House of Commons
Treasury Committee
The run on the Rock
Fifth Report of Session 2007–08
Volume II
Oral and written evidence
Ordered by The House of Commons
to be printed 24 January 2008
HC 56–II
[Incorporating HC 999 i–iv, Session 2006-07]
Published on 1 February 2008
by authority of the House of Commons
London: The Stationery Office Limited
£25.50
The Treasury Committee
The Treasury Committee is appointed by the House of Commons to examine the
expenditure, administration, and policy of HM Treasury, HM Revenue & Customs
and associated public bodies.
Current membership
Rt Hon John McFall MP (Labour, West Dunbartonshire) (Chairman)
Nick Ainger MP (Labour, Carmarthen West & South Pembrokeshire)
Mr Graham Brady MP (Conservative, Altrincham and Sale West)
Mr Colin Breed MP (Liberal Democrat, South East Cornwall)
Jim Cousins MP (Labour, Newcastle upon Tyne Central)
Mr Philip Dunne MP (Conservative, Ludlow)
Mr Michael Fallon MP (Conservative, Sevenoaks) (Chairman, Sub-Committee)
Ms Sally Keeble MP (Labour, Northampton North)
Mr Andrew Love MP (Labour, Edmonton)
Mr George Mudie MP (Labour, Leeds East)
Mr Siôn Simon MP, (Labour, Birmingham, Erdington)
John Thurso MP (Liberal Democrat, Caithness, Sutherland and Easter Ross)
Mr Mark Todd MP (Labour, South Derbyshire)
Peter Viggers MP (Conservative, Gosport).
Powers
The Committee is one of the departmental select committees, the powers of
which are set out in House of Commons Standing Orders, principally in SO No.
152. These are available on the Internet via www.parliament.uk.
Publications
The Reports and evidence of the Committee are published by The Stationery
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notices) are on the Internet at www.parliament.uk/treascom.
A list of Reports of the Committee in the current Parliament is at the back of this
volume.
Committee staff
The current staff of the Committee are Colin Lee (Clerk), Sîan Jones (Second
Clerk and Clerk of the Sub-Committee), Adam Wales, Jon Young and Jay Sheth
(Committee Specialists), Lis McCracken (Committee Assistant), Caroline McElwee
(Secretary), Tes Stranger (Senior Office Clerk) and Laura Humble (Media Officer).
Contacts
All correspondence should be addressed to the Clerks of the Treasury
Committee, House of Commons, 7 Millbank, London SW1P 3JA. The telephone
number for general enquiries is 020 7219 5769; the Committee’s email address is
[email protected].
Witnesses
Thursday 20 September 2007
Page
Mr Mervyn King, Governor of the Bank of England, Sir John Gieve, Deputy
Governor responsible for Financial Stability, Mr Paul Tucker, Executive Director for
Markets, Ms Kate Barker, External Member of the Monetary Policy Committee,
and Dr Andrew Sentance, External Member of the Monetary Policy Committee,
Bank of England
Ev 1
Tuesday 9 October 2007
Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial
Services Authority
Ev 21
Tuesday 16 October 2007
Dr Matt Ridley, Chairman, Mr Adam Applegarth, Chief Executive, Sir Ian
Gibson, Senior Non-Executive Director, and Sir Derek Wanless, Non-Executive
Director, Northern Rock
Ev 47
Thursday 25 October 2007
Rt Hon Alistair Darling, MP. Chancellor of the Exchequer, Mr Nicholas
Macpherson, Permanent Secretary to the Treasury, Mr Mark Neale, Managing
Director, Budget, Tax and Welfare, Mr Richard Hughes, Team Leader,
Comprehensive Spending Review, and Mr Clive Maxwell, Director, Financial
Services, HM Treasury
Ev 78
Tuesday 13 November 2007
Professor Willem Buiter, London School of Economics; and Professor Geoffrey
Wood, CASS Business School, City University
Mr Paul Taylor, Group Managing Director and Global Head of Sovereign, Public
Finance, Corporate and Financial Institution Ratings, and Mr Charles Prescott,
Group Managing Director, Financial Institutions, Fitch, Mr Michel Madelain,
Executive Vice President, and Mr Frédéric Drevon, Senior Managing Director,
Moody’s, and Mr Ian Bell, Managing Director and Head of European Structured
Finance, and Mr Barry Hancock, Managing Director and Head of European
Corporate and Government Services, Standard and Poor’s
Ev 93
Ev 105
6
The run on the Rock
Tuesday 4 December 2007
Mr E Gerald Corrigan, Managing Director and co-Chair of the Firmwide Risk
Management Committee, Goldman Sachs, Lord Charles Aldington, Chairman,
Deutsche Bank, London Branch, Mr Jeremy Palmer, Chairman and Chief
Executive, Europe, Middle East and Africa, UBS, and Mr William Mills, Chairman
and Chief Executive of City Markets and Banking, Europe, Middle East and Africa,
Citigroup
Ev 123
Mr Richard Sexton, UK Head of Assurance, and Mr John Hitchins, UK Banking
and Capital Markets Leader, PricewaterhouseCoopers
Ev 135
Mr Chris Hitchin, Chairman, National Association of Pension Funds and Executive
Chairman, Railways Pension Trustees Company, Mr Peter Montagnon, Director of
Investment Affairs, Association of British Insurers, Mr Guy Sears, Director,
Wholesale, Investment Management Association, and Mr David Pitt-Watson,
Chairman, Hermes Equity Ownership Service
Ev 144
Tuesday 11 December 2007
Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial
Services Authority, and Ms Loretta Minghella, Chief Executive, Financial Services
Compensation Scheme
Ev 153
Tuesday 18 December 2007
Ms Angela Knight CBE, Chief Executive, British Bankers' Association, and Mr
Adrian Coles, Director General, Building Societies Association
Ev 169
Mr Mervyn King, Governor, and Sir John Gieve, Deputy Governor responsible
for Financial Stability, Bank of England
Ev 177
Thursday 10 January 2008
Rt Hon Alistair Darling MP, Chancellor of the Exchequer, Mr John Kingman,
Second Permanent Secretary, and Mr Clive Maxwell, Director, Financial Services,
HM Treasury
Ev 197
List of written evidence
1
Bank of England, Letter from the Governor
Ev 214
Memorandum
Ev 214
Follow-up to evidence session on 18 December 2007
Ev 217
2
Tripartite Authorities
Ev 217
3
Financial Services Consumer Panel
Ev 219
4
Financial Services Authority
Ev 220
Follow-up to evidence session 9 October 2007
Ev 223
Follow-up to evidence session 11 December 2007
Ev 223
Letter from the Chairman of the FSA
Ev 227
5
Financial Services Authority and Financial Services Compensation Scheme
Ev 227
6
Northern Rock, follow-up to evidence session on 16 October 2007
Ev 231
7
HM Treasury, letter from the Chancellor
Letter from Chairman of Northern Rock
Ev 240
Ev 240
Follow-up to evidence session on 25 October 2007
Ev 242
Letter from the Chancellor
Ev 243
8
Julian D. A. Wiseman
Ev 244
9
London Investment Banking Association
Ev 247
10
Dr Paul Hamalainen, Loughborough University
Ev 253
11
The Alternative Investment Management Association Limited
Ev 257
12
Fitch Ratings
Ev 258
Follow-up to evidence session on 13 November 2007
Ev 264
13
The Association of British Insurers
Ev 266
14
Institutional Money Market Funds Association
Ev 269
15
Standard & Poor's
Follow-up to evidence session on 13 November 2007
16
Moody's
Follow-up to evidence session on 13 November 2007
Ev 272
Ev 276
Ev 280
Ev 285
17
Investment Management Association
Ev 288
18
British Bankers' Association
Ev 294
19
The Building Societies Association
Ev 303
20
Council of Mortgage Lenders
Ev 308
21
Professor Willem Buiter, London School of Economics and Political Science
Ev 310
22
National Association of Pension Funds (NAPF)
Ev 330
23
E Gerald Corrigan, Goldman Sachs International
Ev 332
24
David Pitt-Watson, Hermes Equity Ownership Service
Ev 335
25
PriceWaterhouseCoopers, follow-up to evidence session on 4 December 2007 Ev 336
8
The run on the Rock
List of Reports from the Treasury Committee during the current Parliament
Report
Session 2007–08
First Report
The 2007 Comprehensive Spending Review
HC 55
Second Report
The 2007 Pre-Budget Report
HC 54
Third Report
The Work of the Committee in 2007
HC 230
Report
Session 2006–07
First Report
Financial inclusion: the roles of the Government and the FSA,
and financial capability
HC 53
Second Report
The 2006 Pre-Budget Report
HC 115
Third Report
Work of the Committee in 2005–06
HC 191
Fourth Report
Are you covered? Travel insurance and its regulation
HC 50
Fifth Report
The 2007 Budget
HC 389
Sixth Report
The 2007 Comprehensive Spending Review: prospects and
processes
HC 279
Seventh Report
The Monetary Policy of the Bank of England: re-appointment
hearing for Ms Kate Barker and Mr Charlie Bean
HC 569
Eighth Report
Progress on the efficiency programme in the Chancellor’s
department
HC 483
Ninth Report
Appointment of the Chair of the Statistics Board
HC 934
Tenth Report
Private equity
HC 567
Eleventh Report
Unclaimed assets within the financial system
HC 533
Twelfth Report
The Monetary Policy Committee of the Bank of England: ten
years on
HC 299
Thirteenth Report
Financial inclusion follow-up: saving for all and shorter term
saving products
HC 504
Fourteenth Report
Globalisation: prospects and policy responses
HC 90
Report
Session 2005–06
First Report
The Monetary Policy Committee of the Bank of England:
appointment hearings
HC 525
Second Report
The 2005 Pre-Budget Report
HC 739
Third Report
The Monetary Policy Committee of the Bank of England:
appointment hearing for Sir John Gieve
HC 861
Fourth Report
The 2006 Budget
HC 994
Fifth Report
The design of a National Pension Savings Scheme and the role of HC 1074
financial services regulation
Sixth Report
The administration of tax credits
HC 811
Seventh Report
European financial services regulation
HC 778
Eighth Report
Bank of England Monetary Policy Committee: appointment
hearing for Professor David Blanchflower
HC 1121
Ninth Report
Globalisation: the role of the IMF
HC 875
Tenth Report
Independence for statistics
HC 1111
Eleventh Report
The Monetary Policy Committee of the Bank of England:
appointment hearings for Professor Tim Besley and Dr Andrew
Sentance
HC 1595
Twelfth Report
Financial inclusion: credit, savings, advice and insurance
HC 848
Thirteenth Report
“Banking the unbanked”: banking services, the Post Office Card
Account, and financial inclusion
HC 1717
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Treasury Committee: Evidence Ev 1
Oral evidence
Taken before the Treasury Committee
on Thursday 20 September 2007
Members present
John McFall, in the Chair
Mr Graham Brady
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr George Mudie
Mr Mark Todd
Peter Viggers
Witnesses: Mr Mervyn King, Governor of the Bank of England, Sir John Gieve, Deputy Governor
Responsible for Financial Stability, Mr Paul Tucker, Executive Director for Markets, Ms Kate Barker,
External Member of the Monetary Policy Committee, and Dr Andrew Sentance, External Member of the
Monetary Policy Committee, Bank of England, gave evidence.
Q1 Chairman: Governor, good morning to you and
your colleagues and welcome. Can you introduce
your colleagues for the shorthand writer, please?
Mr King: On my immediate right is Sir John Gieve,
Deputy Governor for Financial Stability. On his
right is Kate Barker, one of our External Members
on the Monetary Policy Committee. On my
immediate left is Paul Tucker, the Markets Director
at the Bank, and on his left is Andrew Sentance,
another of our External Members.
Q2 Chairman: Governor, you will recollect that the
idea for the meeting arose from your suggestion that
we consider the August Inflation Report. Obviously
this meeting has been given added relevance by
recent developments so in that context we are
grateful for the paper you sent me last Wednesday 12
September.1 In that letter you told us that providing
extra liquidity at longer maturities—in your
words—undermines the eYcient pricing of risk by
providing ex post insurance for risky behaviour and
that you would conduct such operations only if there
were strong grounds for believing that the absence of
ex post insurance would lead to economic costs on a
scale suYcient to ignore the moral hazard in the
future”. However, yesterday you conducted such
operations. What has changed in the past seven
days?
Mr King: I think the events of last weekend and the
impact on the confidence that people have in the
banking system generally could have been shaken by
the scenes that were seen on television. I do not think
there is any fundamental reason to doubt that
confidence but, as I said in the statement I sent to
you, the balance of judgment between how far you
extend liquidity against a wider range of collateral
on the one hand and being concerned to limit the
moral hazard on the other, to limit the ex post
insurance, is a judgment that we are making almost
daily in the febrile circumstances of the time. The
operation announced yesterday was carefully
designed and judged. It does not give ex post
1
Ev 214
insurance, it is limited in size, it is limited in amount
to each individual bank, and that provides a strict
limit on the extent to which there is some ex post
insurance, so we have balanced the concerns about
moral hazard against the concerns that arose at the
beginning of this week about the strains on the
banking system more generally.
Q3 Chairman: Your critics would say, Governor,
that if you had undertaken the same steps as the
ECB and the Fed then we would not have had the
Northern Rock problem?
Mr King: Could I set out my explanation for why I
do not think that is an argument that I accept. After
the events in August, which essentially closed the
markets in asset-backed securities, Northern Rock
was then a company with a highly illiquid set of
assets. Its assets comprised essentially mortgagebacked securities and plain mortgages which have
not yet been securitised. The markets in those assets
were closed. Northern Rock tried to sell some of
those assets, not just to the UK banking system but
overseas as well, without a great deal of success. The
real problem facing Northern Rock has been that
the assets side of its balance sheet suddenly became
highly illiquid, and one has to ask the question who
would have lent to, or who would have bought the
assets, from Northern Rock? Well, they tried and
did not find any buyers. At that point I think it was
clear that, in one form or another, Northern Rock
required as a backstop a lender of last resort. The
natural place to look for a lender of last resort is the
central bank. You could ask whether the market
could have been the lender of last resort for
Northern Rock. I think the only circumstances in
which that would have been feasible would have
been when we had gone back to normal
circumstances and banks had already financed the
taking back onto their balance sheets of the conduits
and vehicles that they now expect, over a period, to
take back onto their balance sheets and were once
again in a frame of mind to be willing to lend to
others who had illiquid assets. To go back to those
circumstances quickly and get back to where we
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Ev 2 Treasury Committee: Evidence
20 September 2007
Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
were in July would have meant injecting a massive
amount of liquidity. The Federal Reserve and the
ECB have gone nowhere near that far at all. So the
question is how could the market have been an
eVective lender of last resort to Northern Rock? In
these circumstances it is natural to regard the central
bank as being the lender of last resort. In a minute I
would like to go on to explain what were the
problems that arose in our trying to be lender of
last resort.
Q4 Chairman: Let me ask a question, if you like what
the ordinary person in the street is asking: Governor,
how did we get to a situation where the eVort put
into rescuing Northern Rock is the equivalent of
screaming “Fire!” in a crowded and darkened
cinema where everybody rushes for the door and
there is sheer and absolute panic, all as a result of one
company maybe having a bad business model? I
want to extend the questions to Mr Tucker who is
the Executive Director of Markets and also to Sir
John Gieve who has the responsibility for financial
stability. How did we get there?
Mr King: Can I just answer that first and explain
how we got there. You are quite right to be
concerned about shouting “Fire!” in a crowded
cinema. One of the major considerations during
August was there was no reason to believe that it was
inevitable that Northern Rock or any other bank
would get into diYculty. There were clearly liquidity
problems; they might or might not have been
resolved. To have announced at that stage either a
liquidity injection on such a scale that all the banks
would have had their immediate liquidity diYculties
dealt with or to have announced at that stage a
guarantee for depositors in every bank would
undoubtedly have been a signal that the authorities
were deeply concerned about the entire UK banking
system. That is wholly unfounded. The UK banking
system as a whole is well-capitalised. In this context
we should be grateful that banks did make profits in
the last five years. They have a large capital cushion.
They can take the conduits and vehicles that they set
up in recent years back on to their balance sheets. It
will take a little time and the banks will make lower
profits than they would have wished but there is no
threat to the stability of the banking system. To have
announced measures on such a scale that would have
suggested that we did not have that confidence I
think would have been irresponsible, so the question
is what happened with Northern Rock? The main
point I want to make to you this morning is that the
interaction between four apparently unconnected
pieces of legislation prevented us from carrying out
the operation that we wanted to do. You have a
major role as a Committee in trying to get us into a
position where these problems will not arise again.
Q5 Chairman: We want to broaden this inquiry—I
certainly want to—to have the FSA before us who
are coming just after we come back to Parliament
and also to have the Treasury as well. I will ask you
later but the Tripartite Agreement seems to me to be
fundamentally wrong.
Mr King: I will come back to that. The most
important point I want to make is to ask yourselves
how would the Bank of England have dealt with this
in earlier years. How would it have dealt with this in
the 1990s? The first way it might have dealt with it
was to invite the directors of Northern Rock and
prospective purchasers into the Bank or the FSA for
a weekend to see if that could be resolved and a
transfer of ownership agreed over the weekend such
that the depositors in Northern Rock would have
woken up on Monday morning to find themselves
depositors of a larger and safer bank. That is not
possible because any change of ownership of a
quoted company—and Northern Rock is a quoted
company—cannot be managed except through a
long and prolonged timetable set out in the
Takeover Code. The second way in which the Bank
would have preferred to do it in years gone by, and
did do it in the 1990s, and the way that I would have
wanted to do it on this occasion, is to have acted
covertly as lender of last resort, to have lent to
Northern Rock without immediately publishing
that fact, publishing it after the operation had been
over so that you and others could hold us
accountable for the operation itself. As a result of
the Market Abuses Directive in 2005, we were
unable to carry out a covert lender of last resort
operation in the way that we would have done in the
1990s. There is a great tension between asking
companies to disclose things which may aVect the
decisions of shareholders and on this occasion
asking them to disclose something which actually
undermined the ability to carry out an operation
which I believe was in the interests of everyone
connected with the company. We were forced back
to doing it in a covert way.
Q6 Chairman: Sir John Gieve and Paul Tucker, the
Governor mentioned the assets were illiquid.
Certainly the financial services companies who have
spoken to me in great numbers over the past few
weeks have said that Northern Rock was on the lips
of a number of people for the past few months. Sir
John, you sit on the FSA; were you having a sleep in
the back shop while a mugging was taking place in
the front?
Sir John Gieve: I am on the board of the FSA, that
is true. I do not think the FSA or the Bank were
asleep at the wheel.
Q7 Chairman: I am asking you, Sir John, about your
responsibility. Do not talk to me about the FSA—
Sir John Gieve: I thought you were asking me as a
member of the FSA board.
Q8 Chairman: Exactly, about your accountability.
Sir John Gieve: I do not think I was asleep at the
wheel. Yes, you are absolutely right, Northern Rock
was in the newspapers and people could see that its
business model made it more vulnerable than other
banks. The timing of the troubles in August was
particularly severe for them because they were
working up to a securitisation in September. So
through August there was very close monitoring of
their position and before it came to a Bank of
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Treasury Committee: Evidence Ev 3
20 September 2007
Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
England facility being oVered, the FSA took the lead
with Northern Rock in looking to see if there was a
private sector solution. But a private sector solution
was not available, could not be mounted, and as a
result we then moved on to our oVering a liquidity
facility to them. We knew when we did that that the
announcement of that would have two eVects: a
good eVect because it would show they had a new
source of finance but a bad eVect because it would
send the market a signal that they really needed a
new source of finance. We knew that there was a risk
that that balance would go the wrong way and it did.
Q9 Chairman: But let me go back a bit because
Northern Rock grew three times faster than any
other company in the past year. I was with a major
retail bank just the other evening and I said to the
Chief Executive, “Why didn’t you grow like
Northern Rock?” and he said they would not do it
because it would have been folly to do it and the risks
were too great. Someone should have seen the risks
that Northern Rock were taking. It does not seem to
me as if anyone had any concern about it, so we have
one company with a bad business model which ends
up threatening the financial stability of the country
and therefore your role as Deputy Governor and as
an ex oYcio member of the FSA seems to me crucial
here. Should that not have been spotted?
Sir John Gieve: The first people of course who are
responsible for the business model and the decisions
of Northern Rock are the Northern Rock board.
Secondly, of course the FSA through their
supervision team have been keeping closely in touch
with Northern Rock, as with other banks,
throughout. You are saying should someone have
stepped in and prevented them running the business
they ran?
