI capabilities. Those large data centers will require water supply in order to cool down the production line. The needs for water are large from that. And one of the questions is whether the water infrastructure will be sufficient to meet the needs for those developments at the pace that is currently embedded in the expectations of the markets.
What assessment has the Bank of England done on the demand on the grid for AI in the UK and what impact that might have on financial stability? If certain types of projects don't go ahead but AI is demanding that?
Yeah, can I make two points? I think it comes back to this question of growth. So if, and I do subscribe to this view, because I do think technology, I made this point about lower growth over the last sort of 17 years, I do think technology is part of this because I think in the long run technology is one of the drivers of growth. I think we've probably globally been somewhat between sort of technology cycles. So we had the internet cycle, internet ICT cycle. I think the next cycle is likely to be some combination of AI and robotics. So I think this question about grid capacity and data center capacity is relevant here in terms of supporting growth. The other point I make, actually this is a point I have to be honest, I'm not an expert in this field, I hadn't appreciated until going around the country and talking to people who are closer to this, that there is also a question of what's called access to clean power supply. Now clean, I'm using clean in a slightly different context of the environmental point here, it's actually the quality of the power supply. In other words, having a very high quality and very continuous power supply. Some people have made the points to me, and I think this is what's on their own at the moment, renewables don't on their own give that quality, that clean power supply. They can be a big part of it, but they don't completely solve that problem. You need a base load of other power to make sure you've got that clean power supply. So again, I think in thinking of, and that's true for data centers, so I think thinking about that, then I think there does need to be thinking about how you ensure that we've got that mix of power supply.
Thank you very much. John Glen MP.
Yes. Can I turn to the decision to ease the leverage ratio by 0.2 percentage points? I want to try and understand the range of views that exist on this because I understand that, well, it appears to be a split decision. And the quote is "most judged that the benefits of the proposed changes outweigh the costs." This, it would be useful to understand what the range of views were and how meaningful that range is in terms of decisions. Let me start with you, Governor.
Yes, I'm happy to do that. Just to put into context, I think the announcements we've made on the leverage ratio are in my view really about cleaning up some of the issues around the leverage ratio. There was a particular issue where we'd made some changes back in 2019 which I think had created an anomaly which was particularly affecting the large domestic banks. And that's important because they are the people who make the highest proportion of loans into the UK economy, and it had left them facing a higher leverage requirement than was, I think, justified. So I think cleaning that point up was important. We've also, I think, increased the buffer usability in the leverage ratio, which I think also is important because it's exactly consistent with how we operate the risk weighted ratio. Now, the one thing I would say is, of course, the risk weighted regime and the leverage regime are not additive. They're parallel. Yeah.
That's important. So yeah, we'd made some changes to the risk weighted regime when we were here and we talked about them in December.
These are changes in the sort of the parallel regime. Now the question though is this. So I think those things for me were all sensible things to do. The challenge we've got, and this is why there's some quite important words in the announcement which I'll come to, is that we've got an issue with leverage in another context, which is leverage in financial markets. We've talked about this, I think, in previous hearings in the context of particularly government debt markets. What we've seen in the period since the last hearing, and in recent months, is also a growth in leverage in equity market leverage. So in hedge fund leverage in equity markets, also in leverage in exchange traded funds. So there's a further growth in that world. Now, it's all leverage, but it's a different context for leverage. But these two things are connected in the sense that the banking system is the ultimate provider of liquidity, and therefore there are exposures between these parts of the system. So I think the question that we rightly debated at length in the committee was, is the better way, if we think we need to do something in that market leverage regime, is it better to do it in the banking world or in the market world? Is it better to tackle this market leverage question in the market regulation world, if you like, or in the banking regulation world? Now, my own view, it's a personal view, I think it's better to do it in the market world, but we've got to land that because we put out some ideas, got mixed responses. I'm not surprised. But you'll see that final thing I'll say. You'll see that we've included some language which actually means we're going to do a bit of further work before we finalize these changes, which is exactly to this point. And it's particularly to say, do we think these changes might actually increase the market leverage risk? And frankly, the additional question will be, if so, but it's a question we've already got, what are we going to do about it in the market leverage world? Or do we do something in the banking leverage world? So I think there are sensible changes to make in their own right, but we have got this outstanding question about what we do about market leverage.
