On Tuesday 26 June 2012, Sir Mervyn King, Governor of the Bank of England, Spencer Dale, Chief Economist, Bank of England, Professor David Miles, Monetary Policy Committee Member, Bank of England, and Dr Ben Broadbent, Monetary Policy Committee Member, Bank of England, gave evidence to the Treasury Select Committee on the Bank of England's May Quarterly Inflation Report, their assessment of the state of the UK economy.

In light of continuing disappointing figures on bank lending to small businesses, and following recent initiatives announced by the Governor and the Chancellor to increase liquidity support for the commercial banks to enable them to lend, David Ruffley MP questioned the Governor on the Bank's efforts to get the funds flowing. The transcript of David's exchange with Sir Mervyn King is below.

Q80 Mr Ruffley: The first ECTR auction was fully allotted at the minimum spread, so there is obviously an appetite for what you are offering. Have you had any discussions with the FSA about relaxing its liquidity requirements to banks?

Sir Mervyn King: Yes, we have had discussions.

Q81 Mr Ruffley: Could you say something about that?

Sir Mervyn King: I would rather not, because the Financial Policy Committee, in whose area this falls-I think I am the only person here today who is on the Financial Policy Committee-is in purdah, and we publish our financial stability review on Friday. No doubt the FSA will at some point have something to say. The regulation is very much for it rather than us. I have made the general comments that I wanted to make, and I think it is now for the FSA to make their comments in turn.

Q82 Mr Ruffley: You are chairman of the MPC and the FPC, so you must be able to give us a bit more detail on the relaxing of liquidity requirements. It has an obvious impact on the decisions made-

Sir Mervyn King: It does. I will make one general comment, which is linked to what I said in the Mansion House speech, but anything else, I am afraid, will have to wait until Friday, when the FSR is published, because we are in purdah as an FPC, and it is in that capacity that I am speaking. The general comment I make is that the potential regulation, which is proposed to be introduced at international level, and which the FSA has anticipated somewhat-and produced very sensible results, as many of our banks have greater amounts of liquidity than they would have done had the FSA not taken its measures-does not adequately, in my view, take into account the way in which central banks provide liquidity in stressed times. One thing we have to do at international level-and in my capacity as chairman of the Central Bank Governors and Heads of Supervision, when we meet in Basel, I will be discussing this-is determine whether we can modify the regulations and rules that we have been discussing so that we can better take into account the way in which central banks provide liquidity. That is what we will be doing. I can assure you that a great deal of thought is going into this in terms of redesigning the framework, and there is a great deal of concern about an inadvertent application of over-tight regulation in present circumstances.

Q83 Mr Ruffley: Can I just ask, pursuant to John Thurso's line of inquiry, the question that is asked in pubs up and down the country: is there going to be more net lending to households and small business? We know from your own lending survey stats that Project Merlin saw a decline in that lending during the course of its operation. Obviously, the funding for lending scheme is going to try to do better to expand loan books. Could you just have another go, following Mr Dale's answer to this, on why you think there will be an expansion in loan books as a result of funding for lending?

Sir Mervyn King: I do not know whether there will be or not. I can give no guarantees. That will depend on what happens in the world economy and the impact of that on the UK. What I can say is this: the principle behind the scheme, as Spencer Dale pointed out, was to give a significant financial incentive to banks to consider expanding their lending to the real economy. I have always felt that if you want to encourage bankers to change their behaviour, what is better than having a discussion is probably to give them a financial incentive, and that is what the scheme will do. I hope you will have a little bit more patience before we publish the full details. When they are published, I think you will see that it is a real incentive, but we do need to go to the European Commission before we go public to have our discussions with it so that we can ensure that none of this falls foul of state aid rules.

Q84 Mr Ruffley: We await the detail, but can I just take you back to an answer you gave on 29 February when you came to see us on this point and the question of how we can encourage commercial banks to lend to small business over and above what they are willing to lend currently? You said, 'It is either direction, in terms of the banks that the taxpayer owns, or it is an incentive to do something that the banks would not otherwise do. In other words, a subsidy, and questions of subsidy have to be matters for Government.' By 'subsidy', are you talking in the sense of cheap borrowing, or in some other sense of the Treasury covering or underwriting any losses that commercial banks suffer as a result of more risky lending?

Sir Mervyn King: It is in the former sense; the sense that we would be lending-

Mr Ruffley: Cheaper borrowing.

Sir Mervyn King: It is not just that the rate that we would charge would be lower; it is that we would be lending for several years. That is not something that a central bank would normally do, and we would never have produced this scheme had it not been for the circumstances in which the UK currently finds itself. We would not do it without the strong agreement and approval of the Government. The Government have to make clear that this is something that the central bank is authorised to do.

Q85 Mr Ruffley: What do you say to senior bankers who make the obvious point-I just want to check that it is obvious and that this is your understanding-that both the Bank and the Treasury want the risk of any new lending that they might wish to undertake with this cheaper borrowing that you are providing to lie fairly and squarely still with the commercial bank?

Sir Mervyn King: That is certainly part of the scheme and I think that is the right thing to do. All I would point out is that when there were discussions prior to the introduction of the national loan guarantee scheme, one of the ideas that was floated was that there would be a sharing of the returns, and hence the risk, on loans to small businesses, but it would have to apply to all loans. The banks showed no interest in that because, in their words, they wanted to keep the best loans to themselves. That is the other side of the coin to the adverse selection problem. What you cannot do, and you would be foolish to do, is to agree to share the risk of those loans that banks decide they would like to share the risk with you on, rather than-

Mr Ruffley: Yes. You start getting worried if they-

Sir Mervyn King: It seems to me that the banks made their choice when it came to the national loan guarantee scheme, when they said they were not prepared to share the risk because there were many loans that they thought were good loans-that was why they were making them-and they wanted to hang on to the returns on that. That is fine, but what we can do is to provide a guaranteed source of funding for several years-closer to the average maturity of the loans that they are making. This is not liquidity support, but it is funding support for a longer period at terms that will be attractive, and the reason why it should be attractive is that both the amount that the banks will obtain from the scheme and the price that they will pay for the money they borrow will be a direct function of the rate at which they are expanding lending to the real economy. I think that is an innovative scheme and it gives the banks a very strong incentive to consider, at least, expanding lending to the real economy.

Q86 Mr Ruffley: Before you made this announcement in the Mansion House speech, did you have a trot around the block with commercial bank senior executives about trying to share the risk with them?

Sir Mervyn King: No, because they made it clear in earlier discussions that they were not prepared to share risk, except on the terms that they would choose, which were the loans that we would share the risk on. That is not the kind of deal that I find myself attracted to.

Q87 Mr Ruffley: I understand it was on the national loan guarantee scheme when you first heard that response from them. Has there been any other attempt that you are aware of, either by the Bank or, so far as you are aware, on behalf of the Treasury? The reason I ask is that a lot of senior bankers say informally that unless there is some sharing of risk, they are going to find it difficult to make a turn, and they actually be looking at loan applications that they have up until now decided to decline because they were too risky.

Sir Mervyn King: It is a question of the cost they pay. If we are making a significant difference to the cost of funding those loans, and the proposal would indeed make a significant difference, it ought to lead them to decide that loans that they thought were previously marginal are the ones that they would now find attractive. I am in no doubt that the scheme ought to provide a real financial incentive for banks to expand their link to the real economy. What happens in the end, of course, is a result of the macro-economic outcome, not just for the UK but for the world economy, and that I cannot predict. We will be putting in place a scheme-when you see the details, I hope you will agree-that does provide a genuine financial incentive.