Q10 Chairman: No, what I am saying to you is a
wonky business is in existence that may jeopardise
financial stability; you have an obligation to ensure
that you are up to the mark in seeing that and taking
anticipatory action. That is what I am saying. I am
not saying you should interfere. Mr Tucker,
everybody was saying that Northern Rock was
almost a basket case.
Mr Tucker: It is not just a question of the individual
firm; it is also definitely a question of the wider
market circumstances and, as the Governor
mentioned, there are two key features to those, first
of all the asset-backed securities market seized up on
the basis of problems in a relatively localised area—
sub-prime—most obviously because of severe
concerns—
Q11 Chairman: But Northern Rock never had subprimes on its books and the fact is everybody knows
that Northern Rock grew because it depended on
wholesale markets, they did not have enough lenders
so they went to the wholesale markets all the time.
Mr Tucker: That is where I was leading, Chairman.
So the concerns around the asset-backed securities
markets and about the credibility of ratings caused
the asset-backed securities market to dry up. The key
point I think is the way this jumped from the capital
markets into the banking markets or the money
markets, and that was based on the fact that the
banks had provided very large committed lines of
credit or liquidity to a lot of vehicles in the system;
and faced with an increased probability of the
drawdown of these massive lines of credit, they
started to stockpile liquidity rather than lend in the
term money markets. The striking thing is that this
was a feature not just of the sterling markets in
London but of the dollar markets in the States and
the euro markets on the Continent; and irrespective
of the fact that the three central banks concerned
have taken diVerent approaches to their operations
in those markets, there has been a global drying up
of term liquidity and, as you say, Northern Rock
was badly exposed in those circumstances.
Q12 Chairman: Governor, I am not getting much
comfort from the answers I am getting here. There is
an obfuscation going on. There is a simple issue here.
Mr King: Let me try and put it simply: what
happened on 9 August was that there was a
realisation of an event that we had been warning
against for a long time which is that the markets and
the securities that many banks and others had been
creating suddenly dried up. In the Mansion House
speech in June I said very clearly the liquidity of
markets in complex instruments is unpredictable.
The problem for Northern Rock was that if that
eventuality materialised they would end up with a
massive maturity transformation on their balance
sheet. At that stage it was clear that at some point a
lender of last resort might be necessary. My basic
point to you this morning, as I started earlier, is that
the interaction between diVerent pieces of
unconnected legislation made it almost impossible
for us to conduct the lender of last resort option in
the way that we would prefer. I am willing to go
through the other events and explain what
happened.
Q13 Chairman: You have just explained the model
of the lender of last resort. That model is really not
fit for purpose now, is it, it has to be looked at.
Mr King: Can I explain why.
Q14 Chairman: It has to be looked at.
Mr King: There are certainly question marks over it
but the question marks are not because we cannot in
theory act as a lender of last resort but because in
practice we are hemmed in by this interaction
between these four pieces of legislation. Firstly, you
cannot transfer the ownership of a bank over a
weekend because of the Takeover Code. Secondly,
the ability to conduct covert support, which would
avoid the risk of creating concern among depositors,
is ruled out because of the Market Abuses Directive.
Once retail depositors have become concerned—and
it was not obvious that the announcement of the
lender of last resort operation would result in people
wanting to take money their out, it could have gone
either way—once that run had started people were
not behaving illogically in joining it and wanting to
take their money out also because of the two other
pieces of legislation. There was the way in which,
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Ev 4 Treasury Committee: Evidence
20 September 2007
Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
when banks are put into administration, retail
depositors find their deposits frozen and they cannot
access them, even in a solvent bank, and that is not
something that any depositor would want to take a
risk on and, lastly, that the deposit insurance is less
than 100% for most of the deposits. We now require
a serious reform of deposit insurance, of the
administration of banks, of the clash between the
wish for transparency of companies to their
shareholders, the tension between that and how it
applies to banks when in diYculty, and the length of
time it takes to deal with transfer of ownership of
banks. Those four things are fundamental. If any
one of those had not been there, there would not
have been the problem with the lender of last resort
operation. It required all four to be there to prevent
us acting in the way that we wanted to do.
Q15 Chairman: These are issues which we are going
to be looking at, Governor, because the focus of this
Committee will be looking at where the weaknesses
are in the whole system. One area of weakness I
would suggest to you is in the Memorandum of
Understanding in Financial Stability because that
means that diVerent authorities in the tripartite
agreement can “lead diVerent parts of a crisis” and
when Mr Jon CunliVe was here before the
Committee a few months ago he gave a commentary
on the Memorandum of Understanding saying that
the parties will agree who is in the lead of a crisis or
particular aspects of the crisis. Who was in the lead
in this crisis and did that change in the past few days?
Mr King: No, each party in the tripartite authority
has separate responsibilities and if you ask me how
would this have played out if we had not had the
Memorandum of Understanding, I do not think it
would have made any diVerence to the substantive
problems we faced and I think it would actually have
made it harder to manage the process. The great
virtue of the MoU is that it does not change the
instruments available to the authorities in any way.
What it does do is to clarify responsibilities,
everyone knows what their job is, and it enables us
to know and to practise beforehand how we
communicate with each other. When it comes to the
question of decisions that might involve taxpayers’
money it is right and proper that in the end the
Chancellor has to approve any risk to taxpayers’
money.
Q16 Chairman: Everybody knows what their job is
but really the view in society is that nobody knows
what they are doing in this case, Governor, that is
the reality.
Mr King: I think that people outside the financial
sector must regard what has happened with utter
bemusement. We are in a strong British economy—
we still are—we are in a strong world economy and
these problems were not caused by what was going
on in world markets.
Q17 Chairman: God help us if we get a weak
economy in the future.
Mr King: It is good that it has come at a time like this
rather than at a time of weakness and the reason for
that is in the past many diYculties in the banking
sector have come as a result of serious
macroeconomic problems where there have been
major defaults and holes in the assets side of the
bank’s balance sheet and we are not in that position,
this is entirely a question of the structure of the
liquidity funding of the banking system.
Q18 Chairman: When you talk about everybody
knowing their own job, Governor, I have to ask you
this question because it has been in the public press:
are you your own man? Were you lent on in this
situation? Is that why you did a U-turn in the past
seven days?
Mr King: No, I can assure you that the operation we
announced was designed in the Bank. Of course in
these circumstances I want to discuss it with Callum
McCarthy and the Chancellor. It would be very odd
if they were to have woken up and found we had
done this and they did not know anything about it,
so of course we discussed it, but I give you my
personal assurance that I would never do anything
unless I thought it was the right thing to do. The
independence of a central bank is not just about
legislation; it is about having people in the central
bank who will do what is right for the country in
their job and not do what people ask them to do,
whether it is the banks or whether it is politicians.
Q19 Chairman: What I take from this just now,
Governor, is that the issue of lender of last resort, the
tripartite arrangement, deposit protection—to name
three at the moment—are issues that really need to
be looked at and addressed again.
Mr King: Absolutely, and I would urge you all to
regard this as a cross-party issue and I think it is of
fundamental importance. Our system for dealing
with insolvency of banks and deposit insurance is
markedly inferior to other countries. That has been
true under governments of all parties in this country.
I think this was the unintended consequence of
diVerent pieces of legislation coming together and it
needs to be acted on speedily because the guarantee
that we have in place now for the banks cannot be a
permanent solution; we will need an exit route. It will
require speedy thought and action and the thought
needs to come first. Parliament is absolutely crucial
in this and your Committee has an enormously
important role in leading a cross-party discussion on
how we improve these matters which in the end, in
my judgment, were responsible for the diYculties
that we had last weekend.
Chairman: It does not look today as if people have
come out well of it so we have got to try and rescue
it somehow. Michael?
Q20 Mr Fallon: Governor, how long have you been
at the Bank?
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Mr King: Sixteen and a half years.
Q21 Mr Fallon: You run exercises to test financial
stability all the time. Why have you just discovered
that all these legal instruments are somehow
suddenly inadequate?
Mr King: Some of them we had realised and
discussed before as a result of exercises. On some of
them work is already going on, as I understand it, to
think of the legislation; and others are much more
recent. I think the problem in the Market Abuses
Directive which prevented my first preference course
of action here, which was to be a covert lender of last
resort, is that it only came into eVect in 2005 and the
wording in it is ambiguous. I had still hoped and
indeed I pressed strongly for the ability to conduct a
covert operation but in the end the strong legal
advice among the tripartite authorities was that it
could not be done.
Q22 Mr Fallon: It is like the designer of the Titanic
saying it was unsinkable and then we discovered that
once four of the first six compartments are flooded
the whole thing sinks. You are telling us you cannot
handle a financial crisis.
Mr King: No, none of what happened was
inevitable. But given what happened at each stage, if
any one of those four pieces of legislation were not
there, we would have been able to get through it.
This was the unintended consequence of these
things. The legislation on disclosure was ambiguous
and I thought the right way was to conduct a covert
lender of last resort operation. I believe that would
not have caused what we saw last week—the run of
depositors on Northern Rock.
Q23 Mr Fallon: Okay, let me come back to the
Chairman’s question as to who is really in charge of
this aVair. You provided the additional funding that
Northern Rock wanted but you are isolated in the
Bank from its operations; the FSA said it was
solvent but they cannot intervene in the markets;
and the Chancellor then guarantees the deposits.
Who is actually in charge?
Mr King: I think those diVerent actions are all
important and they all go to the responsibilities. This
would have been no diVerent without the
Memorandum of Understanding.
Q24 Mr Fallon: Who was in charge?
Mr King: What do you mean by “in charge”? Would
you like to define that?
Q25 Mr Fallon: What our constituents want to know
given this mess is who is in charge of it, who is
responsible?
Mr King: We are each responsible for the various
responsibilities that we have been given under the
MoU. The final decision on whether to put
taxpayers’ money at risk obviously belongs with the
Chancellor, you would expect that. I do not have the
authority to put taxpayers’ money at risk. The
responsibility for the design of the operations in
markets that we carry out is our responsibility at the
Bank and the judgment about individual institutions
is that of the FSA.
Q26 Mr Fallon: Do you not see that three of you
having diVerent responsibilities all trying to reassure
investors in your diVerent ways that Friday morning
ended up with the result that savers did not trust any
of you—the Chairman of the FSA, you as
Governor, or the Chancellor—because there were
three people saying the same thing.
Mr King: No, it is not true there were three people
all out there saying the same thing. The question of
trust is one that you may want to reflect on. The
behaviour of depositors in Northern Rock was, in
my judgment, a consequence of a perfectly rational
interpretation of what the end game might be. It was
not so much a question of trust. Once the depositors
of Northern Rock had heard the bad news and they
suddenly realised that Northern Rock needed a
lender of last resort facility—this is the problem with
an overt operation—once they had seen that there
was bad news about Northern Rock, and they could
not possibly be reasonably expected to have been
sitting at home thinking about the wholesale funding
structure of Northern Rock, once they learned that
there was concern about Northern Rock it is not that
surprising that they thought perhaps it might be
safer to take some money out.
Q27 Mr Fallon: Would it not have been easier to
have handled this aVair if you were still in charge of
banking supervision?
Mr King: I honestly believe not. I think that now
there is a much more formalised and legalistic
framework of supervision, which is not a
consequence of the division between authorities but
of the evolution of the financial system. I know that
Callum McCarthy and Hector Sants have been
working day and night to monitor all the institutions
for which they are responsible. We have been
extremely busy in the Bank doing the same for our
responsibilities. The idea that one institution should
cope with all of these I honestly do not believe would
make sense. As I said, the root cause of this, in my
view, is not the question of who does what—you can
argue the merits of that quite separately and I do not
believe it is a question of who is responsible for what
or the fact that there is a tripartite agreement. My
own view, for what it is worth, is that the MoU
worked well and it is very sensible to have the
responsibilities laid down so that you know what we
are accountable for. The problems in this case were
quite diVerent. They came from the inherent logic of
the economic position that Northern Rock found
itself in and the various constraints that were placed
on the ability of the authorities to take action.
Q28 Mr Fallon: Okay. Given the that additional
funding oVered to Northern Rock had to be overt in
the end why have you not made public the advice in
the letter that you sent to the Chancellor last
Thursday?
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Mr King: I should be very happy to publish it at any
moment but that is a question for the Chancellor and
not for me.
Q29 Mr Fallon: He is preventing it being made
public?
Mr King: No, I do not think. I would welcome it if
you would like to ask him now for the letters. I have
nothing against publication but I do not think it is
for me to proVer that.
Q30 Mr Fallon: I see. If all the deposits in any bank
are now guaranteed by the Government how does
that not encourage exactly the kind of excessive risktaking that you warned us about?
Mr King: It does not encourage the moral hazard of
the banks themselves. It encourages potential moral
hazard on the terms that might be oVered to retail
depositors, not the structure of the funding which
the banks put in place for the conduits and vehicles
and the risk of a big maturity transformation. You
are quite right, however, that this is not a sustainable
position and it is very important that we move as
quickly as possible to an exit route towards a
sensible framework, but that sensible framework
will not be where we started. The system of
administration for banks which means that retail
depositors find their deposits frozen for months on
end and they cannot access them is a system which is
a direct inducement for retail depositors to take their
money out at any sign of trouble.
Q31 Mr Fallon: On what date did you first become
aware that Northern Rock was seriously exposed
with the freezing up of the wholesale market?
Mr King: Would you excuse me if I refer to the sheet
which sets out dates here. I would like to refer to this
calendar in doing that?
Q32 Mr Fallon: I just want the date you first became
aware of it.
Mr King: 14 August was when the first Tripartite
phone call between deputies took placed and I was
alerted to it. 9 August was when the financial market
disturbance began and it was on 14 August that I
was first alerted to that.
Q33 Mr Fallon: On what date were ministers first
alerted?
Mr King: On the same day, I imagine, because it is a
tripartite process. I cannot vouch for who in the
Treasury was told. You would have to ask them; I do
not know that.
Q34 Mr Fallon: Were you aware that in its interim
statement on 21 July Northern Rock reported that
the FSA had allowed it to weaken its balance sheet
by widening its Basel II waiver and thus enable it to
pay a 30% increase in its dividend?
Mr King: I was not aware of that on 25 July. After
that it became irrelevant, it was water under the
bridge. What I had to deal with on 14 August was the
position as it was on 14 August.
Q35 Mr Fallon: Were you not involved, Sir John?
Did you not read the interim statement of
Northern Rock?
Sir John Gieve: No, I did not read the interim
statement of Northern Rock.
Q36 Mr Fallon: It was the bank that was most
exposed to the freezing of the wholesale markets
because of its particular business model and it
produced interim results on 25 July and you did not
read them?
Sir John Gieve: No, I did not. Remember this was 25
July. At that point the markets were disturbed but
the events of 9 August had not happened, and I do
not as a member of the FSA board try and secondguess the teams who actually carry out the
supervision, who of course would have been in close
contact with Northern Rock and indeed with any
other bank.
Q37 Mr Fallon: So neither you nor the Governor
realised how exposed Northern Rock was until the
middle of August? Is that the position?
Mr King: The 14 August was when we were first
informed through the tripartite process. That is the
process that informs the Bank. We do not monitor
individual institutions.
Sir John Gieve: Can I just say that in our Financial
Stability Report in April, for example, we identified
the increasing wholesale funding of banks as a
potential risk if markets became less liquid. That was
one of the warnings we gave, so I was concerned in
a general way about the growth of wholesale
lending. Did I know the details of Northern Rock’s
position before this blew up? No, I did not.
Q38 Mr Fallon: You were concerned about
wholesale lending back in April but it did not occur
to you until you were alerted on 14 August that one
institution’s business model depended so strongly on
access to the wholesale markets—Northern Rock—
that it was going to be in trouble?
Sir John Gieve: As I have said, there is a range of
institutions—
Q39 Mr Fallon: For four months nobody at the
Bank realised the implications?
Sir John Gieve: The implications of what?
Q40 Mr Fallon: Of the fact that Northern Rock
would be exposed if the wholesale markets froze.
Sir John Gieve: I think Northern Rock has the most
developed wholesale funding model among the
mortgage banks in Britain. There was a detailed
knowledge in the FSA of the positions of the
individual banks. Did we foresee that the way that
events would unfold exactly in terms of the freezing
of the mortgage securitisation market and the
impact on term money markets? No, we did not see
exactly how it would come through. At the point of
April—this is before the events—we identified that
there were vulnerabilities in the system but we did
not see exactly the path that they would lead back to
Northern Rock. And I do not think anyone did.
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Q41 Mr Fallon: You did not see that Northern Rock
would run out of money?
Sir John Gieve: No, I do not think we did.
limiting the moral hazard very clearly by capping the
size of the operation in order to give assurance that
whatever strains we might see would be alleviated.
Q42 Chairman: There was no risk analysis of
Northern Rock?
Sir John Gieve: I am sure that as part of the
supervision of Northern Rock—I am sure this is the
case—the FSA team require them to do diVerent
stress tests, so I am sure the FSA and Northern Rock
looked at the impact on their balance sheet and
operations of diVerent stress tests. I do not have the
details of what those were but that is something that
I know the FSA has been doing a lot of work on.
Mr Tucker: I hold the same position on the
individual institutions, Chairman, but what I would
add is that from July onwards we were focused on
what was happening in the markets as a whole and
analysing the channels of strain. And we did identify
that there could be spillover to the asset-backed
securities market and to the ABCP funding market
and we briefed colleagues on that. Our job in this
structure is to identify what is going on in markets
as whole.
Q46 Mr Fallon: Governor, you have spoken on
moral hazard and you have written us an eloquent
essay on moral hazard, but is not the criticism that
you have passed the theory but when it came to
dealing with Northern Rock and when it came to
dealing with three-month funding actually you
failed the practical?
Mr King: No, I do not think that is true at all. I am
happy to explain a bit later if you like why I think
moral hazard is such an important issue. Can I just
answer this point. I have tried to set out a sequence
of events in which Northern Rock required
ultimately a lender of last resort, the way in which we
would have preferred to do it was not open to us, and
at that point we did it in an overt way. I do not think
it was at all obvious what impact that would have. It
might or might not have led to people wanting to
take their money out. In the event it did and once
that run had started people were not behaving
illogically by joining it and at that point the only
solution was the Government guarantee. I think this
is a very clear chain of events.
Q43 Mr Fallon: You briefed which colleagues?
Mr Tucker: Colleagues in the Bank and colleagues
in the tripartite structure, but this was not about
individual institutions.
Q44 Mr Fallon: All right, could I turn, Governor, to
the three-month facility that you announced
yesterday. Can you explain to us the role of ministers
in this three-month facility? Have they been urging
it on you as long as the big banks?
Mr King: No, the banks have clearly been urging us
to do an operation like this for a long time and to
some extent they would, would they not, because
they are in a position now of having to acquire
liquidity at a much higher price than they would
have wished, given that in their risky business
models, the risk materialised. The real aim of trying
to minimise moral hazard, which is one of the
objectives set down in the 1997 MoU, is not to
provide liquidity at a zero cost, and we are not doing
that. The concerns that led me to want to propose
this yesterday were concerns about the banking
system as a whole. This operation was designed
entirely in the Bank. We have the competence to do
that; I do not think people in either the Treasury or
the FSA have the competence to do that, just as we
do not have the competence to do their jobs. But of
course I discussed it with the Chairman of the FSA
and the Chancellor. In these diYcult times it would
be wholly irresponsible not to do so.
Q45 Mr Fallon: But when did Ministers first canvass
the option?
Mr King: This was discussed among all parties over
last weekend in the aftermath of the run on Northern
Rock and the concerns that were being expressed
about what this meant for the stability of the British
banking system as a whole, and at that point I
judged that it was worth doing something, but also
Q47 Mr Todd: I am going to come to moral hazard
because you are keen to talk about that but I just
want to explore the issue of information and how
people understand it in this story. I think you were
quite correct in saying that the initial step with
Northern Rock could have been interpreted in two
ways. On balance, people felt that it gave a signal of
insecurity in that particular institution and they
headed for the queues. Is there not an argument for
saying that subsequent extension of the guarantees
given to Northern Rock to the banking system at
large, with depositors eVectively being secured by
the Government, and also the wider steps taken
yesterday, also convey a more generic message of
wider concern about the banking system in this
country, which may convey similar messages of
alarm to people on a wider scale? So what I am
exploring is how actions that you can see and others
in the tripartite agreement can see are logical in
themselves can be perceived on the outside in a
rather diVerent way?
Mr King: I think that the announcement of a
guarantee, had it come before the run on Northern
Rock, would indeed have been interpreted in the
way that you suggested might have happened and I
think would have been an irresponsible thing to have
done. It would undoubtedly be said, “Why on earth
is this being done?” It was clear why it was being
done when you could see the run on Northern Rock
because and,, at that point, only a Government
guarantee was capable of stopping that run, there
was no other way out.