Okay. So who can help me understand what a slightly complimentary view to that is amongst the witnesses this morning?
Mr. BL. So, I think the aim of the change to the leverage ratio framework is to fix this idiosyncrasy that was a result of an increase in the countercyclical buffer in 2019. There was an offset in the risk weighted stack of capital. There was an increase in the countercyclical leverage buffer. There was not an offset in the leverage stack. So that was a discrepancy, and that disproportionately affected the domestically systemically important banks. So I think there was unanimity on the committee that that was something to fix, and that's what's been achieved by this package. There's also a broad view that we want to be getting the overall balance of the risk weighted capital requirements and the leverage capital requirements correct. The other view is that in addition to fixing the discrepancy for the D-SIBs, the domestic, which makes a lot of sense and will support lending into the UK economy, there's also a slight reduction in leverage ratio requirements for some other institutions, and that could potentially lead to further provision of leverage into markets. So that's the question about cost and benefit. To the governor's point, I agree that there are mechanisms within the markets, in particular haircuts or margining on repo, that would actually be, I think, very effective for providing stability in markets that can be in some ways arbitrarily levered if you have no haircut on a repo transaction. And the leverage ratio won't fix that if you have essentially no haircuts on a repo. That's arbitrary leverage. So that was the balance in my view of the view.
Yes, thank you. So we had an excellent discussion that I think got us to a very good outcome, exactly as the governor and Steven have said. Key motivation was to make the leverage ratio more effective and make sure that it's doing what we want it to do, which is to prevent excess leverage in the banking system. But I also believe that this is not the right tool to try to deal with market leverage. Things like haircuts or potentially centrally cleared transactions are the best way to try to deal with that. And so I think that what we were doing is trying to make sure that we had a lot of things that could be released in a crisis. Getting back to the previous question, that's a very effective way to try to make sure that banks can continue to intermediate during a crisis and provide both support in the crisis and more rapid recovery. And a 20 basis point change in the leverage ratio does not seem to be material to me in changing the ability of banks to either provide leverage more broadly within the domestic economy or more broadly. And we have much better targeted instruments. So making the capital stack much more releasable is also something that is very helpful in achieving not only financial stability, but also in providing support for a secondary objective on credit provision and growth, because that's something that will allow the banks potentially to reduce the so-called management buffer that they hold above and beyond the required minima. Now, of course, they're always going to hold something beyond that. They shouldn't be running right at the edge. But when there's a lack of predictability, when there's a lack of clarity about what is releasable, how much it has to be rebuilt, how that's going to operate, that leads them to hold a bigger buffer against that. And I think the approach that we've taken will help to reduce that. So make the leverage ratio more effective without in any way affecting financial stability, and not addressing the market risk issues which we'll do through separate means.
Can I just come on to the decision about lowering the capital requirement from 14% of risk weighted assets to 13%? Because I think there are two broad sets of views there. There obviously think that, you know, where does the benefit go to in terms of the banks or their shareholders or to the economy as a whole. But there's also, I think, still significant dissent among many banks over what is the actual net effect of this, because there are so many caveats that the notional 13% is never met because of all the different elements that go into it. And people then say, well, if you look at the bolder measures made in the US, we are not really getting there. There's still quite a margin between where we are in the consequence of this change and what is actually happening in other environments. How do you respond to those observations?
Well, I would disagree that the US has taken bolder measures. I don't think they have actually. The latest package they've announced is to implement Basel 3.1, which obviously we're doing as well. We've published a number of comparisons. We've actually in the latest numbers compared the leverage ratio comparisons. Their leverage ratio is actually higher for international banks. So I would disagree on that point that the US has done bolder things actually. I'd say the same about the euro area. I don't think they've done anything bolder than we have. Let me make two points. I think the first one is just to reinforce what Randy said, which is we know that banks maintain what they call management buffers above our requirements. And Randy rightly said there are reasons for doing that, which will be about how they run their businesses, and that's understandable. But I think what we've done will enable them to have more confidence to reduce those buffers, and certainly that's our aim. But same point, we've actually included a diagram in the publication we made. We would like to see the buffer structure simplified. So if talking about bold things to do, it is too complicated at the moment. We would like frankly a single buffer and a single releasable buffer. The reason I think, if we don't release buffers and if we say to them, look, it's okay to go into your buffers, we won't get upset, they always come back and say, well, will you? So the stronger thing is if you're prepared, when conditions change, to take the buffer away.
I accept that there'll be a rebuilding process at some point further down the line. That's a stronger message. So we'd like to see that and we'd like to see it simplified. So there's only one of them. To do that, we need international agreement. The buffers are a product of the international structure, the Basel structure. Essentially, we are, and Sam Woods when he was with us made speeches on this subject. We've been leaders in advocating that. We will keep working to get an international consensus to tackle the buffers. We're not quite there at the moment. But I think that's the bold thing that should be done, and we're strong supporters of doing it.
But when banks look at what their effective situation is, they tell us that they never get to that amount because of all of those add-ins and overlays that actually occur. And so whilst I understand the aspiration to simplify and have a single buffer, if you like, the reality is that because of their hesitancy around the implications of not doing this in the right way, they don't, and the net effect is they end up holding more than they feel they ought to. And that is a persistent narrative that they bring to us, and members of this committee have had that drummed into them at private meetings recently.
So I mean, you present a very smooth and clear version of where you'd like to go, but the bottom line is operationally it isn't working like that right now.
Can I just, let's take that, let's sort of pick that argument apart for a moment. Why do they say that? Well, there are at least three reasons I can think of. One we've already covered, which is that they maintain so-called management buffers above what we require. That is their choice. But I recognize there are things that we can do to simplify the structure which might assist them to maintain smaller management buffers. I think they'll always have them, but they will have smaller ones. Randy touched on this. And I think what we've done is steps in that direction, but as I was just saying, I think the big step in that direction would be to move to the single buffer if we can get international agreement. That's the first thing. The second thing is, look, capital requirements will differ from bank to bank partly because of the business they do and partly, I'm afraid, sometimes because they fail to demonstrate to us the characteristics of running the business that we expect. So we do sometimes put add-ons in. This is in the PRA's world more than...
Can you give an example of that? Well, yeah. If they show they can't manage risk adequately, our supervisors can put on.
That is an active yes, that happens.
Right. Okay. We should go back to the banks. And yes.
And okay.
Yeah. That's us doing our job.
Look forward to having them.
Mr. Benjamin's nodding. I wonder if Mr. Crossner, who's been...
Get your act together.
Good risk management. If they're not doing good risk management, they're not acting appropriately.
Absolutely. I mean, they can also get higher capital requirements back by bank because, for instance, they have greater concentrations of risk in particular activities. That's again a reflection of the risk they're taking. So that's the second point. Then the third point is sort of the fundamental one. I think many of them still think that 13 is too high. Now I want to come back to points I made actually early on to the chair's question. We will have a strong banking system and they will earn strong returns if they are well capitalized. They are lending into a strong economy and they are earning the returns. Now I think the evidence is that they are in a strong position. I mean, there were a lot of complaints frankly about how much they're earning. Yeah.
I've said, look, they have to earn their cost of capital.
They are doing that, actually doing somewhat more than that. That's a sign of their resilience. So the capital system does support their resilience. They don't like, I mean, they will never say that to you. I'm afraid the odds of us getting them ever to say that, yeah, no, it's not going to happen. But it is a fact. They are supported by that. If they have weak capital, they will not be supported in that sense. But what it feels like to them is that there'll be a move forward in one area and then, for example, Sam Woods did not include the exclusion of unencumbered gilts when looking at the leverage ratio denominator.
But that's not in Basel. No, Basel does not. Nobody does that. The US doesn't do that. I mean, excluding gilts from the leverage ratio, I know they'd like it, but frankly, that's not in Basel. It would be contrary to Basel. Nobody does that.