Q48 Mr Todd: That guarantee has now been
extended beyond Northern Rock, that is the point I
am making.
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Mr King: For the reason that, once depositors see
that if a run starts our current ability to deal with it,
given that the insolvency legislation and the deposit
insurance, is inadequate, people must know that
there is a Government guarantee and it is the
Government guarantee that prevents the run. This is
not a permanent solution. We have to find a way
through to a better permanent system but a
Government guarantee is there now to give complete
reassurance that no depositor will lose. The
important point to hang on to here is that no
depositor has lost anything at all.
Q49 Mr Todd: Absolutely but extending that point a
little further, the extension of liquidity that you have
oVered yesterday, on terms I entirely accept, does
that not also convey a wider implication of concern,
because I think that I have interpreted your actions
as being to try and act cautiously and in a rather
focused way and give a clear message that the broad
system is working reasonably well, we have a strong
economy and our banking system should be able to
cope with these circumstances? There is an argument
for saying that some of the actions which have been
taken most recently suggest to an outsider that that
statement of confidence is misplaced.
Mr King: I do not think confidence in the banking
system as a whole is misplaced. As you say, there is
always a delicate judgment to make about whether
putting in place an auction of the kind that we did
would create more concern because of the fact that
we were doing it than it would benefit the system in
terms of alleviating the strains, but my judgment was
that after the Northern Rock run and the impact of
the sight of depositors queuing in the streets to take
their money out, there were potential strains, at
least, in the system that were worth guarding
against. It is a diYcult balancing judgment. I cannot
claim that it is obvious that the judgment was right
or not but we have to make these judgments in real
time and I think given where we are today I would
still have done it yesterday.
Q50 Mr Todd: In your covering note to the letter
that has been published—and I do not know
whether the letter to John was published at the
time—I quote the words you said there: “I am
conscious that in sending you this statement I am
taking a snapshot of a fast-moving situation with a
long exposure camera.”
Mr King: Absolutely right.
Q51 Mr Todd: I think that was a reasonable
summary of the position you found yourself in. Can
we talk about moral hazard. Your focus on that has
perhaps been interpreted as being academic, even
puritanical, in comparison to the approach taken by
other central banks, and it is certainly noticeable
that in the public statements of other central bankers
there has not tended to be the same emphasis on
moral hazard as you have placed on it yourself. Can
you explain that diVerence of approach?
Mr King: I do not believe that moral hazard is just
some dry academic concept.
Q52 Mr Todd: Nor do I.
Mr King: It is moral hazard that has actually led us
to where we are. I do not want to blame anybody at
all for what has happened. I think one of the
interesting aspects of this crisis is that all the players
have acted completely rationally given the position
they were put in, and the point about taking moral
hazard seriously is that if what we do is to say to the
banking system if you take these risks again in the
future then do not worry we will provide you with ex
post insurance, that means there is no incentive for
them to take out any insurance or to behave in a less
risky way beforehand. Why do I think this is
important? About four weeks ago I remember
listening to an interview on the radio in which a
young woman was explaining that she had taken out
a mortgage for her and her husband. They had not
anticipated the events that occurred with the rise in
interest rates and she had found herself in a problem
where they were short of liquidity. They had turned
to other sources which were more expensive and they
had now built up debts of £100,000 which she could
not repay. She put those points to someone from the
banking industry who I thought responded very
reasonably, namely “We are deeply sympathetic, we
understand the nature of your problems, but can you
imagine what would happen if the banks were to
forgive you those debts? What could the banks say
to those customers who actually behaved more
prudently, that did not borrow more than they could
aVord? What would happen to people’s willingness
to behave prudently in future if we bailed you out?”
It is a little bit strange that that seems to apply to the
borrowers from banks but not to the banks
themselves.
Q53 Mr Todd: By my question was slightly diVerent
to that because I have to say I agree with your
missives on this (I have got a rather stern puritanical
streak too!) but the puzzle is why that has not been
emphasised by your colleagues.
Mr King: It may not have been emphasised in
speeches to the same extent.
Q54 Mr Todd: Or acted on.
Mr King: It has been acted on. If you look at what
the ECB and the Fed have done in their market
operations they have not provided complete ex post
insurance, they have not put suYcient liquidity into
the banking system to enable the banks immediately
to take back onto their balance sheet all the risky
conduits and vehicles that they have created without
incurring a cost. All banks around the world will pay
a price for what has happened. What I want to do is
to make sure that when they get liquidity from
central banks they pay a price for it and do not get
it free. The banking system as a whole can aVord to
do this. If I thought there was a risk to the British
banking system as a whole and that the capital that
the British banking system has was inadequate to
take this onto their balance sheets, I would be out
there putting liquidity in at a lower price to stabilise
the British banking system. That is not necessary. If
you always provide ex post insurance you can be
quite sure that in five or ten years’ time another crisis
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will come. That is exactly what we have seen in the
last 20 years. The one thing I do not want to do is to
find myself five or ten years down the road saying,
“Why did I take the easy option? Why did I do that?
Why did I sow the seeds of a future crisis?” The
whole regime of monetary policy that we have put in
place has been to demonstrate that taking the easy
option and giving in in the short run without looking
to the long-run consequences of those actions is
damaging. Every manufacturing company I go out
and meet around the country every month has come
to realise that the short-term option which they
wanted ten to 15 years ago—a cut in interest rates at
the first sign of a problem—is not the way to go; it is
having a stable framework. We need to put that view
back into the financial system.
Q55 Mr Brady: Governor, can I ask when you first
discussed the possibility of the 100% guarantee for
retail deposits?
Mr King: The first discussion I had about that
subject was on Sunday after the run had started.
Q56 Mr Brady: Did the impetus for that come from
the Bank or from the Treasury?
Mr King: It came out of discussions among all three
of us. I think it was clear to everyone that the only
way to stop the run at that stage was indeed a
guarantee.
Q57 Mr Brady: And what was it that finally made
that decision necessary? You referred earlier to
seeing the screens and the impact on the screens, was
that part of the rationale?
Mr King: No, I think it was clear that if the run had
continued then all the retail deposits would have
disappeared because once it had started it was not
illogical for others to come in behind it, and
therefore something had to be done to stop the run,
and at that point without an adequate insurance
scheme, without the ability to put the company into
a position where it could immediately repay the
depositors, only a Government guarantee would
stop the run. It was the only solution at that point.
Q58 Mr Brady: You have already said that it is a
temporary solution, which I suppose is obvious, but
what is the set of circumstances which needs to be in
place for the guarantee to be removed? Does it
require the piece of legislation to which you referred
and the whole regulatory environment to be changed
or can it happen sooner?
Mr King: I think you have to ask the question why
was this not regarded as something so urgent in the
past? Governments of all parties did not regard it as
a top priority and I think the reasons are because,
first of all, the recent circumstances are pretty
unusual so it was not a pressing problem and,
secondly, at that point the Bank of England did have
the ability to act as a lender of last resort in ways that
we were not able to this time. However, I think that
has all gone now. My feeling is that legislation
introduced not too speedily but after careful thought
is absolutely crucial now and that is the exit route
from where we are into a more stable future system.
This Committee clearly has an important role in
leading it because this is not—and I would urge you
not to regard it as such—a political issue, this is a
cross-party issue in which everyone has an incentive
for putting in place a more stable structure for our
banking system.
Q59 Mr Brady: Can I also ask for some clarification
about the extent of the guarantee. I do not think this
is clear yet. Does the guarantee extend to retail
deposits held with overseas banks operating in the
UK or is the guarantee only to British banks?
Mr King: Sir John has been involved in the
discussions. Can I just summarise the broad
principle behind it which is that this would be
extended to other banks if they found themselves in
a similar position, that is to UK retail depositors and
other unsecured creditors, but perhaps Sir John
could comment on that. The Treasury put out a
notice at 7 o’clock this morning and I think
questions on the detail of that should go to them.
Sir John Gieve: The note that the Treasury put out
was about the guarantee to Northern Rock, and that
is the only guarantee in place at the moment, and it
defines what “existing deposits” means and it defines
that in terms of “accounts up to midnight on
Wednesday 19 November”, with the addition that
accounts closed in the last few days can be reopened. It defines the wholesale market cover as
being to existing and renewed wholesale deposits, so
wholesale deposits that are rolled over at the end of
their term will be covered and so will existing and
renewed wholesale borrowing which is not
collateralised. The point about the broader banking
sector is covered in what the Chancellor said. If
another bank found itself in the same circumstances
it would get the same treatment.
Q60 Mr Brady: And it is your understanding that
that would apply whether it was a UK bank or a
foreign bank operating in a UK environment?
Sir John Gieve: If you have a foreign bank with a
branch here obviously the lead on that is taken by
their own supervisor and central bank in their
country of origin. So, for example, if there was, I do
not know, a French bank that had a branch here, the
question of whether or not that needs liquidity
support depends on its position in its home country
and internationally. It is diYcult to think of an
example where there would be a purely British
liquidity crisis for a branch of a foreign bank.
Q61 Mr Brady: So UK depositors with such a bank
can take no comfort from the guarantee that has
come from the Chancellor?
Sir John Gieve: The Chancellor’s words are not
specific on this and it would obviously depend on the
circumstances, but generally the home country
authorities would take responsibility for their banks,
and that would apply to us, too.
Q62 Mr Brady: Thank you. Can I ask just one other
slightly diVerent question to the Governor again.
Governor, you said earlier that you had pressed
strongly for the ability to conduct a covert
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
operation. When did you press strongly for it? I was
not sure whether that was a reference to the period
when the Market Abuses Directive was under
consideration or whether it was in the period since it
had come into force.
Mr King: No, it was during this particular crisis with
Northern Rock where I found it hard to believe that
a public policy intervention that was in the interests
of everyone in Northern Rock could not go ahead
because of a legal responsibility to disclose. There is
wording in that Market Abuses Directive which
would give you the impression that, in a case of
financial distress, it would be possible not to disclose
but we had to take legal advice. I would say this
occurred in the period between about 22 August and
the date on 9 September when it became clear that
we were discussing seriously doing the lender of last
resort operation and we were advised finally that it
could not be covert, but Sir John was involved in
many of the discussions here at the deputies level.
Sir John Gieve: Can I just clarify one point about
foreign banks. Of course many foreign banks form
British subsidiaries here and they are authorised in
their own right by the FSA, so the legal structure
matters a lot here. I do not want to mislead you on
that.
Q63 Mr Mudie: I find it hard to believe and sad, I
think, that you were warned by Mr Tucker—and I
am speaking to the Governor and yourself—the
relevant people were warned and the relevant
institutions were warned in July about the problems
that were there in terms of the money markets and
yet took until 14 August for it to get on your desk
and there be some thought of action. What I have
heard today (which alarms me) is that you have
spent some time in the last question telling us what
you could not do but I am sitting here as a politician
and I am thinking you are the Governor of the Bank
of England, you knew about this in July, you gave it
some attention in August before those crowds built
up outside Northern Rock and it became an issue;
what was the Bank of England’s inclination or
policy intention because you could not sit and do
nothing, you knew there was a problem, you knew it
was going to blow up in September because that is
when Northern Rock was going for money in the
markets in a major way. How was it going to be
solved before you took that action in September?
What was your plan?
Mr King: The Bank of England is not responsible for
individual institutions.
Q64 Mr Mudie: Sorry?
Mr King: The Bank of England is not responsible for
individual institutions. We act when the FSA come
to us and say, “We think an individual institution
...”
Mr King: Can I just—
Q66 Mr Mudie: You said it is not our responsibility
but you have spent the time up to now saying, “We
would have loved to have done something but it was
a lack of legislation, it was this, that and the other,”
and I say okay, you appear to be very concerned and
wanting to do something, you looked at various
things and you found excuses for not doing them, so
what on earth were you going to do?
Mr King: Let me tell you an answer to that question.
Q67 Mr Mudie: Good.
Mr King: The problems in Northern Rock were
drawn to our attention on 14 August.
Q68 Mr Mudie: No, Mr Tucker—
Mr Tucker: To be clear about what I said—
Q69 Mr Mudie: Mr Tucker, I know what you said,
you said that you became aware of the problems in
the capital market and you sent it across to the
relevant people and institutions. Northern Rock’s
business model is regarded as extreme. It works but
it is extreme because it depends on cheap credit and
easy money, liquidity at a high degree. You were
telling people in the institutions and your own
institution, the other departments and divisions,
that we have got a problem, and anybody would
have put two and two together and said which of our
institutions is going to be hit first. Northern Rock
was an obvious one and I am just saying that should
have rung bells. Is that fair? Thank you, Mr Tucker.
I am just saying in a well-run institution it should
have rung bells and we would have expected the
Governor of the Bank of England to say, This is
going to cause us problems; what can we do?” We
have heard he did say that and then he discovered
that he could not do things. What could you do,
what were you planning to do?
Mr King: I will tell you what we were planning to do.
The problems that could have arisen in all these
institutions, Northern Rock and any other British
bank were triggered by the events of 9 August and
we knew that if this were to cause problems we could
act as lender of last resort but a lender of last resort
is a lender of last resort. If we had jumped in within
a week and announced that we were lender of last
resort to Northern Rock that could have been very
damaging to the institution. We knew that we were
there as the backstop, as lender of last resort.2
Q70 Mr Mudie: So you were content to watch this
impending disaster, this train running towards the
buVers, you knew it was going to happen in
September and you were saying, “I cannot do
anything, but I will be the lender of last resort when
it hits the buVers”? Did you tell the Government and
did you tell the FSA, did you get that Tripartite
2
Q65 Mr Mudie: That is nice to know, but the
impression you have given this Committee is you
were very anxious to do something, not the answer
you have just given that it is nothing to do with us.
Note from witnesses: I explained to Mr Mudie that, during
the weekend after the lender of last resort facility was made
available to Northern Rock on Friday September 14, I was
asked by the FSA whether that facility would continue to be
available in the event of a successful bid for Northern Rock.
I explained that it would be.
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Committee round the table? What did they decide to
do, if anything, or did they sit with you and say—
because this is the impression you have given which
is horrifying—we do not know what to do. I will tell
you what is horrifying, that on both things—your Uturn on three-month money and on Northern
Rock—it was forced upon you by people queuing
outside the building societies, not that you had a
well-ordered plan, not that you were preparing
plans; you just watched it hit it and you panicked
because it hit the buVers?
Mr King: I am afraid that none of that is true.
Q71 Chairman: Answer that short question,
Governor!
Mr King: Indeed.
Q72 Mr Mudie: It is a relevant question.
Mr King: It is a very fair question and I would like
to answer it.
Q73 Mr Mudie: That is what ordinary people and
that is what the City are asking.
Mr King: Would you let me answer it. On 9 August
the events were triggered that meant that the risks we
had been warning about for a long time materialised.
On 14 August we discovered that those risks were
serious in Northern Rock. At that point there did
not seem much point in blowing up the train before
it hit the buVers because there was a long time in the
intervening period in which we might be able to find
a way for Northern Rock to survive. That was the
main
responsibility
of
Northern
Rock’s
management. It tried to find funding and it tried to
sell its assets. If it had been successful in these events
then the problem would not have materialised. We
knew that in the last resort we could be lender of last
resort and we prepared for that. The way I would
have preferred to be lender of last resort was not
open to us but if we had activated lender of last
resort earlier the same problems would have
occurred beforehand without giving a chance to find
another way out.
Q74 Mr Mudie: There is a suggestion that TSB
walked away from the table because you were
unwilling to give that guarantee. I heard that it took
you about nine days to get legal opinion, which I find
alarming.
Mr King: I am sorry, this is complete nonsense.
Q75 Mr Mudie: Why did TSB walk away?
Mr King: I have no idea what bid discussions were
going on. I knew that there were some bidders
interested. When I was asked last Sunday what the
terms on which a bid could be completed were, I
confirmed very quickly that we would roll over the
lender of last resort facility to any bidder. I am
absolutely in favour of having a bid as a long-run
solution to Northern Rock if that can be achieved. I
did not oppose a bid, I supported it, but last Sunday,
Mr Mudie, only a Government guarantee would
have stopped that run. A bid would not have done it
nor would any other solutions.
Q76 Mr Mudie: Let us just be clear. TSB were still at
the table until last Sunday when they got word from
you that the legal advice you had got meant you
could not be the lender of last resort?
Mr King: No, not at all. I was asked by the FSA
whether in the event of someone bidding—and this
was a generalised proposition, not a particular
institution—
Q77 Mr Mudie: Who asked you?
Mr King: Callum McCarthy at the FSA. He said in
the event of a bid being made would it be the case
that the lender of last resort facility that had been put
in place the previous Friday would be extended and
rolled over to a bidder, and I said yes.
Q78 Mr Mudie: Let us clear it up for the City and for
the media. This has been in the press for some time
that Northern Rock were touting themselves
around, there were two British banks interested one
of which was Lloyd’s (who stayed the course) but
they went away after getting bad news. Are you
saying this took place last Sunday when they got the
bad news? The City has got the impression they
walked away long before that because they were told
you would not agree terms.
Mr King: That is absolute nonsense. The lender of
last resort facility was only announced at seven
o’clock in the morning on the Friday.
Q79 Mr Mudie: It was only announced that you
were going to be lender of last resort. Lloyd’s TSB, it
is rumoured, had put it as a condition of taking over
Northern Rock and giving a market solution that
would have saved all this nonsense, and they put that
to you some time before.
Mr King: That is not true.
Q80 Mr Mudie: Okay.
Mr King: The lender of last resort facility was
announced on the Friday and on Sunday I was
asked—to be quite clear because it was a facility we
were extending and if any bank were to bid for
Northern Rock they would need to know the terms
for the bank that they were acquiring—very
explicitly would the lender of last resort facility that
had been extended to Northern Rock be rolled over
with the rest of the bank to a bidder, and I said yes.
I encouraged the bid process. However I can tell you
that last Sunday the only solution to stopping the
run was a Government guarantee; anything else was
a sideshow. Only a Government guarantee would
have been suYcient to have persuaded the
depositors to leave their money in Northern Rock.
Q81 Mr Mudie: Just going on to one last question in
terms of the second major matter of the three-month
money. The Chairman asked you that question at
the beginning and you said later on to one of my
colleagues that there were four reasons. I wrote
down, not in shorthand but as best I could as a poor
Scot, your four reasons. I got two of them, if I can
read my writing, queues was one, the media was one,
and I am not sure I got the other two. In that letter
that you wrote—and you knew about Northern
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Rock when you wrote this letter that put you in the
corner—you said “strong reasons” and then you
said to one of my colleagues “four strong reasons”.
Could you spell out—
Mr King: The number four was referring to the four
unconnected pieces of legislation that were relevant
to the diYculties we had.
Q82 Mr Mudie: So what were the strong reasons
then because you needed strong reasons to depart
from your macho line? Tell us the strong reasons
then.
Mr King: As I said in the statement to the Chairman,
the balancing between concerns about strains in the
banking system as a whole and the moral hazard
that I have described is a balancing judgment that we
were making almost daily, and we did make it daily,
and after the weekend we had seen some volatility in
the overnight rate, we had seen some upward
movement in the spread in longer term markets, and
we had seen people worried about the reputation of
the British banking system and strains in it, and I
judged at that point that the right balance to strike—
and people can reach diVerent views on it, I do not
pretend there is an absolute right or wrong here—I
reached the judgment on balance that it was better
to conduct a limited operation which minimised the
risk of moral hazard but did inject at that point
through the announcement of the auction to be held
next week some additional liquidity. That balance is
one that everyone has to strike in a central bank and
I struck it in that way.
Q83 Mr Mudie: What do you think of the FSA
meeting the bankers in the morning, when you met
them in the evening, either directly or implicitly
indicating that they thought you should do this Uturn?
Mr King: I cannot comment on the meeting with the
FSA but I can comment on the meeting that I held.
I had asked for a confidential meeting with the
bankers and they came along and I had hoped that
it would have been regarded as confidential. In that
process of course they said they would prefer to have
more liquidity at a lower price. That is not very
surprising. If I were in their position I would ask for
exactly the same. I tried to explain why if they were
in my position they would understand that I had to
make a public policy judgment which is to balance
the use of providing free liquidity to them against
moral hazard.
Q84 Mr Mudie: But it was not the rate that you were
charging, it was the assets that you were prepared to
take, you were extending them.
Mr King: And what I discussed with them at that
meeting quite explicitly was to ask them why they
felt that extending support with liquidity injections
against a much wider range of collateral would be
helpful to them and they explained that it would. In
the auction that we announced yesterday we
announced that we would be willing to allow people
to bid against collateral for a very much wider range
of liquidity including mortgages. That is not
something that either the Fed or the ECB have done
and we did that because we felt that it was the
breadth of the collateral that was important rather
than the size of the operation.