Thank you very much, Mr.
Did Mr. Crossner, did you want to come in? You look like you were.
So, I think this is one of the reasons why we have stress tests, to make sure that they do have appropriate risk management.
And most banks do pass those stress tests now. So it's not that we're setting a barrier or a hurdle that is so high that it's unattainable, that no one can get an A in the class. Now, most of the banks are getting an A in that. So they know how to achieve that, and I think it's completely appropriate that if they are taking undue risks then they should have add-ons. If they have processes in place and sufficient capital and appropriate risk management, then they are free from that.
But the fact that major UK institutions have an effective requirement closer to 14.25% rather than 13% in reality is really just a function of them not operationalizing risk management appropriately.
Well, it will come down when Basel 3.1, I mean part of this is that Basel 3.1...
Because when we went, there's work in progress. When we went from 14, look, when we went from 14 to 13, we were actually marrying up top-down and bottom-up. The FPC does top-down, PA does bottom-up. The bottom-up element is coming down consistent with 14 to 13, and a good part of that is parcel 3.1, and that's why the FPC felt it was sensible to match the top-down.
Could I ask you, Mr. Crossner, about this? What the banks tell us about the apparent gap with the US that the governor pushed back on. I mean, what some of them have said to us is that UK banks now face a 190 basis point capital premium compared to their US competitors. Now you can dispute the quantum of that, but do you recognize anything like that or any meaningful difference between the US and the UK?
Many different ways to calculate those sorts of comparisons.
Yeah. And that's how you sort of get out of jail on this subject.
Yes, yes. And one of the challenges also is that accounting is very different for what are considered bank assets, and so that becomes a challenge to do international comparisons. I think we've been trying to undertake a review, and obviously what we put into our reports is looking at international comparisons. The UK is a major global financial center and it has to be competitive, and I think we very much take that into account. I'm very cognizant of that and bring that into the discussions. But then when we get into the specifics of where there's 190 basis points or minus 10 basis points, that becomes much more of an art than a science.
Do you think we'll ever get to a point where it will be apples and apples and you can make a reasonable comparison, and we'll stop receiving all these representations from the banks? Might be worth, I mean, that may want to come in because we published obviously in December a detailed comparison, I think the most detailed comparison.
You've looked at the feedback that we've had, which is where they make these points to us.
Yes, right. And there has been a range of feedback coming from different sides. So I think the fact is that with the package we have now set out, this brings in line UK capital requirements with requirements in other jurisdictions in a way that is consistent with the analysis that we did and consistent with the feedback we received on this point. I think the other point to note is, often US banks – I used to supervise US banks – US banks also hold an internal management buffer above their regulatory requirement, actually much more than some of the UK banks, and yet that doesn't have a detriment to their earnings or their profitability.
Just very briefly, we also hear this in the US, the international comparisons. The US banks always feel that they are being unfairly gold-plated, so I think it's a natural thing for domestic banks to go to their domestic regulator and say, 'Look at the others, they get away with this, we don't get away with it.' So I think you would hear a very similar thing if you were sitting in the US Congress.
Sounds like managing teenagers, but that's a bit flipped.
Sorry, yes. I can do that. Let's ask one more question around the net effect of this in terms of to the banks and the bank shareholders or to the economy as a whole. The narrative that they bring to us is that if they can actually get access to more money to lend to grow the economy, yet we see banks doing quite well in these circumstances. Do you have any views on how we should review the performance of banks financially and the impact on the economy and what they do with the freedom they've got?
Well, let me come back to what I said at the beginning. I do push back at this, what I sometimes call a 'lump of capital' argument, which is this idea that they've got a fixed amount of capital and if only we'd lighten the regulatory regimes they could lend more out, support the economy, and everything would be good. Because there isn't a lump of capital. The fact is they earn their earnings, they then have a decision to take about how much of their earnings they distribute to their shareholders and how much they retain to grow the business. That's a process they have to go through with their shareholders. Now, I recognize we went through a period up until about two or three years ago after the financial crisis where they were not earning their cost of capital, and it was very hard to go to the shareholders and say, 'You should leave this money in the business because it's a good thing,' because the shareholders would say, 'No, it's not a good thing because you're not earning the cost of capital. I can take it somewhere else.' But that's not true anymore. They are more than earning their cost of capital, and the best illustration of that is the price-to-book ratios. They're now on average about 1.7, whereas they were below one. So one is the point where they're at cost of capital. So they're in that position. They are resilient. That's why, as we talked about stress tests, they pass stress tests.
They can make choices now, and the choice they can make is to support lending into the economy with those earnings, and that's what to my mind they should be doing. A resilient system will support that and it will support the economy.
I'm just going to... Mr. Supply that wants to come in, and we do need to wrap this section up because we could spend forever discussing capital the bank, and I'll bring in Mr. ...
Thank you. I just wanted to bring attention to that we've published the feedback from a very broad consultation about this matter, not only from banks but from academics, rating agencies, bank analysts, and bank investors. I think that is a very rich picture, and it's clear that banks, all things being equal, prefer to have less capital and less requirements. I mean, any investor or risk taker would like that. And what we heard from academics and bank analysts in particular is their arguments that the capital should be higher and bringing it down is not the right thing to do. So I think this is a quite balanced argument. From rating agencies and bank investors, they say, 'Well, we look carefully at the capital people are holding, and we want to make sure that's appropriate in order to invest in these banks.' I don't think their view is that the capital levels should be going down.
That's very helpful. Um, Chris Coin, one brief.
Sure. Govnor sounds slightly skeptical about the banks' position on this. Of course, prior to 2008, banks were making exactly the same argument that you need to just deregulate, lower capital requirements, all will be fine, economy will go gangbusters in the process of the global economy. To what extent does that history inform your thinking now?
Well, it does a lot actually. I'm realistic enough to know that memories of the financial crisis are now disappearing into rearview mirrors. Some of us probably all of us have undying memories of having had to deal with it. But they are disappearing, and so you have seen this in history before; you get these cycles. I think we are seeing this where people are now saying the response to the financial crisis was too great and too strong. It didn't feel like that at the time, I have to tell you, when we were dealing with a system that was extremely weak and having to rebuild it. I get people saying, 'You've solved that problem, you should move on.' And you say, 'Yes, in the sense that the system is now resilient, it's rebuilt.' But the idea that we therefore relax the standards because it's all over – no, that's not the way it works. So, yeah, I'm philosophical. This is a debate we have. I come back to this point: I'm not going to defend all our rules as perfect. They're not. But the central point is we will not have a strong economy without financial stability.
Thank you very much indeed. I'm actually going to move on because we could go on forever discussing this, but we do have other topics. On the subject of AI, which we parked at the beginning. Governor, I'm going to bring in Bobby Dean.
Thank you, Chair. Yeah, Governor, I'd like to return to something you made a point of highlighting in your opening remarks, which is about the sort of heightened risks around frontier AI. I think critics will say I told you so when the discussion started talking about AI a few years ago and it was kind of leveled down as another risk to manage, and now you're saying that it's grown much faster than you anticipated. So, what is it that you didn't foresee previously?
Well, it's not just us. If you talk to the people who run Anthropic, OpenAI, they will tell you that the advance they've seen in these models in the course of the last months has been much faster than they expected. They draw these exponential curves, and they're saying we've now moved into the vertical part of the exponential curve in terms of the advances of these models. So they too were taken by surprise. If you take Opus, which was the Anthropic model that really kicked this off back in April, I've talked to Dario Amodei about this; they were surprised by the advances this model made. The reason is that these models actually do a self-learning, recursive learning process. So the speed and effectiveness and ability of these models has moved dramatically forward. When they're subjected to the sort of tests that the AI Security Institute in the UK – which is absolutely world-leading on this subject – subjects them to, they say how effectively and how quickly are these models solving and developing... I think we can all accept that the reality has moved on much more quickly.