Q85 Peter Viggers: Is there a qualitative element in
the guarantee you are giving to retail deposits? Does
the guarantee cover less prudent as well as more
prudently run banks or is it a blanket guarantee?
Mr King: The Chancellor said that the guarantee
would be available to banks who found themselves
in a similar position. I think what that means is
depositors should be reassured that when they put
deposits in a British bank they will be completely
protected. In the long run that is clearly not a
sustainable resting position but in present
circumstances I think it is absolutely vital.
Q86 Peter Viggers: How severely do you think the
principle of moral hazard has been compromised
since you wrote us your rigorous and lucid letter?
Mr King: I hope that it has not and I do not believe
that it has but, as I said, this is a balancing judgment.
When I listened to the banks I do not believe that
they felt that oVering them an ability to bid for
liquidity at a 100 basis point premium over bank rate
was something that they regarded as entirely
generous, so I think there is still a fair chunk of
restriction against moral hazard in what we have
done.
Q87 Peter Viggers: When you make advances under
the proposed auction it will be against, as you have
just explained, a very wide range of collateral
including mortgage collateral. How rigorously will
you be able to scrutinise the mortgage collateral that
has been oVered to you? Will there be collateralised
debt obligations, securitised mortgages, which will
be in a bundle and which will not be capable of
proper analysis by you?
Mr King: Let me ask Mr Tucker who is responsible
for dealing with the practicalities of this.
Mr Tucker: We will announce the details tomorrow.
There will not be collateralised debt obligations.
There will be triple A tranches of prime mortgagebacked securities. The issue that you raise is an
important one. It will be addressed by conservative
haircuts so that we would lend against X% of the
value of the security and the haircuts will be
conservative for precisely the reason you say.
Q88 Peter Viggers: Perhaps for those who are not
conservatives and do not know about haircuts you
would just explain that?
Mr Tucker: Sorry. Say a security is valued at £100.
We might lend £50 against that £100 security or £70
against that £100 security and that would protect us
against a fall in the value of that security during its
life. That is the first step. The second is that the loan
will be for three months. If the value of the collateral
we hold falls during that period we will call for more
collateral to protect ourselves and then if a borrower
were to default we would be protected by the
haircuts I described at the beginning—lending a
fraction of the value of the securities that we hold.
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Q89 Peter Viggers: Very well. Governor, when the
Memorandum of Understanding eVectively took
direct banking supervision away from you and gave
it specifically to the Financial Services Authority it is
now quite specifically responsible for the prudential
supervision of banks, building societies and for the
conduct of operations in response to problem cases
aVecting firms. You happen to be here today and the
original intention was to talk about the Inflation
Report—
Mr King: Indeed!
Q90 Peter Viggers: But it should really have been the
Financial Services Authority which should be
answering many of the questions which are being put
now. Yet on the other hand when a proposal came
through to provide a lifeline and a rescue operation
it was the Bank of England, as you have explained to
us, which led on this. Would you not agree that the
comment originally made in 1997 that the
Memorandum of Understanding was “unworkable
in a crisis” has actually been proved to be correct?
Mr King: No, I do not accept that. One of the very
good reasons for taking supervision away from the
Bank of England was that it was becoming more and
more impracticable to regard banks as being part of
the financial system that could be regulated
independently of a wider range of financial
institutions. The whole process of supervision now is
much more formal, much more legalistic, much
more international. I think it is a full-time job. It
takes up all the energies of senior people to do that.
In the event of any crisis like this it is inevitable that
those responsible for supervision, those responsible
for central banking activities and the Government
have to work together irrespective of where they are
actually located, so even if two of those had been in
the Bank of England we would still have had to work
with the Government so having all three people
there I think is crucial. The MoU in my experience
has ensured very eVective, speedy communication.
Callum McCarthy, the Chancellor and I have talked
regularly and frequently. We have a team of deputies
under us who speak even more frequently. I do not
believe that the communication or the eVectiveness
of the tripartite arrangements have been in any way
responsible for this. Indeed in my experience it has
enhanced it. I just do not believe that one
institution—a central bank—can manage in today’s
world both monetary policy and the entire range of
financial supervision.
Q91 Peter Viggers: And is the communication
between the three members referred to formalised
and will communications between the three of you
be published?
Mr King: I think that will depend on the chair of the
tripartite arrangements. I would expect a lot of the
conversations that we have held to remain
confidential because they are market sensitive. We
have had many communications both formal and
informal and the informal collaboration and
communication between the Chancellor, Callum
and myself has been absolutely crucial in dealing
with what was a fast-moving set of events.
Q92 Peter Viggers: Finally can I ask Paul Tucker if
he would comment on the current state of the
commercial paper market?
Mr Tucker: A little bit better than a week ago. This
is important and over the last few weeks the
underlying problem has started to be addressed. The
underlying problem is that investors should
distinguish between one type of security that has got
real diYculties and other types of security that are
maybe okay. That process will take a while and it
does seem to be gradually underway. I think there is
still a long way to go and there could still be
setbacks. The last ten days in terms of global
markets as opposed to our local position have been
very mildly encouraging.
Q93 Peter Viggers: And how important was it that
banks were unable to raise money on the commercial
paper market?
Mr Tucker: I think the fact that banks and these socalled conduits were not able to raise commercial
paper or were only able to raise commercial paper at
very short maturities is right at the heart of the
problem. It is diYcult to see that the problem will be
resolved without either that market being restored to
something like normality or, alternatively, a lot of
that paper coming on to banks’ balance sheets,
reintermediation if you like from the capital markets
into the banking system. It is because of the latter
possibility that banks have been stockpiling liquidity
and trying to protect themselves against that
eventuality and that has been individually rational
but collectively deleterious.
Q94 Ms Keeble: I wanted to ask a bit about the role
of the credit ratings agency. I have also got some
questions, Paul, on some of the things you have just
said. Sir John, I wonder if you could say from the
FSA’s point of view if you think that the ratings
agencies have provided markets with the kind of
information that they need on which to base their
decisions?
Sir John Gieve: I think this is something that we are
going to look at on an international basis with other
regulators and central banks in the future. I think
that people definitely relied on ratings agencies’
ratings in an inappropriate way. The ratings
agencies would say that if they had read the fine print
there was plenty of explanation about the limited
assurances that they were putting forward. But I
think many investors and people setting investment
remits did just say “if it is triple A it is all right”, not
distinguishing between diVerent sorts of
instruments. What we obviously need to look at is
did the ratings agencies do it wrong or was it the
investors who did not use the ratings agencies
properly and put too much dependence on them?
Q95 Ms Keeble: If I can just come back on that.
Firstly, why so late and, secondly, it is fairly wellestablished, is it not, that the ratings agencies work
very closely with the banks to compile the vehicles to
attract the kind of ratings which are then required to
be attractive on the market; would you accept that?
Why so late and do you not think that it is really
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
unacceptable to have the ratings agencies virtually
colluding with the banks in the construction of
vehicles which are then, as the Governor has
accepted, risky?
Sir John Gieve: I think the ratings agencies’ response
to that is that their reputation and their future
business depends on producing ratings which stand
up in practice.
Q96 Ms Keeble: But what is your response?
Sir John Gieve: I think there is a question about
whether they went too far in relying on their models
to put firm ratings against products which did not
have an obvious market value. Particularly in the
sophisticated credit derivatives field, where they
have, I think, as good models as anyone, maybe
those models were simply too limited to justify a
firm rating.
Q97 Ms Keeble: And then for Paul, because you are
obviously working at a diVerent end of it, when you
did your report on July 25 warning of the risks, what
did you rely on and in saying now that this week is a
little bit better than it was a week ago, what are you
actually looking at and what real risks are you
taking into account? Then I wanted to ask the
Governor something about this as well.
Mr Tucker: What are we relying on? First of all, we
are relying on two sources of information. One is
conversations with people in these markets around
the world, both people who are selling commercial
paper, coming back to that particular question, and
people who are buying commercial paper. This
would go not just for the commercial paper market
but across a whole range of markets. The second
source of information is published information on
the prices at which, in this case, commercial paper is
being issued and also the quantities that are being
issued. It is virtually always a blend of market
intelligence drawn not just from the banking system
but from asset managers and from many others as
well and hard information produced from all sorts of
sources, some of them oYcial.
Q98 Ms Keeble: If I can just ask the Governor
because this issue about risk assessment is something
that the Committee has looked at in the private
equity investigation as well and you referred to the
possibility in the coming weeks of what would
happen if the banks were forced to take risky—and
I have not got your exact words because I have not
got perfect shorthand either—risky conduits and
special investment vehicles back onto their balance
sheets? Which are those risky investments and how
do you know where they are if you have not got the
ratings agencies giving a good, robust assessment of
what the risks are?
Mr King: Can I step back one point because I think
it is very helpful to put this in the context of the real
financial crisis that started on 9 August. I know most
of the questions naturally have been about Northern
Rock but we should not forget that all this came out
of this general problem that you are referring to.
Q99 Ms Keeble: That is right, I want to know where
the risks are and if there are more out there.
Mr King: I will come on to that. There is one point I
want to make about ratings agencies. There is a very
important call and longer term analysis to be made
of how ratings agencies behave. The conflicts of
interests that you have alluded to are clearly part of
that, but it would be most unfortunate in present
circumstances if for political reasons pressure was
brought to bear on ratings agencies to have a kneejerk response to go completely in the opposite
direction and to downgrade everything at sight
because they might be held responsible for their
behaviour. That would lead us into a really diYcult
position and I know you are not suggesting it but it
has come up in various international fora. We need
a long look at that. In terms of the risks, what has
happened is that many of the banks created these
vehicles to hold oV balance sheet (perhaps
sometimes
to
avoid
regulatory
capital
requirements). These vehicles hold securities in
which the market is now illiquid. The banks will now
have to take back onto their balance sheets these
assets which may well be perfectly good value in the
longer term when the markets re-open but they are
highly illiquid. That will require some use of capital
of the banks to finance this in the short term and that
is why, as Paul said earlier, banks are currently
hoarding liquidity in order to finance the taking
back onto their balance sheets of these vehicles.
They know what these vehicles are, they set them up,
and the FSA and the parallel regulatory authorities
around the world have been talking to the banks and
finding out whether the banks know about their
exposures. They say to us that they are confident
that all the major banks know about their exposures
and that they could take these back onto their
balance sheets without any major hit on their capital
so that they would still be left with capital well above
their capital regulatory minimum. It does mean that
the banks will have to find more expensive sources of
liquidity than they had expected or hoped, they will
pay a price in terms of profits. There is absolutely no
diYculty in due course in their doing so but in the
meanwhile there is this great demand for liquidity.
You can get liquidity at a price and this is a matter
of price.
Q100 Ms Keeble: Can I just come back on that
because is it not the case that people do not know
where the risk is, which is one of the factors which
has led to the seizing up of the market, and is it not
also the case what we want is not wisdom after the
event, it is a warning of where the risks are, and
unless there is a more robust assessment of that then
you do not know where the next Northern Rock is
going to be?
Mr King: There are two points I would make on
that. First of all, it does not matter fundamentally
whether we know exactly where the risk is, provided
that the regulators know exactly what the position is
of the banks with retail depositors because the
ultimate aim here is that we are concerned about
protecting depositors and the payments system, not
protecting banks or shareholders or other investors
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
like hedge funds. The key point here is that the
investors themselves know what risks they have
taken on. This is the issue. I think the problem has
been that many investors, ranging from German
public banks to other banks, have discovered that
they did not know exactly what risks they had
taken on.
Q101 Ms Keeble: Yes, which is a bit of an
indictment.
Mr King: It is an indictment of them.
Q102 Ms Keeble: Yes, but it is also the fact that they
do not have any system of robustly assessing what
their risks are because of the ratings that are
provided to the taking on of these investments.
Mr King: I do think that investors must take
responsibility for what they buy. As Warren BuVett
said, do not invest in what you do not understand.
Q103 Ms Keeble: Can I just ask one question
because you have referred repeatedly to the pressure
for greater liquidity, the regulation in relation to
savers’ deposits is 5% and five days worth of business
falling due, which Northern Rock actually had, did
it not, so is there an argument for saying that those
rules need to be looked at?
Mr King: I think this is a very important point that
you make of should the regulatory system not put
more weight on liquidity, and the Bank of England
and the FSA have been urging in international fora
that more attention be paid to this issue. It takes a
very long time to get agreement at international level
about
what
the
appropriate
regulatory
arrangements should be and we have been pressing
that case internationally for quite some time.
Q104 Ms Keeble: Can I ask one further question
which is just about the Inflation Report. We all have
hindsight but looking at your own Inflation Report
the one warning I see about all of this is where it was
talking about domestic demand and it says: “Recent
developments in financial markets, if they become
more widespread, could pose a downside to the
central case.” A downside risk is a bit of an
understatement given what then ensued. I think we
would expect to have perhaps a greater projection of
an impending crisis. Would you want to re-visit that
phrase and give greater weight to the risks that you
had foreseen?
Mr King: If we were back at that time when we were
writing this—
Q105 Ms Keeble: This is August.
Mr King: This was before 9 August. If you are asking
whether before 9 August we would have said the
same things, I think the answer is yes. After 9 August
we would have said something rather diVerent.
Q106 Ms Keeble: But anyone could have said there
is a downside risk, even if I could have said there is
a downside risk.
Mr King: I have been very clear with this Committee
throughout. I do not pretend to be able to forecast
the future with any great foresight at all; no one can.
Nobody that I know said on 9 August these events
would occur. We have been saying for several years
that they could occur, that there were risks. It is not
that we were not aware of it. We said these risks are
there and the banks themselves decided to take those
risks. It was their judgment, they decided to take the
risks and on 9 August those risks came home to
roost. I could not possibly and I would not pretend
now that I could have anticipated that 9 August
would be the event but once it had occurred we then
responded.
Q107 Mr Love: You indicated in an earlier answer
that the takeover panel rather curbs the ability to
bring the parties together when there is a possible
takeover in view. Going back to questions that Mr
Mudie asked, do you not think since there were press
report for some considerable time about a possible
takeover of Northern Rock and that Northern Rock
was in some diYculties—and we have discussed
that—that more active intervention ought to have
taken place by the authorities to assist that process?
Mr King: Perhaps Sir John could comment but as far
as I know a great deal was done. It was clearly the
responsibility of the FSA in discussion with
Northern Rock’s board, and it cannot be forced
onto Northern Rock’s board, they have to make the
judgments, but I think everyone in this process was
hopeful that discussions about a bid would emerge
to provide a suitable end game to all of this.
However the point you referred to at the beginning
meant that even if a bank and Northern Rock had
reached agreement on a bid, that could not possibly
be final until we had gone through all the processes
laid down, and no depositor would have known that
it would have been final until then and they would
have known that there was always a probability,
small though it might be, that something might have
gone wrong with Northern Rock in the intervening
period before the bid could be consummated and
that posed a risk to them and therefore it is not
surprising that they thought they might wish to take
their money out.
Q108 Mr Love: Can I just turn to Sir John because
there is unhappiness at Northern Rock, there is
unhappiness with the suitors; where did it go wrong
and what responsibility does the FSA or other
authorities have for it going wrong?
Sir John Gieve: Firstly, as a member of the FSA
board I will give you an answer, but of course it is for
Callum McCarthy and Hector Sants to come here to
speak for the FSA, not for me as a non-exec. Two
things: firstly we were alerted first to the position of
Northern Rock on 14 August but it was not obvious
to them or to us at that point that they were going to
require government assistance. There were two
things that they were actively exploring: one was a
possible merger or takeover, and the other was
raising money both through short-term money
markets and by securitising their debt. They were
still hoping to securitise some debt and thus relieve
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
their liquidity pressures right into September, and it
was only when that proved impossible that it became
clear that they needed another source of liquidity. In
terms of the crisis, the key question is was it worth
on Friday announcing that the Bank was making a
facility available or should we have said at the same
time that the Government guaranteed all the
deposits? We did realise there was a risk that, if you
like, the shock eVect of an announcement would
overwhelm the positive eVect of saying the Bank was
standing by with some money. We knew that was a
risk but we thought that it was not an overwhelming
risk and it was worth taking that step. As a result the
guarantee which proved essential in the end came
out on Monday. If we had known it was going to be
essential on Monday we might well have oVered it on
Friday but that was not certain at that stage.
Q109 Mr Love: Can I move on, you mentioned
earlier, Governor, that the Market Abuses Directive
of 2005 requires you—and you got legal advice to
this eVect—to make public the lender of last resort.
Mr King: It does not require us to make it public; it
requires the recipient company or bank to make it
public.
Q110 Mr Love: It has to become public. Recognising
that was the case and also you mentioned earlier that
you accepted that depositors of Northern Rock were
rational in rushing down to Northern Rock
following that announcement, was there any
consideration given that because of the impact of the
public statement there might be another way to do
this that would not have required such a public
profile for Northern Rock at that time?
Mr King: It was not obvious that the shareholders at
that stage would decide to take their money out. If
they had been reassured by the provision of the
facility and kept their deposits in then there would
have been no clash of that kind, but once some
people had started to do it—and this is the key
point—once some people had started to take their
money out did it then make sense for others to join
in. As I have said before, the only solution at that
point was a Government guarantee. But it is a big
step and to have done that at an earlier stage when
it was not strictly necessary might well have caused
wider problems and I think would have incurred the
diYculties and we now need urgently to get out of
this temporary position into a more stable long-run
structure for the legislation around banks.
Q111 Mr Love: Let me press you on that because the
statement yesterday about the three-month facility
you mentioned that because of the impact on the
banking sector but there are some concerns that it
specifically related to smaller banks—I will not
name them but they are being named regularly in the
press at the present time—to what extent was that a
consideration in yesterday’s statement?
Mr King: I am not going to go down the road of
individual institutions and you would not expect any
Governor to do that. We put that facility in place for
the reasons I gave. It was designed and structured in
a way that minimised the moral hazard but it
provides some liquidity to the markets at a point
when the strains seemed somewhat greater. I have
explained it was a balance of judgment and that was
the balance that we struck.
Q112 Mr Love: It would seem from all that we have
discussed here that the run on the Northern Rock
came as an enormous surprise to everyone. Should
we have expected it? Should it not have come as a
surprise? I know we have not had one for 140 years
but should the authorities, whichever of the three
tripartite authorities, have had a better judgment
about how the public would respond to these events?
Mr King: I think everyone knew that a run was a
possibility. The question was what could you have
done to avert it at that stage? It was not obvious that
the announcement of the lender of last resort facility
would prompt the run. It might have done the
opposite and actually reassured depositors. It did
not and at that point the guarantee was necessary.
Q113 Mr Love: Can I just stop you there because it
has been widely reported that the Bank expected that
the announcement would reassure rather than panic;
was that the case?
Mr King: Nobody could have known what the net
eVect would be. It did reassure wholesale funders to
Northern Rock. The situation on that front eased
after the announcement, but of course those people
were aware of the liquidity problems of Northern
Rock. I do not think anyone could have known with
any certainty at all what would have been the
consequences on retail depositors of the
announcement.
Q114 Mr Love: The interpretation put on
yesterday’s events is that everyone is chastened by
the experience of Northern Rock. Have you yet had
an opportunity to try and assess the reputational
damage that has been done to the British banking
system as a result of the first run for 140 years?
Mr King: I think that is what really matters and I do
not believe that in a year’s time people will look back
and say there was any lasting damage to the British
banking system. It is very well capitalised, it is very
strong, and, as I explained before, although the
banks at present are having to pay a bit more for
their liquidity than they would wish, they will be able
over the coming months to take these vehicles and
conduits they have set up back onto their balance
sheets and they will be strong. Headlines come and
headlines go and even television pictures come and
go, and I cannot believe and I do not believe that
there is any lasting damage to the reputation of the
British banking system, although I fully understand
that the impact of the pictures on television last
weekend came as a shock to many.
Q115 Mr Love: You said earlier on that your
concern, if I can call it that, about moral hazard
related to the seeds of future financial crises. Do you
perceive any negative eVects from yesterday’s
announcement of injecting liquidity into the market?
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
Will that create problems as you indicated both in
your statement to this Committee and publicly that
may have consequences further down the road?
Mr King: I think not. I think the banks in this
country realise that they have not been provided
liquidity for free. I think they understand the reasons
for the decision that was taken yesterday that they
would have to pay a penalty rate to obtain liquidity
from the Bank. I think that is appropriate and it is
appropriate because of the circumstances in which
we are providing it, with the realisation of risks that
the banks themselves took in full knowledge of what
the consequences would be. The one thing I would
like to say at the end is if these same problems were
seen in the banking system today and they had been
the result of some completely diVerent cause, say a
major terrorist attack, we would be injecting
liquidity at absolutely zero cost because that would
not be the result of the risks that the banks
themselves took. The reason for the penalty rate now
is not a punishment it is not to blame anybody; it is
simply to make sure that when people think about
the risks they are taking in the future they do so in
the knowledge that it is costly to take risks.