I think we can all accept that the reality has moved on much more quickly. But we obviously had an inquiry into AI in financial services, and I feel that we heard evidence about the potential advances in AI and how they felt that the financial service sector was perhaps underprepared for the potential movements. The fact that this happened more quickly than anticipated is one thing. But one of the things we heard from lots of regulators at the time was that actually our existing risk frameworks are fine, we can be technology agnostic. Do you still hold that?
Well, I think there are two things here that need to be kept separate. On frontier, we're talking about cyber very specifically. To use a sports analogy, frontier AI will strengthen the defense and the offense. So if the defense, if you're the banks, firms, you can put frontier AI to work to strengthen it because it will find flaws that have been buried for a long time and you can fix them. Unfortunately, if the offense gets hold of it, they will do the same thing to attack you. The whole thing at the moment is, can we make sure that the defense gets strengthened effectively before the offense? That's getting much more challenging. The second thing, which I think you're referring to, is equally important: how banks use AI. We're not talking about cyber here; we're talking about how they use it and the risks that come with that. Your report was very helpful and very good in this respect. We are actively engaged on that subject. I think banks are using AI a lot more. Where I think it's still more talk than actuality is things like agentic trading systems, setting up your own agents. I think that's right because there are some very big questions still to be answered about how that world would work. For instance, I'm not a lawyer, but what strikes me is if you have an agentic trader system as a bank, and going back to frontier AI, what frontier AI demonstrates is that the recursive learning capacity of these systems means they develop their own abilities. As my colleague Sarah Breeden has said, they learn to cheat and they learn to lie. I'm sad to say, where do they learn that from? It's partly inherent in them and partly because they're trained on vast amounts of past experiences and they cover things up. If you've established an agent, you've got to be very clear where the legal liability rests in all of this. There are things that will need to be resolved before that world really develops.
Mr. Pedro, if I could turn to you, and we might want to continue with the governor's World Cup analogy about attack versus defense. What are firms' current access to these frontier models? Presumably they're on the defensive side of this equation. So how is their defense?
The financial sector generally has been putting a lot of focus on these things. What is happening at the moment is firms are in the process of testing those types of capabilities on their own systems. The big risk that comes with frontier AI development is the speed at which weaknesses in IT estates can be identified and what that means for patching and the speed at which software upgrades need to be made. That is the work that is happening. Andrew mentioned earlier things that give the edge to attackers versus things that give the edge to defenders. One of the key aspects is the speed at which those capabilities become accessible to attackers. They are typically accessible before to the defenders, so this buys them time to identify weaknesses and vulnerabilities and to prepare for much faster patching. Another risk is that the moments when software are upgraded are also the moments where there is greater risk of disruption internally, not because of an attack but because of the effect of the upgrade itself. This is the work happening within banks and large firms to get them prepared for this new state of the world. We've been talking about risks in the abstract. Could you describe to us what the impact would be if the attack got there first to a standard financial firm institution?
Two ways cyber tends to manifest itself. One is those who want to disrupt systems and then often there's blackmail effectively, and the other is stealing information. Those are the two things that can go on. As Nat was saying, what is being found is that flaws that have existed in very core pieces of software in the world – finance systems are just a subset – have often been there for a very long time and can be discovered by these systems quite quickly. I think the people who know much more about this than I do, at the moment, going back to the football analogy, it requires a lot for an offensive party to set this up. It's not, you don't go home and get Metasploit, plug it in, and off you go. It's rather more than that. But this is the second issue we've got. As I said, we're now on this vertical exponential curve, they say. These models have a shelf life of only about two or three months now, and then they're replaced by something even more powerful. If you talk to the developing firms, they say there are going to be open-source versions coming online which will make it much harder to restrict access. Let's be honest, other regimes are developing their own, and China is the big case there. They may be some months behind, but they're not that far behind.
I bring in Mr. John Grady, just one.
Briefly, Governor, you mentioned legal responsibility for agentic models. I'm a recovering lawyer. If a bank uses an agentic model and it starts cheating and lying as you describe, do you think we are clear about who is responsible?