Chairman: Graham seeks clarification to one of
Andy’s questions and George has a short question
before I ask one final question.
Q116 Mr Brady: Just a very quick point of
clarification really to Sir John. You said that if you
had realised what the consequences would be when
you announced the facility on Friday you might also
have announced the Government guarantee then.
The Governor has told us that the question of the
guarantee was not discussed until Sunday. Can you
make it clear whether there was any consideration at
all on Friday or before that as to whether a
guarantee ought to come at the same time as the
facility was announced?
Sir John Gieve: We had of course discussed what
would happen if the negative news of the
announcement outweighed the positive news, and
obviously a Government guarantee was one of the
possibilities. But I think this the Governor was
saying that it was formally discussed as an action,
and whether we should take the action now or
tomorrow, on the Sunday. We did realise that simply
announcing that there was a new source of funds for
Northern Rock might not be suYcient to restore
confidence, but we thought there was a reasonable
chance that it would, and in any event it was the right
thing to do. They were having to make a profit
warning and I think for them to make a profit
warning without having clarity on their sources of
funding would have been disastrous.
Q117 Mr Mudie: All this discussion today has been
about the financial markets, but of course you are
here in a wider capacity and we are talking about the
real economy. I see that Kate has not said a word in
two hours and as she is the housing expert I would
say the number of repossessions on the latest figures
has gone up from 33,000 to 77,000 which means that
we are starting to get back into the very worrying
situation where we had the last negative equity
collapse. The Fed not only gave the financial
markets some help, which you might disapprove of,
but they also put some aid in on the mortgage side
to give some relief to people who were in danger of
losing their houses. A lot of these mortgages are subprime in this country and there were lenders who
would foreclose in the way the big banks would not.
I had a ten minute rule bill about it and I have
researched it. I know you are preoccupied with all
the financial markets but have the Treasury,
Financial Services or yourselves got it anywhere on
the agenda because it is a genuine problem where
people are losing their homes in greater numbers?
Have we got an agenda to see whether and what help
can be given to stave repossessions oV until the
market turns?
Ms Barker: I think the first thing I would say in
response to that is although it is certainly true that
repossessions have risen, they nevertheless remain at
relatively low levels.
Q118 Mr Mudie: They have more than doubled,
Kate.
Ms Barker: Yes, I realise that but relative to the
levels we saw in the last crisis, they are nothing like
so high, and the housing market itself, on the latest
figures we have, remains relatively robust, so I do
not feel that we are yet in a situation where we would
want to necessarily take those steps nor indeed
would I really be the appropriate person to carry
that forward.
Q119 Mr Mudie: But in terms of the wider
organisation then if you are not the appropriate
person to that, I disagree with you on the figures; the
figures are starting to be alarming. What you have
said is the conventional wisdom of three months ago
and they are more alarming set against the
background of what we have been discussing for the
last two hours, and there are a lot of people out there
in danger of losing their homes. If it is not on an
agenda and if you do not prove to be correct and the
numbers stay at this level, would you not think it is
an appropriate thing to start looking at to see which
is the appropriate agency, whether it is Treasury,
whether it is Financial Services, whether it is you, to
do something about it along the lines of the Fed?
Ms Barker: To go back on that, it is very diYcult to
take any pleasure in these numbers. These are very
serious events for the individuals concerned. I do not
feel however they are at the kind of levels I
personally would describe as alarming.
Q120 Mr Mudie: I know that and you said that. I am
saying if it turns out that they are—and we have
already heard and been critical of the lack of
activity—would you guarantee that we will have
some activity if the numbers keep at this high level?
Ms Barker: Again, I have to say, and it must be
apparent, I could not give that guarantee because it
would not be within my remit.
Mr King: We have two ways in which we can be
involved in this. One is that we will look carefully at
the credit conditions in the economy and the housing
market in making our judgments about interest
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
rates, and that is a key point. If we feel that there are
aspects of the housing market that require separate,
specifically tailored interventions, we can discuss
that with other government departments. It would
be quite wrong for me to—
Q121 Mr Mudie: No, I realise it is oV-the-cuV but
that second one is very useful. Will you undertake to
do that if the high figures continue and it looks as
though we are going to revert?
Mr King: I will certainly undertake to talk with
colleagues in government.
Q122 Mr Mudie: Thank you.
Mr King: One last point I would like to make is that
the United States does face quite serious problems in
its housing market which are of an altogether
diVerent order of magnitude from those here.
Q123 Mr Fallon: Governor, you have just said that
you expect the events of the last seven days not to
have damaged long-term confidence in the British
banking system. How much damage do you think it
has done to the reputation of the Bank of England
and your Governorship?
Mr King: I think only others can judge that. All I can
do is take the decisions that I think to be appropriate
in the interests of the country as a whole, to come
and explain that to you and others before this
Committee and elsewhere. You will have to make
that judgment, not me.
Q124 Chairman: Paul Tucker, you have discussed
the liquidity problems, you have done that all
morning but what are the markets saying about the
sub-prime credit problems? Are they going to wash
up soon and where are they going to wash up?
Mr Tucker: This goes to the point that the Governor
was just making. This is the underlying serious
problem and the data over the last few months has
suggested that it has got worse, and I suspect that the
Federal Reserve’s action on interest rates earlier this
week has partly been taken with that in mind. I think
one of the most important things now will be to see
whether the action that the Fed has taken starts to
stabilise the market in the US.
Q125 Chairman: What action are you taking, Sir
John, at the FSA? Have you got any anticipatory
action that you are taking on this? Do you vet it
very closely?
Sir John Gieve: On sub-prime within the UK as
opposed to the US sub-prime losses, the FSA has
been doing some intensive work on, if you like, the
riskier end of the mortgage market and you will see it
issued something just at the beginning of last month
about mis-selling and standards at that end of the
market. I would just like to repeat what the
Governor says that all the analysis that they and we
and I think outside commentators have done
suggests that the sub-prime problem insofar as it
exists in the UK is very, very much smaller than in
the US.
Q126 Chairman: 5% I think it was. Paul Tucker, you
are in charge of the market area. How long has
market chatter been going on about Northern Rock?
Somebody has described it to me as “a bright red
flashing light which the FSA did not look at” and
“they would not know a potential problem if it hit
them in the face”.
Mr Tucker: We do not focus on individual
institutions. We really do stick to our mandate under
the MoU and the market situation as a whole and I
have described and John and the Governor have
described—
Q127 Chairman: It does not give me much assurance
that you stick to your mandate because we ended up
with a crisis. As George Mudie said, we are looking
for some action from people to ensure that we do not
get into the diYcult situations, so sticking to your
mandate is a pretty unacceptable phrase.
Mr King: Chairman, there have been other
occasions when we have come before the Committee
where you have asked us the question “Is not that
going outside of your mandate?” We have been
given a clear mandate and our responsibility is to
meet our mandate.
Q128 Chairman: I understand, Governor, but the
fact of the matter, as I said earlier on, is here we have
a situation where we end up with problems that
aVect the whole financial system and it is how you
work that, that is what we are looking for; we are
looking for reassurance.
Mr King: I understand that and what I would
suggest is that you talk to all the players involved
and then reflect on it and make your judgment.
Q129 Chairman: We will do that. Are there any
others in potential trouble? You do not need to
name them!
Mr King: I think you know perfectly well that central
bank governors cannot go—
Q130 Chairman: Governor, I was not even talking to
you; I was talking to Paul Tucker.
Mr Tucker: Central bank directors take the same
approach.
Q131 Chairman: Okay. John Gieve, you say you
were alerted to the Northern Rock situation on 14
August. How many days have you been at the Bank
since 14 August? Has every day been a strenuous day
for you?
Sir John Gieve: No, I was not at the Bank on 14
August. I was away for two weeks in August, first at
a family funeral and then for a week in France.
Q132 Chairman: So you were away for three weeks?
Sir John Gieve: No, two weeks.
Q133 Chairman: So from 14 August you were away
until the beginning of September?
Sir John Gieve: No, I was back at the end of August.
I was in touch with the oYce. I discussed with the
Governor whether I should return. At that stage he
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Mr Mervyn King, Sir John Gieve, Mr Paul Tucker, Ms Kate Barker and Dr Andrew Sentance
thought that was not necessary. I therefore came
back before the beginning of September and of
course I have been here since.
Q134 Chairman: Okay. Are your FSA and Deputy
Governor roles at one? In other words, is the agenda
which the FSA has the agenda which the Bank of
England has at one? If we read some of the papers
yesterday we would be forgiven for thinking they
were not at one. What is your view as an ex oYcio
member of the FSA as well as Deputy Governor?
Sir John Gieve: I think, as the Governor said, the cooperation has worked extremely well and relations
are good and there has been no conflict. Of course
there are diVerent views between and within
institutions about whether we should do this or that,
but I think the tripartite arrangements have worked
well. Just on this red flashing light, it is easy to be
wise after the event but the markets through the
spring and early summer were not saying that
Northern Rock was a disaster waiting to happen and
it was not the institution that would be aVected by
problems in sophisticated credit derivatives.
Q135 Chairman: But there was market chatter.
Sir John Gieve: Market chatter accelerated through
August.
Q136 Chairman: Northern Rock increased its
mortgages threefold beyond anybody else in the
market. It had fewer deposits to which to have
recourse. In other words, it was almost wholly
dependent on going to the wholesale markets. Any
good risk director worth his or her salt would have
said, “Wait a minute, if we are dependent on one
variable here, if that goes wrong we are all up the
shoot,” so what we are really asking here is was the
FSA on the job, were you on the job in saying, “Wait
a minute, if things go wrong here, Mr Applegarth,
we are really in trouble.” You are not giving us any
assurance this morning that you were on the job.
Sir John Gieve: I first spoke to Mr Applegarth about
the facility we were going to operate on 10
September. It is not my job as a non-executive
director of the FSA to get involved in talking to the
risk managers and managers of individual banks,
but I do know that the FSA were very closely in
touch with them.
Q137 Chairman: Do not try and minimise this.
Sir John Gieve: I am not trying to minimise this.
Q138 Chairman: You are responsible for the
strategic focus, that is what it is, we are not asking
you to go into micro management, it is the strategic
focus, and we are asking you were you alert to that
and your answer given to us this morning is that you
were not doing much. In fact it seems to me that you
were pretty laid back about it.
Sir John Gieve: I do not agree with that. We were
alert to the dangers of the financial markets.
Q139 Chairman: I do not think you have convinced
this Committee.
Sir John Gieve: If you look at what we said in April
and what we said in a number of speeches, notably
the Governor’s speech just before the summer, it
could not have been clearer about the risks of
liquidity problems in financial markets. If you say
did we see exactly how it would pan out and why it
would impact on Northern Rock, which had no
particular sub-prime connections and credit
derivatives holdings, no, we did not see that, but of
course you are absolutely right—
Q140 Chairman: People were talking about
Northern Rock. They were talking to me about
Northern Rock and others were talking about
Northern Rock so it is absurd for you to come here
and say you did not know anything about it. You are
the guy in charge of financial stability. You have
twin hats on as the Deputy Governor of the Bank
and at the FSA and, frankly, I do not think you are
doing your job.
Mr King: Chairman, may I just say it is very clearly
not the job of the Bank or Sir John as a nonexecutive director of the board of the FSA to take
responsibility for individual institutions.
Q141 Chairman: Governor, understand this, we do
not want to be complacent here, there is a big picture
we have got to focus on but when we get complacent
answers it gets us riled.
Mr King: I do not think the answers are complacent,
with respect, and I would urge you please to suspend
your judgment about this until you have been able to
talk to all three parties in the tripartite arrangement.
Q142 Chairman: Okay. Sir John, lastly, are you
disappointed that market participants appear to
have taken no notice of comments made by you and
the Financial Stability Report warning of the
dangers of a change in the price of risk and the
illiquid nature of certain market instruments?
Sir John Gieve: Well, I think some of them took
more notice than others and adopted less risky
approaches, but, yes, obviously it would have been
better, and it is not just the Bank, it is the FSA and
other regulators too. Obviously looking back on it
they mispriced risks especially some liquidity risks.
Q143 Chairman: What lessons have you learned
from that?
Sir John Gieve: Well, I think two things. Firstly,
markets under the new sophisticated markets as well
as under the old banking markets, do get a
momentum of their own and the players fear more
the possibility of being left behind and losing
business than they fear the possible costs if
something goes wrong. That has been apparent in
other financial booms, if you like. I think a lot of
lessons have been learned about the details of how,
in particular, sophisticated derivative markets work,
and I think we will see in the market and among
regulators a number of changes in the requirements
on and structure of dealings.
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Q144 Chairman: Governor, this £10 billion facility
that was announced yesterday what about the point
of view from banks who say, “We are not going to
go near that money, we are not going to ask for it
because if we go for the money then there will be a
question mark about us and some people will say
there is a problem with our bank.” In other words,
there is a mark of Cain on people who approach you
for that money. How are you going to get over
that issue?
Mr King: This is an anonymous auction, we do not
reveal the names of the people who appear at the
auction.
Q145 Chairman: You do not think it will leak?
Mr King: I know this is a leaky world but frankly this
is about the only facility—
Q146 Chairman: You are sitting in the leakiest place
in the world here.
Mr King: That is why I am not going to tell this
Committee the names of the banks who will take
part in it.
Q147 Chairman: I hope that was not a snub,
Governor.
Mr King: We have designed this with a balance of
considerations and we are putting on the table some
liquidity. I would say one last thing, you put to Sir
John what lessons have we learnt, for me the key
lessen in all this is that I do not want to let down
those banks who did read our report and did get out
of profitable business in order to reduce the risks of
their activities, and what is most important now is
that we actually make clear to all banks that if they
undertake risky activities we cannot stop them doing
that and I do not believe you can get the regulators
to stop them doing that. The only thing that will stop
banks undertaking risky activities is the knowledge
that if things go wrong and the risks materialise they
and they alone will bear the consequences.
Q148 Chairman: Governor, thank you very much. I
have got a last question and, believe it or not, it is for
Dr Sentance, sorry, my apologies but in terms of
inflation what signals are you looking for that would
indicate that the credit crunches are having a
worrying eVect on the real economy and have you
seen any indications already?
Dr Sentance: I think it is very early to talk about
indications. I think so far the indications from the
real economy, if you take for example the most
recent CBI survey, do not show much impact but we
would expect it to take some time if there are going
to be impacts. I think the things we are looking at
where we expect these financial market
developments to impact are through the cost of
borrowing and through the availability of
borrowing in various forms, both to companies and
to individuals, so we will be monitoring that very
closely and Bank staV have stepped up the
information they are providing to us on the
Monetary Policy Committee on this issue. I think we
made clear in the minutes that we will be monitoring
very closely the price and the availability of credit to
see if it is being impacted. I think we have to have an
open mind at the moment and it will be the impact
on the real economy and hence on inflation that will
guide our actions on the Monetary Policy
Committee. In my mind that is very clear. We have
a mandate on inflation on the Monetary Policy
Committee. Clearly demand conditions overseas
and in the UK will aVect inflation prospects and that
is where we need to be looking to see if this is going
to have any impact.
Q149 Chairman: Governor, as I said earlier, as an
all-party Committee we are intent on ensuring that
we get to the root of this issue and the root of the
problem and for us that is to see that the system is
working properly. To date that has not been the
case. We want to work with you and others in the
future on that. As I said earlier, we are taking
evidence from the FSA very soon after the house
returns and then we will hear from the Treasury, but
as a result of today’s meeting I will also be writing to
the Chancellor and when we have heard from him
and sought wider evidence then we will no doubt
come back to you for further questions and perhaps
a further evidence session. Can I thank you and your
colleagues for your attendance this morning.
Mr King: Thank you very much, Chairman. Can I
say there is a very key area, as I stressed before, of
working together forward and that is the exit route
from the current Government guarantee, which can
only be an exit route to something better than where
we were before. This Committee has a very
important role to play in that and we would be very
happy to work with you on it.
Chairman: Thank you very much.
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Tuesday 9 October 2007
Members present
John McFall, in the Chair
Mr Graham Brady
Mr Colin Breed
Mr Philip Dunne
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr Siôn Simon
Mr Mark Todd
Peter Viggers
Witnesses: Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial Services
Authority, gave evidence.
Q150 Chairman: Sir Callum, welcome to the
Committee. Can you identify yourselves for the
shorthand writer, please?
Sir Callum McCarthy: Callum McCarthy,
Chairman of the FSA.
Mr Sants: Hector Sants, Chief Executive of the FSA.
Q151 Chairman: How much responsibility do you
accept as an organisation for the recent damage
caused to the UK financial system?
Sir Callum McCarthy: I think that you have to look
at the responsibilities of the FSA in relation to
Northern Rock in respect of two periods. One is the
way in which we discharged our responsibilities of
supervision up to the time when market conditions
became turbulent and diYcult in August and the
way in which we have acted since then. I am happy
to describe, and I hope our memorandum to the
Committee has described, how we went about it in
both those periods.
Q152 Chairman: How do you respond to the
suggestion by the BBA that “our reputation as a
country will not have been strengthened as a result
of the wall-to-wall coverage of the queues” at
Northern Rock?
Sir Callum McCarthy: I have made clear that I
regard the events of Northern Rock as having been
damaging.
Q153 Chairman: Do you think that the Bank was too
wedded to the concept of a moral hazard and that
liquidity operations should have begun earlier?
Sir Callum McCarthy: Those are questions which, I
think, have to be addressed to the Bank rather than
to the FSA, but I would say that our responsibility
in relation to the period when the diYculties of
Northern Rock became clear were essentially three.
One was to monitor the position carefully, the
second was to give advice to the Chancellor in
relation to insolvency and in relation to the systemic
importance of Northern Rock and the third was to
investigate whether there was a possible private
sector solution, and I think that we did all three of
those.
Q154 Chairman: The reason I ask that question, Sir
Callum, was quite simple. There was a Tripartite
agreement with you talking to the Bank, talking to
the Governor; so no doubt during these private
discussions you would have had a view on this
concept of moral hazard?
Sir Callum McCarthy: Indeed, yes, Chairman.
Q155 Chairman: What was your view?
Sir Callum McCarthy: I think that there it is an
important question of balance between the issues of
moral hazard, which the Governor addressed very
clearly in his memorandum to this Committee and
what I would call the problem of damaged innocent
bystanders in the sense that there is a problem
associated with a worldwide liquidity drying up,
which aVects not only people who have played a part
in arguably irresponsible behaviour, which is the
Governor’s concern, but much more widely in terms
of other people who can possibly be harmed by
that event.
Q156 Chairman: So you agree 100% with the
Governor?
Sir Callum McCarthy: No, the Governor’s
document was his document. I am saying it is a
question of balance.
Q157 Chairman: I am asking if you agree 100% with
the Governor on that subject.
Sir Callum McCarthy: I think that it is possible for
people to have diVerent views, and my own view of
the balance between the moral hazard arguments
and the other instances is slightly diVerent from the
Governor’s.
Q158 Chairman: In what way is it diVerent? Could
you speak up, please?
Sir Callum McCarthy: It is diVerent because I place
a slightly diVerent weight on the diVerence.
Q159 Chairman: In what way is it diVerent? The
reason I am asking this is to ensure that we get a
satisfactory solution to the future and we never see
a bank run again.
Sir Callum McCarthy: I very much hope that we
avoid future bank runs actually.
Q160 Chairman: What is the diVerence between your
view and the Governor’s?
Sir Callum McCarthy: The question that I was
trying to explain, Chairman, is the balance between
the moral hazard arguments, which are clearly
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Ev 22 Treasury Committee: Evidence
9 October 2007 Sir Callum McCarthy and Mr Hector Sants
important, and equally the importance of making
sure that when there is a liquidity problem there is a
means of dealing with it.
need to deal with the question of bank insolvency
problems and also the question of the compensation
arrangements.
Q161 Chairman: So I can take from that that you
would have dealt with it in a diVerent way from the
Governor?
Sir Callum McCarthy: No, I do not have the
responsibilities that the Governor has; I do not have
the requirement to weigh up the general monetary
policy questions that the Governor has to weigh. I
have a diVerent set of responsibilities.
Q168 Chairman: So the Market Abuse Directive was
an impediment?
Sir Callum McCarthy: We knew—. I do not think it
is simply the legal requirements of the Market Abuse
Directive which is an impediment.
Q162 Chairman: I understand. Did you ever conduct
a war-game type exercise of a similar scenario to the
Northern Rock crisis?
Sir Callum McCarthy: We have conducted a series of
war games but they have been diVerent because the
nature of the problem that we have dealt with in this
instance has been diVerent. What we have looked at
in the past has been institutional-specific problems,
whereas this has been a very diVerent sort of
problem. It has been a worldwide drying up of
liquidity, and that gives rise to very diVerent
questions.
Q163 Chairman: You conducted war-games
scenarios for avian flu. Is that correct? Did you
conduct any war-game scenarios for a run on a
bank?
Sir Callum McCarthy: Yes.
Q164 Chairman: So why did not things operate
smoothly then?
Sir Callum McCarthy: Because the circumstances
that we looked at—
Q165 Chairman: Because war-games are of no use?
Sir Callum McCarthy: No war-games are useful. I
think that the ability of us to work together has been
significantly improved by the fact that we have
practised. It is almost impossible to anticipate in
advance the particular circumstances of any
particular crisis.
Q166 Chairman: Why did you not discover the
problems of launching a covert lender of last resort
operation in the war-game simulation?
Sir Callum McCarthy: The positions that we looked
at were rather diVerent from the position that
occurred in relation to Northern Rock.
Q167 Chairman: The Governor said to this
Committee that he stumbled on four pieces of
legislation which frustrated his ability to support
Northern Rock in his preferred covert way. Do you
agree with the Governor’s interpretation on those
four pieces of legislation?
Sir Callum McCarthy: I agree with him that each of
those four problems are significant problems. I
would add that when we conducted a particular
exercise with the Treasury and the Bank in February
we had identified in particular the problem of having
a means of dealing with banking problems and the
Q169 Chairman: I did not say that.
Sir Callum McCarthy: I think there are also a variety
of other practical questions which made covert
operations diYcult.
Q170 Chairman: Let me focus on the Market Abuse
Directive because the Commission came out with a
statement that was contrary to what the Governor
said. Was it flashing up in red lights to the Tripartite
body that the Market Abuse Directive was an
impediment and something had to change there?
Sir Callum McCarthy: No. I think that what was
clear to the tripartite authorities, and certainly clear
to us, was that there would be obligations of
disclosure on a publicly quoted company which
would have to be taken into account.
Q171 Chairman: But it was not a complete
impediment?
Sir Callum McCarthy: The obligations for
disclosure are very much specific to the
circumstances of any case. It is impossible to say in
all circumstances.
Q172 Chairman: With Northern Rock was it not an
impediment?
Mr Sants: If I might just explain a little bit further.
As Sir Callum has indicated, each individual
judgment has to be situation specific. It was certainly
known to us both during any war-games and, of
course, generally during the course of our normal
business that there would be certain sets of
circumstances which would require disclosure. The
disclosing circumstances revolve around, of course,
the extent of the support being oVered and the
relevance of that support to the long-term viability
of the company and in terms of the knowledge in the
market place at that given point, and so, of course,
the nature of support which came into play would
have an impact on its future profitability and so
forth. So there are a set of inter-related
circumstances which determine whether a support
operation of that type needed to be disclosed at
that time.
Q173 Chairman: I understand, but I am trying to get
a simple answer to this. When the Governor came he
said “there were four pieces of legislation here that
stopped us in our tracks”. The Market Abuse
Directive was mentioned. The reason I am asking
this is quite simple, Sir Callum, because the
Governor said that this took place in 2005, I think.
If that was a big problem, (a) was everyone in the
tripartite agreement alive to that and (b) if they were
alive, was some legislative programme implemented
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
to change it so that in your war-games, when you are
doing your simulations, you say, “Look, if a bank
run occurs, then this Market Abuse Directive is a
problem and we really need to get on top of that”?
Sir Callum McCarthy: The point I was trying to
make, Chairman, is that there is a legal position
which, as Hector has explained, is specific to any set
of circumstances. It does not necessarily mean that
in every single circumstance there would have to be
an announcement. With the position of Northern
Rock, in the particular circumstances, the Northern
Rock Board took the view that they had to make an
announcement and we believed there was no legal
basis for preventing them. If I look quite apart from
the law, there is also a series of practical questions
which I think also have to be recognised—for
example the need to discuss funding with credit
rating agencies, the probability that that would
become public by a diVerent route—so there are
both legal and practical questions which are
important.
Q174 Chairman: So there was no legal impediment
in terms of the Market Abuse Directive?
Sir Callum McCarthy: I am not sure what the legal
impediment is to.
Q175 Chairman: In other words, the Market Abuse
Directive was not stopping everything happening in
terms of the Northern Rock situation?
Mr Sants: In those particular set of circumstances
we saw no reason to disagree with the Board’s view
that it was necessary for them to make an
announcement. Of course to some degree this is a
moot point, because once it had been leaked the
night before they certainly had to make an
announcement in relation to that set of
circumstances.
Q176 Chairman: In a sense there is simplicity to this,
that if the Market Abuse Directive was a problem, it
was discussed in 2005 and nothing was done about
it, then you were behind the curtain?
Sir Callum McCarthy: The point that I am trying to
make, Chairman, is that there were disclosure
obligations, which we accept, which have been
accepted by the British Government and the British
Parliament. There was also a series of practical
questions and, as Hector has just said, the important
thing (I think it bears out my point about the
practical importance of these constraints), the thing
that actually happened in relation to Northern Rock
was the leaking of this information on the evening of
13 September and the coverage of that in the news.
So, irrespective of whether we had sought to conceal
it or not, it was actually in the public domain.
Mr Sants: I think it would be clear to us that it was
not going to be the case that all support operations
could be covert. It would be clear from the Market
Abuse Directive that there would be sets of
circumstances when that was not going to be
possible, and that would be clear from the point the
Market Abuse Directive came into force.
Q177 Chairman: Would you have preferred a covert
lender of last resort operation to save Northern
Rock?
Sir Callum McCarthy: I think that if that had been
a practical possibility it would have had some
attractive features. Unfortunately it was not a
practical possibility.
Q178 Chairman: Sir John Gieve is a non-executive
member of the FSA Board, due to his position as
Deputy Governor in charge of financial stability.
How well did having this connection work during
the crisis?
Sir Callum McCarthy: Perhaps I could just explain
what we have done to strengthen the links between
the Bank and the FSA in relation to financial
stability questions. We have ensured that there is
FSA representation or attendance at the Financial
Stability Board at the Bank, which looks at largely
the macro-economic questions associated with
financial stability although the Bank has a very
specific set of responsibilities in relation to payment
systems because so many of the important payment
systems pass across the balance sheet of the Bank.
They also have particularly important positions in
terms of various international bodies. They are, for
example, leading the work in Basle on liquidity. In
terms of the FSA one of the things that I arranged
was for the Risk Committee of the Board to have
John Gieve on it to ensure that there was a proper
interlinking between the analysis that is made at the
Bank and the analysis that is made at the FSA. If I
look at the actual work during the time of the post 9
August problems, I think that the clarity of
information between FSA and bank was quite clear
and I think that the transmission of information in
both directions worked well. From essentially 9
August we set up a daily Tripartite meeting in which
we compared notes and information and identified
problems. So I think that overall those arrangements
worked well.
Q179 Chairman: Sir John gave us the impression
that the FSA Board on which he sits was not greatly
engaged. Sir Callum, you sit on the Court of the
Bank of England. Do you believe that the Court
non-executives were kept fully informed and
consulted throughout or were the independent
members equally supine?
Sir Callum McCarthy: I am sorry, I would like to
make clear that I would not accept in relation to
FSA non-executive directors the adjective supine. I
think that the non-executive directors of the FSA do
the task that they are required to do and that is not
a detailed involvement in particular decisions in
relation to the firms in the most part.
Q180 Chairman: Were the non-executives in both
the FSA and the Court of the Bank of England kept
fully informed at all times on this issue?
Sir Callum McCarthy: Can I explain what we did in
terms of the FSA? After the liquidity problems
developed in August I wrote to all Board members
explaining what we were doing. I wrote to them
again in September and gave them a warning that we
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
had a particular problem with an unnamed
institution. We briefed them on 13 September and
there have been, since then, a series of board
meetings in which aspects of Northern Rock have
been discussed.
Q181 Chairman: Back to the initial question: do you
believe that the non-executives in both the FSA and
the Court of the Bank of England were fully
informed at all stages?
Sir Callum McCarthy: I believe, if I can speak for
the FSA—
Q182 Chairman: You can speak for the Court of the
Bank of England because you are on that.
Sir Callum McCarthy: Yes, but I do have some
specific responsibilities as Chairman of the FSA
which are diVerent from my responsibilities as a
member of the Court; but if I speak as the Chairman
of the FSA in relation to the FSA Board, I believe
that they were appropriately involved at all stages.
Q183 Chairman: Appropriately?
Sir Callum McCarthy: Yes.
Q184 Chairman: The Court of the Bank England,
giving you a non-executive role there, were they kept
informed at all stages.
Sir Callum McCarthy: They were informed and took
a particular decision, which was an important
decision of the Court, at a Court meeting on the
evening of 13 September.
Q185 Chairman: One final question from me. On the
day we had the Governor of Bank of England in (20
September), the Financial Times did a front-page
story where it was talking about property: “Hector
Sants urged the banks to lend to each other, but Mr
King did not respond fully.” Why did your spinners
in the FSA feel it was necessary to go to the Financial
Times that morning before the Bank of England
came along?
Sir Callum McCarthy: I am sorry, it is not a
reporting of events that I understand. I believe that
that refers—
Q186 Chairman: John must have been telling me the
FSA’s risk people and spinners were out fully just
before they came to our Committee. That just seems
to undermine the Tripartite agreement with the
Bank of England that the FSA are supposed to work
in tandem?
Sir Callum McCarthy: All I can say, Chairman, is
you are making statements which I do not recognise.
Q187 Chairman: You should read the Financial
Times of 20 September. If you read those statements,
you would see yourself that it was the FSA getting
their oar in first.
Sir Callum McCarthy: I repeat, these are allegations
which I do not know.
Chairman: I do not think you can react as simply as
that, Sir Callum, when you read that report.
Michael.
Q188 Mr Fallon: Could we turn now to the events
leading up to this fiasco. In your letter you admit
that you had not carried out a full risk-assessment of
Northern Rock since February 2006.3 That is 18
months ago. Why was that?
Sir Callum McCarthy: Because it is—. I think I
would draw a distinction between the formal
examination that we do under something called an
“Arrow process” which, as you say, was carried out
on a particular date, and the interim work that was
done. If I may, I will ask Hector to describe that
interim work.
Q189 Mr Fallon: I just want to know why a full
assessment was not done in the 18-month period
between the last one and the problems that Northern
Rock ran into?
Mr Sants: I will be happy to answer that. There are
two points to make, first of all. The full arrow
assessment, even for high impact firms under close
and continuous supervision, of which Northern
Rock is one, is not done at a frequency greater than
every 12 months or so in terms of normal practice.
Q190 Mr Fallon: Every 12 months?
Mr Sants: Between 12 and 18 months. The most
frequent assessment we would do would be 12 to 18
months. What we do, however, is engage very closely
with specific thematic issues of concern, and
Northern Rock were regularly visited by
supervisors, roughly speaking (and I do have a full
list here), on two to three months or so intervals. If
I may finish, I would like to say something about our
supervisory practices.
Q191 Mr Fallon: Can you just answer the questions
that we put to you. I want to know when was the next
full assessment due?
Mr Sants: The next full assessment due would have
been three years after the one in question, and, in my
opinion, that is inadequate.
Q192 Mr Fallon: You are dealing with a bank which
is lending quadrupled from 25 billion to 100 billion,
that was taking one in five of the mortgage market,
and you only did a full assessment every three years.
Mr Sants: As we lay out in the statement we put
before you, I completely agree with you. I think
there are lessons to be learnt here with regard to our
supervisory practice and I think we do need to look
back over our engagement with this particular
company and do a lessons-learned exercise,
particularly with regard to particular areas. I think
we need to look into our assessment of probability
with regard to the set of scenarios that actually did
develop. We did have this organisation as a highimpact organisation, but in terms of the probability
of it getting into diYculty we had it as lowprobability, and there was no question, of course,
looking at the way events transpired, that that
probability analysis has been proved to be incorrect,
so we had some serious lessons to be learned in terms
of the way we went about measuring our probability,
3
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
and linked into that, which I think links into your
point about the Arrow risk assessment, which I
completely agree with, is that we need to look more
carefully at the stress testing issues in relation to this
company. I think the question is not: did we
understand the Northern Rock business model? I
think we did completely understand the Northern
Rock business model and I would not, by the way,
agree with your analysis of how the Northern Rock
business model worked, but what I would agree with
absolutely is that we did not engage in our
supervised process in a way to my satisfaction with
regard to the stress testing scenarios, because the
stress testing scenarios which they were operating
with did not envisage the set of circumstances that
transpired in August, which was complete closure to
them of all reasonable funding mechanisms,
including the repo market. I have to say, I do not
think any reasonable professional would have
anticipated that set of circumstances, but I think as
a regulator we should have engaged with that in an
extreme stress test. Indeed, we had been saying over
the previous period, in anticipation of market
conditions declining, that we wanted firms to take a
more extreme view of their stress testing; and we had
that engagement with Northern Rock in July when
we went to visit them with regard to their stress test
and pointed out that we were not comfortable with
their scenarios, but, regrettably, as is apparent to us
all, that was rather late in the day. So, we take the
view that we should look at our supervisory
practices and we agree with you to that point.
Q193 Mr Fallon: That is quite a long answer. Could
you answer the questions as briefly as you can? You
have a budget of 300 million; you employ 2,659 staV.
How many were supervising Northern Rock?
Mr Sants: In terms of direct supervision it, it would
be three, which is standard practice for high impact
firms, and, of course, they are drawing on groups of
specialist individual in the area such as stress testing
and risk-management and these areas would also
contribute to the visit programme.
Q194 Mr Fallon: Was Northern Rock treated as a
small bank?
Mr Sants: No, it was treated as a high impact bank
under close and continuous supervision—one of our
top 160 high impact close supervision
organisations—so it was treated at the same level as
the other major UK banks in terms of its supervisory
engagement.4
Q195 Mr Fallon: Why do you think now its exposure
to a freeze in new securitisations was not picked up
earlier?
4
Note from witness: I commented on the number of the FSA’s
high-impact supervision organisations which were similar
to Northern Rock. The number I provided was actually
the number of high-impact assessments (ie the same as
Northern Rock) that the FSA was carrying out at that
time; this is not the same as the number of high impact
firms. The number I provided—160—was not current.
The correct figure should have been 131.
Mr Sants: As I said before, I think that the set of
circumstances that transpired in the market were
highly unusual and was not, I think, in fairness,
anticipated by any regulators around the world; nor,
indeed, if you look at the individual commentators.
Some, of course, or a number, may have been
pointing out the share price was too high; there was
nobody really anticipating that set of circumstances.
It is not just a question of the securitisation market
being closed to them for a prolonged period, it is also
a question of other mechanisms of wholesale
funding, in particular the repo market being closed.
As we indicated, they had high quality assets—there
is no suggestion here this is an organisation taking
on poor quality assets—and it really is an
extraordinary set of circumstances which lead to
them being unable to repo those assets for a period
of six weeks or so as well as the combined closure of
the securitisation. One final point, if I may, because
I think it is important to understand, they did not
actually have a complete closure of the wholesale
funding market here. As we pointed out in our note,
what happened was the duration of that funding
shortage shortened to the point that they were
funding over night. They were not not funding this
themselves. What happened, however, was that with
the duration shortening the Board very properly
(and I think quite rightly, and we would agree with
that) took the view that they needed the insurance of
opening up a facility with the Bank of England. They
would not have had to use that facility, or it may well
have been that they would not have had to use that
facility unless there had been a retail run. So, to
focus solely on the securitisation issue and the fact
that market was closed as the sole driver in the set of
circumstances that have taken Northern Rock to
where it is now would be incorrect. We need to look
at it as a combination of circumstances which
included the retail run as a major driver of their
problem. They were not using the Bank of England
facility until the retail run.
Q196 Mr Fallon: Why were they allowed a waiver
under the Basle II Directive? Why were they allowed
a waiver in June?
Mr Sants: The Basle II waiver is standard procedure
of the implementation of the CRD and was the
standard procedure we were going through with any
bank who wished to apply for one at that stage. The
actual change in their regulatory Basle II surplus at
that point as a result of that waiver was only some
30 million, which I do not think in the context of the
problem that we are talking about is significant. It
was basically a standard process. It should not be
seen as a one-oV special exercise on their behalf.
Q197 Mr Fallon: But in their interim report it says,
“This means that the benefits of Basle II enable us to
increase our 2007 interim dividend by 30%. You
allowed them to weaken the balance sheet and, as a
result, they increased their dividend?
Mr Sants: It clearly is the case, as the statement
makes clear, that it gave the Board confidence in
relation to their dividend increase, or at least that is
how the statement describes it, but I will be clear,
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
under their Pillar 1 capital, even under Basle I, they
could have paid that dividend. As I say, this was a
standard procedure that we were going through at
that time in terms of implementation of the CRD.
Q198 Mr Fallon: Paul Tucker from the Bank sent
you a memo in early July warning of the potential
dangers of a liquidity freeze. Why was nothing done
until early August when the retail market dried up?
Mr Sants: It was actually 1 August, the memo in
question, and I completely agree with the contents of
the memo. Indeed, as we pointed out when I took
over the chief executive role at the end of July, I
made a great point in the press conference that I
thought market conditions were deteriorating. I do
not think that the content of the Paul Tucker memo
is materially diVerent from the general sentiment
that I was expressing in that press conference. I
completely agree with him. I think, once we saw the
beginnings of the problems in the US sub-prime
market beginning to develop, it was reasonable to
assume that we were moving into a more diYcult
period here in the UK and, as I have mentioned
earlier, we did already step up our engagement with
the market place, convening more regular meetings
around the current issues, and as I mentioned earlier
as well, we were actually in dialogue with Northern
Rock over their stress testing scenario during the
course of July. Paul Tucker’s memo I say is actually
the first week of August.
Q199 Mr Fallon: But there was already a profits
warning from Northern Rock; you had the memo on
1 August; why did it take until 14 August for you to
alert the tripartite and Treasury ministers as to the
problems that Northern Rock had? Why was there
a gap?
Sir Callum McCarthy: I was simply saying that it
was the events around 9 August which resulted in the
fundamental drying up of so many markets, both in
terms of securitisation and asset-backed,
commercial paper, asset-backed, and in so many
geographical markets and currencies, and I think the
speed with which we have responded to that is
perfectly reasonable.
Q200 Mr Fallon: Why was there a five-day gap from
9 August to 14 August before you alerted the
Treasury?
Sir Callum McCarthy: Because the identification of
Northern Rock was a reasonable thing for us to
consider. The ninth to the fourteenth does not seem
to me of particular materiality in this. You may take
a diVerent view.
Mr Sants: If I can maybe amplify a little bit.
Certainly as of the ninth we were in regular
discussion with Northern Rock in monitoring their
liquidity, but if you look at their liquidity
availability in terms of days, which is a way of
looking at their liquidity regime, you are not actually
looking at a significant deterioration in their profile
until well after 14 August. So we properly identified
that, because of their dependence on securitisation,
which required them in general to do around £5
billion of securitisation in a quarter, with the closure
of the markets this was potentially an at-risk firm,
but the actual deterioration in the profile does not
occur until well into September and, indeed, it was
not until 10 September that they reached a
conclusion that securitisation was not going to be
possible. They were actually in negotiation, as you
know from our memo, with a number of banks
about the possibility of doing under-written
securitised transactions during that period. So, in
terms of alerting the Treasury to the fact that we
anticipated a significant issue with Northern Rock,
which was done by myself on 15 August, I would say
that was very early to alert them to specific concerns
about a specific firm in the light of the liquidity
information we had available and not in the light of
our knowledge of the business model. So I think we
very quickly identified that that business model was
at risk. Also in passing, whether we had told the
Treasury on the fifteenth or a few days earlier would
not have made any diVerence to the set of
circumstances that transpired.
Q201 Mr Fallon: Sir Callum, you were quoted on a
BBC website in September as describing Northern
Rock’s heavy reliance on short-term loans to fund its
mortgage business as “extreme”. When did you first
come to the conclusion that Northern Rock’s
business model was extreme?
Sir Callum McCarthy: I actually said the business
model was extreme but it was in relation to the fact
that they had a heavy dependence overall on what I
will loosely describe as wholesale funding. Their
overall pattern of funding was around more 70%
from securitisation, covered bonds, long-term, and
in that respect they are an outlier in terms of most
British banks, though not necessarily banks in other
countries. I would point out that that is not
necessarily a source of vulnerability, the long-term
funding, because those long-term funds can match
the assets that people have.