I'm not a lawyer, so let me... I think we are certainly doing this to get the views of the legal world on this. But here's my understanding. Let's go back to basic principal-agent law. If I'm the principal and you're the agent, I give you a remit to act on my behalf. I am liable for what you do when you dispense my remit. If you go outside my remit and start doing other things, you're liable. That works when you and I are both legal persons; we can be held legally liable. But with an agentic AI model, it's not a legal person. Now, I think normally in that case, if the agent does something outside the remit, the principal is liable where the agent is not a persona. But I don't think this has been tested much in the AI world. If that is the case, then banks are going to have to think very carefully about how they manage the use of agentic AI, because if they're going to be responsible for everything it does and if there's the issue that it can go off-piste, then they've got to think that through before they start using this stuff.
And I think it'll be useful once you... limit my knowledge, I have to be honest with you... to come back to us in writing on that important point.
Yeah, of course. There are the third parties that are involved as well, the AI companies and some of the major tech companies. If we move on to a slightly separate point, which is the critical third parties regime, I think you said four will be brought into the regime now. A concern that has been raised is how much oversight you're actually able to have over these firms when they are quite opaque about the technologies that they hold. Mr. Benjamin, I don't know if in your capacity, what is your relationship with these providers and how much do you get to look inside their black boxes to understand what the real risks are?
The regime is coming in place now, and our colleagues on the PRA will be the ones supervising them. So that is going to begin, and we needed the regime to be in place first before coming into that.
Are there general concerns about working with these providers and how much information they're willing to share about their systems to be able to understand them?
No, if you're referencing the four that have been nominated, I wouldn't say there are concerns at all. We've had relationships with them, we've had discussions with them for broader reasons in the past, and they're very open to those types of discussions. So I'm not worried about that.
I guess my point is more about regulatory capacity. I'm sure they're going to appear to be very open and willing to cooperate. But does the bank have the staff, the knowledge, the know-how to properly hold all their systems to account?
We have our colleagues in the PRA have entire divisions of people who are specialists in operational resilience and who are well-versed in these technical topics.
Okay, I'm going to move on to a slightly different threat that's still related to AI, and perhaps Mr. BL you can speak to us about this, which is growing concerns about the threat of an AI bubble and the impacts that that could have. The easy comparison is that of the dot-com bubble. Are the risks similar or worse?
It's a good comparison in terms of the level of concentration and heightened valuations, especially in equity markets. There are a number of elements here. First, the continued growth in equity valuations, especially in AI stocks, has been coincident with very strong earnings. But the current valuations are predicated on a very optimistic future earnings path. So it's not clear that it's necessarily a bubble, but it is in our estimation based on a quite optimistic path going forward. If earnings don't materialize along the optimistic path, then there could be a significant repricing of AI equities. On that point, could I put to you: I think it was JP Morgan's report where they said something like $650 billion worth of revenue per year would be needed to get a reasonable return. And they also remarked on some of the physical limitations in ever achieving that kind of revenue because of water supply, data centers, and other physical infrastructure. Is that something you recognize? Do you think that actually as things stand, the returns required are physically impossible to get at?
I wouldn't say they're physically impossible, but we're very cognizant of the risks: power, cooling, planning, actually getting approval to build data centers. All these things are risks to a positive earnings story. From a financial stability question, there are two elements that are particularly concerning. One is that funding for a lot of AI expansion is now going in debt form rather than equity form or from cash flow. The growth in debt in 2026 has been extreme, and if there's a popping of the bubble, debt can have a lot more impactful downside. The second is that there is a lot more leverage on the long side in AI equities, both institutional and retail. Institutionally, levered funds and hedge funds have been taking long positions in AI equities funded by derivatives or prime brokerage. On the retail side, a lot of levered ETFs. If there's a fall in equity prices, that can lead to a negative spiral. From a financial stability point of view, market volatility is not per se a stability concern, but when it can be amplified rather than contained, it does become one. Those risks are growing on the AI side.
And that change towards heightened leverage positions has happened very quickly over the last year. We got information about Alphabet's position, for example. Does that make you feel that a potential bubble burst is much closer than it was this time last year?