Q202 Mr Fallon: What is the answer to my question?
When did you first realise that this model was
extreme?
Sir Callum McCarthy: In terms of its reliance on
securitisation in terms of the overall balance sheet,
that was something that was well-known. I do not
know what time in the last two years, three years I
became aware of it, but it was well-known that that
was a particular feature.
Q203 Mr Fallon: You were in charge of supervising
Northern Rock, you were aware that its business
model was extreme, yet over the last two years
nothing was done to prevent this particular crisis.
Sir Callum McCarthy: No, that is not a description
of events that I would recognise. I have tried to
explain that my comment on “extreme” related to
the overall balance sheet of Northern Rock. The
particular problem, as Hector has explained, related
to the short-term funding, and the short-term
funding is a problem which has been acute but has
been caused by the fact that they had access to
securitisation, to covered bonds, to commercial
paper and had high quality assets to repo, and they
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
did that in euros, in dollars, in sterling, and all those
markets, including the repo market, closed and that
is an exceptional, indeed unprecedented, set of
events to have occurred for the duration and severity
that has occurred. I absolutely accept, as Hector has
said, that we did not identify the probability of that
happening. I would also say that very few people and
no regulator that I know anywhere round the world
have succeeded in identifying that.
Q204 Chairman: To clear up, Mr Sants, you said you
had three supervisors for high impact banks of
which Northern Rock was one and there are 160
institutions that are high impact. Is that correct?
Mr Sants: Yes, I am saying that depending on the
high impact institution, the number of supervisors
tends to vary between about two and six so three was
a fairly standard number within our normal range
for high impact banks. Even the biggest UK
financial institution would not have more than six or
seven supervisors.
Q205 Chairman: I have spoken to a number of the
biggest UK financial institutions in the past week in
preparation for this inquiry and one of them in
particular told me that FSA have had a line sideteam dedicated to them and over a year they could
see 1,000 to 1,200 people in the FSA in terms of
supervision. The group risk director is almost in
intimate contact with the FSA almost on a daily
basis and the FSA are coming in for themed visits—
for example safety, private equity—so there is
intensity there. That was described to me, that
intensity. Are you saying the same intensity was
provided to Northern Rock?
Mr Sants: I am saying that certainly in the period in
question during the second half of 2006 and early
2007, yes, I was answering the very direct question,
possibly not giving a full answer in that respect of the
precise number of dedicated supervisors in our
supervisory group, but the supervisory model is like
that of other investment banks, as I have indicated
earlier, namely you have coverage supervisors, you
have the relationship with the bank and then you
have a series of specialist teams who regularly visit
the bank on particular issues. So, the question, for
example, of stress testing would be addressed by a
specialist team who come and visit to look at the
stress test, and that was the visits that were carried
out in this case in April and May 2007 and, indeed,
we also have teams looking at the securitisation
process and so forth during that period. So, if you
are asking the question about the total number of
people involved in the FSA engaged with Northern
Rock, you would have a much higher number.
Q206 Chairman: The question I am asking, before
we go on, was it of the same intensity as your
relationship with say the big banks?
Mr Sants: Yes, for our high-impact institutions we
have the same coverage model, which includes all the
specialists that you refer to.
Q207 Mr Todd: Can I get some procedural stuV
straight. In your annual report you refer to stress
testing: “We reviewed the stress testing practices in
ten large firms in the banking, building society and
investment bank sectors. Was Northern Rock one of
those ten?
Mr Sants: No, it was reviewed in May.
Q208 Mr Todd: So it was reviewed after this report
was concluded?
Mr Sants: Yes.
Q209 Mr Todd: So you did have a stress test under
this model that is referred to in your annual report
in May?
Mr Sants: We reviewed their stress test in the context
of their Basle application, and it was that review
which led to the conclusion being reached in July,
which I referred to earlier, that their stress testing
could take into account more extreme scenarios than
they were and, as I have already acknowledged in the
earlier statement, I think, in terms of our lessonslearnt exercise, we do need to return to our
supervisory engagement with the stress test.
Q210 Mr Todd: You have said what is later said in
your annual report in the same paragraph in which
you say (and this was after seeing the ten firms which
did not include Northern Rock, and so presumably
you had already worked out some of the
inadequacies in your stress testing then) that further
improvements were needed, particularly where firms
were not fully taking into account severe but
plausible scenarios when making strategic all-risk
management decisions. So you already had some
intelligence from the stress testing models that you
had applied elsewhere than Northern Rock on the
perhaps limited compass of that exercise. Did that
not give you any hints as to the insight you ought to
apply to a business model which I think Sir Callum
was not alone in regarding as an outlier in this
market place?
Mr Sants: I agree with you. As I said before, if you
look at the type of stress test Northern Rock was
using, they were not anticipating closure of the
securitisation market and the repo market. The only
set of circumstances actually which they had in
which those type of closures occurred were
operational failures rather than market failure and,
as I said earlier, I think that type of scenario should
be in a stress test; and we would like to see more
extreme stress tests and we were making those
points, as you kindly point out, in the document in
question, and it is incumbent on us to make sure that
we carry that through with all the major firms that
we regulate, and I think that lessons learnt point, as
I have said before, needs to be picked up in our
supervisory practices and we will be returning to—
Q211 Mr Todd: My point was a slightly diVerent
one, which was that from what one can understand
from your annual report, which refers to a period
before this, you were already learning some of those
points about the lack of testing of severe but
plausible scenarios. Presumably this particular
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scenario did not fit into your category of severe but
plausible. You regarded it as wholly implausible,
did you?
Sir Callum McCarthy: I think it was unprecedented,
and I would say that we have for some time been
emphasising the importance of severe but plausible.
I would also point out that that is a matter of
judgment, it is particular to any institution and it is
quite diYcult to decide what level of stress to test
against.
Q212 Mr Todd: Can I follow this line of argument a
little further? We have got again in your Annual
Report, if you turn to 66, 67, the role of the Risk
Committee of the FSA—and you have already
referred to one of the august members we met
earlier. In the list of risks that the Committee does
consider one can see some resemblances to some of
the issues that have occurred in this particular case.
Is it perhaps the case that this Risk Committee
treated this as a rather academic exercise of running
through risks in a routine way or did not actually
consider this in the depth that one might expect?
What was this risk committee actually up to?
Sir Callum McCarthy: Perhaps I could describe the
Risk Committee of the Board. It is chaired by Hugh
Stevenson; its members are Deidre Hutton, Peter
Fisher, who is ex New York-fed, New York based,
both an ex-central banker and an investment banker
nowadays, David Miles, whose proper title, I think,
is the European economist for Morgan Stanley, and
John Gieve.
Q213 Mr Todd: They are not lightweights.
Sir Callum McCarthy: They are absolutely not
lightweights and were carefully chosen for that
reason.
Q214 Mr Todd: They have big reputations anyway!
Sir Callum McCarthy: If I may say so, the idea that
they were looking just at what I think you described
as academic points is absolutely not the case. They
looked at a variety of issues and those included the
credit risk, derivative risk, the sub-prime risk in the
US; so they were examining those—
Q215 Mr Todd: I have got that. We are tight for
time. I just want to explore the linkage between your
Risk Committee and the stress testing models that
you have used. Is there some linkage? You have just
touched on one issue, sub-prime markets and its
possible implications. Is there any linkage in which
the risk committee communicates to those who
deliver this process on the ground?
Sir Callum McCarthy: Yes, indeed. One of the
responsibilities of the Risk Committee is to examine
the way in which the FSA mitigates against the risks
that have been identified.
Q216 Mr Todd: You prepare fact books. Was there
a fact book on Northern Rock?
Mr Sants: A fact book is a very particular statement
about a particular set of data which we are preparing
for the Tripartite, and that is an electronic set of data
which is held on a particular IT system and is not yet
completed for any institution currently in terms of a
central IT depository. We carry data of the same
nature on all major high-impact institutions. So the
answer in that sense is yes.
Q217 Mr Todd: I am sorry, the answer is yes but you
sound as if you are at an early stage. It sounds as if
the answer is no actually.
Mr Sants: I am slightly confused by your question.
If you are asking me is the FSA holding the same set
of data on Northern Rock as it does on the other
major UK institutions, the answer is yes. If you are
asking a very particular question about an IT
system, the answer is no because it is not generally
ready, it is in development.
Q218 Mr Todd: Even though actually this was
referred to as to something that was needed back in
October 2005?
Mr Sants: Yes, I agree. It would be a useful tool for
speedy decision-making.
Q219 Mr Todd: It is one of these projects which is
rolling away gently in the background.
Mr Sants: Yes. It would be a useful tool for speedy
decision-making, but in the context of this issue,
which arose over a long period of time, I do not think
it is a relevant gauge of our handling of it.
Q220 Mr Todd: When Michael was asking you
about Basle II he perhaps did not ask you a rather
blunt question because you, I must admit, implied it
was a box-ticking exercise; the normal sort of thing,
“We thought that was okay and would not have
made any diVerence anyway because it was a small
sum of money.” Is that the way you appraise your
approach to this? It was delivered actually only
shortly before the crisis hit this business and it did
give a signal of apparent health. I do not know
whether you recognise that, particularly the way the
company responded, which was bumping up their
dividend. Do you appreciate the linkage between
your decisions and market reactions to what a
company does?
Sir Callum McCarthy: Could I explain a little bit
about the Basle I to Basle II change, which is to try
and have a much greater granularity and a much
greater accuracy for the estimate of the capital that
individual financial institutions require. I do that
because I think the description that you gave of it as
a box-ticking exercise is absolutely incorrect. It is a
rather detailed analysis but it was concerned with
capital and the capital requirements of Northern
Rock have remained intact during the whole of this
period. So, this is not a capital requirements
problem, this has been a liquidity problem and the
fact that Hector has said, I believe completely
correctly, that the change is immaterial to the
problem should not be taken as in any way saying
that we treated this in a lightweight way.
Mr Sants: If I could be clear here, if the issue is
whether the CRD or Basle, which, of course, is a
European directive and international agreement, is
relevant here, then we need to bear in mind that we
are talking about a liquidity issue here, not a credit
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
issue, and we actually do agree that the liquidity
regime should be modernised. We do not want to in
any way not indicate there are some other lessons to
be learnt here.
Q221 Mr Todd: Let me turn to the liquidity issue.
You have just sent out liquidity questionnaires to
banks and building societies.
Mr Sants: With due respect, I think that is a
misreporting by the press.
Q222 Mr Todd: Let us get the record straight then.
Mr Sants: I think the press were a little confused in
that particular case. Obviously, from the moment
that the market conditions deteriorated, we
intensified our liquidity communications with the
major institutions. That was being done on a regular
basis. I think the press either picked up on the fact
that that was one of the weekly reports that we had
requested or, and I hesitate—
Q223 Mr Todd: So you have not changed your
practice at all?
Mr Sants: We have significantly increased our
practice from the beginning of August, and they only
noticed it when they reported that article and gave
the impression that was the first time that we had so
done. Or else, I think they may have possibly
confused it with a diVerent piece of paper that we
had recently sent out to some sub-prime lenders. So
I think, to be honest, it was a complete misreporting
of the facts.
Q224 Mr Todd: It sounds as if there was something
there actually.
Mr Sants: With due respect, no.
Q225 Mr Todd: Obviously you have explained that
it was not an entirely novel activity, and I would
have been shocked if it were, but the impression one
gets is that you have significantly ramped up your
activity since August.
Mr Sants: Yes.
Q226 Mr Todd: So the point stands that clearly you
felt that you had inadequate intelligence on this.
You have correctly drawn the distinction between
the capital base of the business and liquidity, but the
important issue of liquidity was an area where your
intelligence was presumably relatively weak before
August because otherwise you would not have been
significantly improving the catch on it now?
Mr Sants: No, I think that is not right, is it? What we
are trying to do is monitor regular and get a real-time
feel in a crisis. You would expect us to respond to a
crisis diVerently than the way we respond to business
as usual. I think you would not expect us to be
asking for minute to minute, real-time information
from our banks in normal business, in usual
circumstances. I think you would feel that was over
regulation. In the circumstances of a crisis you
would expect us to be carefully monitoring their
liquidity positions, as we were doing.
Q227 Mr Todd: But obviously not as carefully as you
now are. Mr Sants, I think it would be helpful,
bearing in mind the time, if you can produce a paper
for us on the distinction between your practice
before this crisis and your practice now so we clearly
understand your point about the press not
understanding quite what you were doing.
Mr Sants: I would be very happy to do so.
Chairman: Again, it amuses some of the large banks
because they mentioned to me that this
questionnaire seemed a bit monotonous. So it is very
important, Mr Sants, that we probe that because we
will be coming back to these things in the future and
no doubt we will be seeing you again sometime.
Q228 Mr Breed: Briefly, because we have
concentrated rather a lot on one side, obviously
liquidity and the liabilities, but it has been said by
you this morning and, indeed, in the Chancellor’s
written statement yesterday that Northern Rock had
a good quality loan book. There are various tests of
that and one of the essential tests would normally be
arrears, repossessions and so on. It does seem
somewhat strange to many of us that an
organisation which has a lending criteria somewhat
outlying, reported to be five or six times income and
such, even lending up to 125% of the property,
apparently has arrears statistics and repossession
figures somewhat lower than the industry average,
and that does not seem to ordinary, sensible people
to be a likely scenario. We keep on saying this
wonderful thing about the good quality loan book
and such. Have you really looked into the actuality
of the statistics within the loan book to satisfy
yourself that there was indeed a good quality loan
book on an organisation which has lent five to six
times income and up to 125% of a property?
Sir Callum McCarthy: If I look at the assets of
Northern Rock, of course we were concerned to
look at its record. If I look at, for example, the three
month arrears figure, although it has increased
slightly over the last year, it is still running at less
than half the industry average. Northern Rock has
no exposure to the sub-prime market because it laid
oV all that exposure to another institution. If you
take the particular 125% oVering, which actually has
got some limits within it which have to be
recognised, the record of bad debts and arrears on
that was also very limited relative to the industry
average. The loan to value is not excessive. So, in all
those respects, we believe that it is correct to say that
the loan book was a good quality loan book.
Q229 Mr Breed: But it was not a means of the way
in which they constructed their lending to
individuals in respect of the mortgage and the
personal loan, the secured and the unsecured and the
way in which the unsecured proportion could
actually assist the repayment of the mortgage
monthly figure, thus ramping up, on an unsecured
basis, the lending to an individual whilst at the same
time appearing to, of course, satisfy the arrears
statistics on the mortgage itself?
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Mr Sants: The diYculties they have got into, as we
have all reflected on, was their diYculty in achieving
a securitisation programme, or repaying the
mortgage book, or in some way or other sensibly
raising funding on those asset base. In addition to us
having obviously looked at those assets and, of
course, as you would no doubt expect, also the Bank,
of course commercial banks were in negotiations
with them during this period in respect of their
endeavours to do a securitisation or a repo and at no
point have we heard from any of those parties any
suggestions that the loan book is anything other
than Sir Callum has described. So I think there is no
suggestion here that the problem is that their loan
book is anything other than, generally speaking, a
good quality loan book that can, indeed, be turned
into rated paper; the problem is with the failure or
the reluctance of the market to take any of this
rated paper.
Q230 Mr Breed: But you base that upon the statistics
or returns provided to you by the company not in an
investigation?
Mr Sants: No, we have been to see the company and,
as I mentioned before, we know the commercial
banks that have been looking at that mortgage
book.
Q231 Chairman: You are aware that the Northern
Rock funding was carried out through oV-balance
sheet special purpose vehicles, a lot of that funding?
Mr Sants: Yes.
Mr Breed: That is the other side?
Q232 Chairman: I know it is the other side, but you
are aware of that.
Mr Sants: Indeed we are.
Q233 Chairman: Was it clear to the FSA that that
was just a means of shifting the risk into unregulated
entities beyond the view and the scope of the FSA?
Mr Sants: As Sir Callum has indicated, we need to be
here careful that we do not inadvertently stigmatise
wholesale funding operations as necessary bad for
banks. In order to have a securitisation programme
which, once a securitisation is done, creates longterm secure funding, you need a special purpose
vehicle which provides the avenue.
Q234 Chairman: Were you aware it was done
through a Channel Island subsidiary?
Mr Sants: The visibility, the content of the
programme was perfectly visible to the FSA.
Q235 Chairman: So you were aware of that?
Mr Sants: Yes.
Q236 Chairman: What was the subsidiary in the
Channel Islands?
Mr Sants: We are fully aware of the content of the
special purpose vehicle.
Q237 Chairman: What was the subsidiary in the
Channel Islands it was under? Do you know that?
Mr Sants: Under. I am sorry?
Q238 Chairman: The Channel Island subsidiary.
Mr Sants: Granite.
Q239 Chairman: It was under Granite?
Mr Sants: Yes.
Q240 Chairman: That was actually established
under charity law and actually owned by a Channel
Island subsidiary of the Law Debenture
Corporation. Does that not seem a totally artificial
construction to shift liability and avoid
responsibility? Did the FSA not smell a rat?
Mr Sants: It is possible with regard to the Granite
structure. We would probably have to come back to
you with the detail of that proposition. I am not
totally convinced. We might be talking at cross
purposes here, so let me give you a written reply with
regard to the Granite structure.5
Q241 Chairman: I would welcome correspondence
on that. Have you spoken to the Northern Rock
auditors to find out why they were content with this
and, if you have not, can you include that in your
correspondence to us?
Mr Sants: We would certainly be happy to do that.6
Q242 Mr Love: Can I just be clear from one of your
earlier answers, Sir Callum, that what you said was
that the reason why Northern Rock has got a high
quality loan book is that they have passed on all the
bad risk to others?
Sir Callum McCarthy: No, I said that one part of it
is that the sub-prime business that they do, which is
very limited in scale, has actually been passed on to
others. That is true, but that is not the only
component that results in their having a quality set
of assets.
Q243 Mr Love: Going back to questions that were
asked earlier on, we know that Northern Rock were
taking up one in every five mortgages; so there was a
massive expansion in the loan book. We know from
American experience that because a lot of these
banks like Northern Rock were passing on the risk
through securitisation, the lending practices had
become somewhat suspect. Are you concerned
about that in the Northern Rock instance?
Sir Callum McCarthy: We are concerned about that
across the board, which is why, since we took
responsibility for mortgage brokers, we have been
consistent in looking at the standards that have been
used and have taken significant enforcement action
across the board.
Q244 Mr Love: If I extend the American experience,
I think almost all commentators say that the highrisk, if you like, sub-prime mortgage eVect grew
exponentially in the last months before the crisis hit.
Is that the case? Have you been able to track the
5
6
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
quality of the loans that Northern Rock were
making as they grew to consume one in every five
mortgage and is that a continuing concern for you?
Sir Callum McCarthy: Can I just deal with the fact
that Northern Rock did get a significant increase in
market share in the first half of this year. The first
point I would make is that the mortgage market is a
competitive market which has quite considerable
swings in market share from quarter to quarter, and
that is not unusual and it is not something which in
itself we should take action about; this is a
competitive market. What we should be concerned
about is the eVect of that on the actual financial
ability or capabilities of any firm, and I think that is
something which we looked at the carefully and I
think Hector has got the figures on it.
Mr Sants: Yes, as you rightly point out, clearly the
balance sheet for loans to customers did grow in the
first half of 2007 something of the order of £10.7bn
extra loans net to customers. It is an increase, but I
think we need to put it into perspective. The second
half of 2006 was £9.3bn, so clearly an increase, as
you say, growth, but I think we need to have a
context there. But also, critically, back to our earlier
conversation, if I may, we are talking about the
vulnerabilities which resulted from that business
expansion to its funding process and actually where
you look there, a degree of that was covered by
increased retail deposits, probably around two
billion or so, and the actual amount of quarterly
securitisation which, back to our earlier
conversation, of course, was what they failed to do
when they subsequently encountered the market
turbulence, in terms of volume did not change
hugely. In the first half of 2006 that was about
£5.8bn, in the first half of 2007 it was £5.6bn. So their
dependence on what we previously identified as
being the issue here, the securitisation volume, did
not actually materially change too much at the time
their balance sheet was expanding. So, yes,
absolutely, a period of growth should well be a signal
for regulators to take increased interest (back to my
earlier point there) but I think if you look at the
actual impact on the securitisation programme, that
growth has not really been the point at issue here.
Q245 Mr Love: Before I come to the securitisation
programme I just want to be absolutely clear. Of
course, in general terms, competition is a good thing
but there is also a negative impact of competition in
that in the desperation to sign up mortgages the
lending practices will be set aside to some extent.
Was there any concern in the FSA in relation to that?
Mr Sants: I think, as you rightly point out, you
should always be concerned where you see market
share growth and the question always has to be
asked, therefore, around the conduct around that.
Of course, being able to tell at this stage whether or
not there were improper practices in terms of the
quality of the mortgages, it is traditional when you
are securitising mortgages to wait for a period of
seasoning to see what happens to the performance.
So, in terms of looking at the financial data, it is
diYcult to tell at this point. In terms of mortgage
practise, from our point of view we have no evidence
of this at this stage to say that their practices were
out of line with quality market delivery. Do bear in
mind on this sub-prime point that we are only
talking here in the UK around 8% of the UK market
being sub-prime relative to around 25% in the US.
We do not have any particular signs of the sub-prime
market growing, and, indeed, probably as a result of
recent market events it will contract a bit, and there
is a genuine social purpose in the sub-prime market,
which is to deliver aVordable housing to some. It is
a question of whether the practices that go alongside
with that are reasonable.
Q246 Mr Love: Let me ask you: looking at it now
should the FSA have reigned in the aggressive
growth strategy that Northern Rock has been
pursuing?
Mr Sants: I think relative to the funding issue which
was the cause of the problem that they have put
themselves into, it does not seem to me that the
particular market share increase in those few months
was a trigger that we should have been particularly
concerned about. I do think we should have been
concerned around the stress testing issues that I
referred to earlier. So, I am more than happy to
indicate, I think there are some significant lessons to
be learned, but I am not sure that the market share
point is particularly the critical point in terms of
identifying the driver that led to their problems and
the scenario that we should have envisaged.
Q247 Mr Love: I am not absolutely clear. At any
stage in your discussions with Northern Rock did
you highlight the strategy they were pursuing? Did
you say there might be significant risks involved in
it? Did you try in any way to discourage them from
being as aggressive as they turned out to be? What
role did you play? Obviously you were monitoring
them. Were you advising them and did that advice
include: “Hey guys, this could be very risky for
you”?
Mr Sants: Yes, but as I have said earlier, I think the
intensity of that dialogue, at the time of the original
arrow visit and subsequently, should have been
more forceful. I think those points were being
identified by July when we were engaging in the
discussion around their stress test, but obviously at
that point in time events overtook the firm. I want to
be clear here, and I know you are questioning the
FSA, but let us remind ourselves, it is the Board’s
responsibility to run a company prudently and the
stress test scenarios are designed by the Board, not
by us. We do not give prescriptive stress tests to
firms; we think it is the job of firms to identify the
right set of stress for themselves, but I agree with
you, yes, we should have been in more intensive
dialogue with the company earlier.
Q248 Mr Love: Is there any evidence to suggest that
they changed any of their practices, any of their
aggressive growth strategy as a result of the
discussions they had with you, because we cannot
see any. Is it the case that they ignored entirely what
you were saying to them?
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Mr Sants: As I have said before, I think the stress test
that they were operating with and their funding
policy statement set out in 2006 did not anticipate
the severity of the market downturn, and when we
get to July 2007 that was still the case, which is why
we were intensifying our dialogue with them.
Q249 Mr Love: There have been suggestions that
actually you should not have treated Northern Rock
as a bank but more as a finance company. They took
in mortgages for mortgage brokers and they
securitised them. That is eVectively the direction in
which they were going very aggressively. Do you
have any sympathy with that argument and should
you have dealt with them slightly diVerently from
the way you would deal with ordinary retail banks?
Mr Sants: As we have mentioned before, the use of
wholesale funding is not in any way an unreasonable
tool in the funding proposition for a bank and,
indeed, securitisation programmes per se which
create long-term secure funding are in fact a very
good source of funds. May I remind you here that
the ultimate problem here is a retail run which
reminds us that we should not necessarily equate
retail deposits with having greater stability than
long-term securitisation products. I think in terms of
the way we address this supervisory issue, I realise I
am repeating myself and I do agree with you, I think
the stress test should have been looked at.
Q250 Mr Love: Let me ask you finally, Victoria
Mortgages has gone into administration now. We all
accept that was a very small bank, that it was
completely in securitisation, but are there any other
problems out there of a larger nature that you are
aware of and are concerned about?
Mr Sants: I think in terms of the wider public
interest you can reasonably expect me to say that
would not be a question I would ever want to answer
in terms of particular companies. I am sure you
appreciate that.
Q251 Mr Love: Are there any other continuing
problems in the market place?
Sir Callum McCarthy: Could I make clear that that
is an answer which Hector or I would give in good
times or bad times. It is, as a question of principle, a
question that should not be answered and I do not
believe would be answered.
Chairman: That is okay. I anticipated that would
come from your lips. Do not worry about that. You
mentioned about Northern Rock. We are having the
company before us next week, so I will be sending
you a letter after this hearing in terms of your
relationship with the Northern Rock Company so
we can be ready for that. We then go to Peter.
Q252 Peter Viggers: When the so-called Tripartite
system of regulation was set up in 1997 by the former
Chancellor of the Exchequer some commentators
said the system would prove inadequate in a crisis,
and, of course, so it is proving. Of the three
authorities you are quite specifically made
responsible for the prudential supervision of banks
and building societies, so if something goes wrong it
is your fault. I assume you would not wish to
disagree with that.
Sir Callum McCarthy: I absolutely accept, and I
think Hector has made clear, that we believe that
there are lessons to be learned which we are busy
identifying and will apply in respect of the
supervision of Northern Rock. In that respect I
agree. In one respect, I think it is important to
recognise that we cannot run and do not run what is
called a zero-value regime, because if we were to do
that we would insist upon a degree of avoidance of
risk across financial services which would be deeply
damaging to the economy.
Q253 Peter Viggers: If I probe the chronology, it is
simply so that we can understand the manner in
which this works. The crisis emerged on 9 August
and in the memorandum to us you say that from 9
August onwards senior management held daily
meetings, increased supervisory activity, passing
daily telephone calls. It does not sound to me like
very much co-ordinated action at that point until 14
August when the Bank of England was informed.
Sir Callum McCarthy: No. If I may say so, from 9
August we set up a daily, and sometimes more
frequently than daily, meeting, which was a
telephonic meeting, of the Bank, the Treasury and
the FSA. We exchanged information—I believe that
information exchange has worked well—we
identified problems and we have agreed actions.
Q254 Peter Viggers: I put it to you that, whilst you
have the duty of supervision, many of the actions
that need to be taken by government lie elsewhere
and that real action in seeking to find a solution only
emerged after 16 August when you set up a project
team with the other two regulatory bodies?
Sir Callum McCarthy: No, I think it was
appropriate. I think Hector gave an account of the
developing liquidity problems. I do not believe that
it was a mistake not have to set up those project
teams before 16 August and I think that there was no
indication that the date of 16 August was too late a
date.
Q255 Peter Viggers: So who was negotiating with
Northern Rock? Who was discussing actively on a
personal basis the solutions that might emerge? Was
it you or was it the other members of three
regulatory authorities, the Treasury and the Bank of
England?
Sir Callum McCarthy: It was principally the FSA,
and we can give you details of the various
discussions and who conducted them if you would
like.
Q256 Peter Viggers: What was your position as to
whether Northern Rock should be taken over?
Sir Callum McCarthy: I am sorry?
Q257 Peter Viggers: What was your position as to
whether Northern Rock should be taken over?
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Sir Callum McCarthy: One of the responsibilities
that we have under the Tripartite arrangements are
to identify whether there is a possibility of a private
sector solution. We did that and encouraged and
closely monitored discussions that took place
between Northern Rock and potential acquirers.
Q261 Peter Viggers: Would that involve the
Financial Services Authority being given more
authority or more power which is currently held by
another body?
Sir Callum McCarthy: Not necessarily. The issues
that I have been dealing with I think are wider
than that.
Q258 Peter Viggers: The Governor of the Bank of
England has spelled out to us a number of statutory
and regulatory matters which prevented a takeover
of Northern Rock or an orderly solution to the
problems of Northern Rock. Were you inhibited by
those statutory and regulatory matters?
Sir Callum McCarthy: In relation to the acquisition
of Northern Rock by a potential acquirer, I do not
believe that those legal problems were particularly
significant in relation to that possible outcome and
my recollection of the Governor’s evidence to this
Committee is that he was commenting on those legal
obstacles in relation to the lender of last resort.
Mr Sants: We were quite properly identifying
potential private sector solutions prior to the need to
apply to the Bank of England for a facility. In that
prior period I do not believe that there were any
barriers to those takeovers taking place in relation to
takeover rules. It would have been done in the
conventional fashion through the normal
framework.
Q262 Mr Brady: The Governor of the Bank when he
came before us was very specific, that he believed
there was the interaction of four diVerent pieces of
legislation that caused diYculties in the response to
the Northern Rock crisis: the Market Abuse
Directive, the takeover code, the nature of the
insurance scheme and the way in which deposits are
frozen in the event of administration. The answer
you were giving a few moments ago seemed to
suggest that you do not share that view?
Sir Callum McCarthy: No. I am sorry, if I gave that
impression it was not the impression I was trying to
give. I was trying to reply to the earlier question in
saying what are the issues, and two of the issues that
I identified, namely the compensation scheme and
what I described as bank insolvency but in fact
another way of rephrasing it is the way you have
rephrased it, are two of the four that were identified
by the Government.
Mr Sants: It is clear there was no consumer
confidence in the authorities here, and that was no
doubt a factor contributing to the bank run, and we
need to give careful consideration to addressing
those mechanisms for improving consumer
confidence, which takes us back to the FSCS and the
bank administration scheme. I think there is a strong
argument that says that we might not have had those
queues if consumers had had the confidence their
deposits were safe.
Q259 Peter Viggers: You said in your memorandum
to us that no acceptable structure for a takeover was
identified. What were the main barriers to such an
operation being successful?
Sir Callum McCarthy: I think there were two issues
which were significant in terms of the most serious
indication of support. One was the question initially
whether the bidding bank would receive support
from the Bank of England, the second was the terms
on which any support would be given and, as I think
the Governor has made clear and has elucidated in a
letter to the Chairman of this Committee, there was
a decision that it would be improper to give support
to a bidding bank. There was subsequently clarity
that after the lender of last resort facilities had been
announced for Northern Rock those would be
available on the same terms if Northern Rock were
acquired by a new bidder.
Q260 Peter Viggers: Do you think that lessons have
been learned about the Tripartite method of
supervising banks and building societies?
Sir Callum McCarthy: I think that one of the things
that we need to do is undoubtedly to look at the
lessons of the tripartite arrangements, and I am
particularly concerned about issues aVecting
financial compensation and the need to have a bank
insolvency route which enables us to deal with a
bank in diYculty in a way which gives clarity and
certainty to its customers so that the probability of
the anxieties that led to the queues for Northern
Rock is something that we can deal with. So I think
those are very real issues.
Q263 Mr Brady: So do you share the Governor’s
view that those four pieces of legislation need to be
changed?
Sir Callum McCarthy: I share his view that they are
all important things to look at.
Q264 Mr Brady: In answering questions earlier
about the Market Abuse Directive specifically, I
think it was Mr Sants who was saying that the
inhibition appeared to arise really on the part of the
responsibilities on the Board of Northern Rock
rather than the regulatory authorities or the Bank.
Would that be accurate?
Mr Sants: The initial responsibility as to whether
disclosure should be made undoubtedly rests with
the board of a company, and in this particular case
they felt disclosure should be made. We had, as you
say, no reason to challenge that conclusion they had
reached, that is absolutely right, and I would repeat
the point I made earlier. I think it was clear that there
could be sets of circumstances in which disclosure
would have to be made and we ended up in one in
this particular case.
Q265 Mr Brady: Is it your view that under Article 7
of the Directive, which exempts central banks from
its provisions, that that exemption is—
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Mr Sants: Does not apply to these circumstances.
Q266 Mr Brady: So there was no impediment on the
Bank acting as a covert lender of last resort, except
that it would not remain covert because of disclosure
from Northern Rock?
Mr Sants: Correct, in relation to the circumstances
they were in and concerned as to the implication of
that facility in terms of its magnitude and
implication for their profits forecast, and of course I
repeat this is all a moot point once the leak had
occurred. A more general point here might well be
that it is very diYcult going forward to imagine in
modern society that it would be that easy to keep a
covert operation of that size covert for any length of
time anyway. There are other obligations here,
particularly to credit agencies.
Q267 Mr Brady: So do you think it would be sensible
to look at changing the disclosure rules or not?
Sir Callum McCarthy: I think the point that we both
have been trying to make is, quite apart from the
legal
obligations, there
are fundamental
practicalities which are at least as important as the
legal concerns.
Q268 Mr Brady: So if the Directive had diVerent
provisions it might not have helped?
Mr Sants: It might not have helped, no. We are
expressing a view that it seems unlikely in the overall
set of circumstances that prevail in the market-place
today that keeping an operation of this size and
complexity covert for any length of time is realistic,
independent of the standing of the Market Abuse
Directive.
have absolutely no responsibility for any of this at
all. Who was in charge of this bank? Who was in
charge of making sure this did not happen?
Sir Callum McCarthy: If I may be clear, I think both
Hector and I have made it absolutely clear that the
responsibility for supervising Northern Rock lies
with the FSA, that is point one; and if that is not
clear can I now make it clear to the Committee. We
have also made it clear that we believe that there are
things we need to look at again to make sure that we
discharge those responsibilities in a way which
recognises the lessons that we should learn from
Northern Rock. If you have taken the impression
that we are avoiding responsibilities that are
properly ours, can I make it quite clear that we are
not.
Q272 Mr Simon: I was not asking who is responsible
for supervising the institution; I was asking who is
responsible for this crisis, this fiasco, this debacle?
Which of the Tripartite Authorities ultimately was
responsible the most?
Sir Callum McCarthy: I am afraid that, rather like
the Governor who answered the question, (I believe
correctly) by saying here are the responsibilities of
the Bank; here are the responsibilities of the FSA
and here are the responsibilities of the Chancellor
and the Treasury, I will give the same answer.
Q273 Mr Simon: Do you think the Tripartite
arrangements work?
Sir Callum McCarthy: I think that they do work. If I
look at the exchange of information which has taken
place between the FSA, the Bank and the Treasury,
I think that that exchange of information has been
clear. I think that each of us has discharged our
responsibilities.
Q269 Mr Brady: But consideration was clearly given
to that covert lender of last resort possibility. When
it was decided that it would not be a viable
possibility, did your advice change within the
tripartite authorities?
Mr Sants: No, our advice had been consistent. In
this set of circumstances if they transpired we would
not wish to disagree with the company’s conclusion
that was reached.
Q274 Mr Simon: So as a Committee we are supposed
to conclude that these arrangements worked and
that is why it all went so well?
Sir Callum McCarthy: You are not supposed to
conclude that things have gone well. If I may say so,
Chairman, you will come to whatever conclusions
you come to.
Q270 Mr Simon: Sir Callum, have you ever boxed?
Sir Callum McCarthy: Twice in my life.
Q275 Mr Simon: We are not likely to conclude that
it worked very well, are we?
Sir Callum McCarthy: You will come to whatever
conclusion you come to.
Q271 Mr Simon: It strikes me that this morning
when confronted with uncomfortable truths you
have consistently said “that is not a description that
I recognise”. I am going to present you with another
description because it has also struck me that you
may well be the Herol “Bomber” Graham of the
financial services industry, a medium ranking British
boxer who could not punch, who was the very
antithesis of hard-hitting but upon whom it was
impossible to lay a glove, you could not hit Herol
“Bomber” Graham under any circumstances. It
strikes me that during this fiasco the Governor and
the Bank have got it spectacularly in the neck
whereas you, who actually were responsible for
looking after this organisation, this bank, seem to
Q276 Mr Simon: There was a run on a bank; the
nation was a global laughing stock; and you say that
the arrangements worked?
Sir Callum McCarthy: Sorry, I have said that the
Tripartite arrangements in terms of what was done
by each of the parties were clear in responsibilities,
and in relation to the FSA, for which I take
responsibility, I believe that we discharged our
responsibilities. I also believe—and I repeat this—
that we consider what has happened and particularly
what happened in the supervision of Northern Rock
up to the time that these problems developed, are
things that we have to learn lessons from and make
changes and respond to.
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Q277 Mr Simon: Given that you have said the
arrangements worked, do you think they would have
worked even better if one of the Tripartite parties
had had more responsibility than the others, if there
was somebody with whom the buck ultimately
stopped (presumably not you)?
Sir Callum McCarthy: If I look at the decision to
extend facilities, it was a decision taken by the
Chancellor on the basis of advice from both the
Governor and the FSA, and I think that there is
clarity of that responsibility. I am not quite sure
what lies behind your question.
Mr Sants: What is true, if you look at the period
prior to the regrettable situation developing of the
queues outside the bank—and I think, as we have
indicated earlier, there are a number of contributory
factors to that such as the limitations of the FSC
Scheme and the Bank Administration Scheme which
should be properly looked at—if you look at the
period prior to that and ask the question whether
something could have been done between the
development of the global crisis which led to the
freezing up of the access to liquidity and the bank
applying for its facilities, realistically the only
solution to the disappearance of commercial credit
would have been the provision of some type of
central credit. That is axiomatically true. There was
a decision made not to do that, but if you look at the
logical sequencing of events that is probably the only
other thing that could have happened. A judgment
was made not to do that. Let us just be clear, in terms
of was there an option that was not considered and
missed, then the answer to that is no. Were there
options which were considered and the decision
made for wider policy reasons not to do them, then
the answer to that is yes. It is not obvious to us that
there is some action that could have been taken by
the FSA in that period that would have led to a
diVerent set of circumstances at the point the facility
was leaked.
Q280 Mr Simon: That is what the Chairman
suggested.
Sir Callum McCarthy: Could I just make it clear that
if I knew of anybody within the FSA doing that I
would fire them.
Q281 Mr Simon: Will you undertake to find out?
Sir Callum McCarthy: I have no reason to believe
that what you are suggesting has any truth. If I
discovered that it were true, I would take action.
Q282 Mr Simon: What kind of things would need to
happen to you to make you believe? Everybody else
in this room knows that this has happened; you are
the only person here who does not believe it. What
would we need to do to convince you that this kind
of thing goes on and that your organisation that you
are supposed to be in charge of is doing this and has
been doing it so disgracefully that the Chairman of
the Treasury Committee mentioned it to you right at
the top of his remarks and you just say, “I do not
know anything about it. I do not get involved in that
sort of thing.” You are involved in that sort of thing.
Sir Callum McCarthy: If you could provide chapter
and verse and evidence other than assertion, I would
take it seriously.
Q283 Mr Simon: But without chapter and verse and
evidence you do not take it seriously?
Sir Callum McCarthy: I am afraid it is an assertion
which is so contrary to the clear policy that is
established at the top of the FSA, and which has
been made absolutely clear, that I do not believe it is
true. I do not know if you want to add to that,
Hector?
Mr Sants: No, I think you are very clear on our
position.
Q278 Mr Simon: Relations between the FSA and the
Bank have been described recently as “poisonous”.
What do you say about that?
Sir Callum McCarthy: I would say that I have a good
and clear relationship with the Governor. I believe
that Hector and senior colleagues work eVectively
and well with their opposite numbers in the Bank,
and it is a description which I in no way recognise.
Mr Sants: I would say absolutely not true.
Q284 Chairman: How many press oYcers do you
have, Sir Callum?
Sir Callum McCarthy: Do you know the answer?
Mr Sants: Not to the precise one. I think we have a
quantum of ten to 15, about a dozen or so, covering
a variety of diVerent issues, which of course include
retail issues and consumer communications.
Chairman: In your responses before next week in
your letter to us, if you could look at that report that
was in the Financial Times and give us your
comments on it and consult your press oYcers, that
would be helpful to us in our inquiry. George?
Q279 Mr Simon: I thought we would get to
“descriptions that you did not recognise”, which
reminds me of your answer to the Chairman, which
I thought was disingenuous when he asked you
about the spinners, you just said, “Spinners I do not
know anything about spinners.” Are you telling us
now, on the record, that either the FSA does not
employ people who spin on its behalf or that it does
but you do not know anything about it?
Sir Callum McCarthy: No, I am saying if, as I believe
is the import of your questions, you are suggesting
that the FSA goes around briefing against the Bank
of England—
Q285 Mr Mudie: I think there can be some criticism
of not anticipating what happened before it
happened and your supervision role, but I would like
to just push further on what you said, Hector, about
there was a big option and you were working against
a decision by one of your partners which was not to
put liquidity into the situation. That seems to me
something that exacerbated and brought on the
crisis, which has not happened in Europe and has
not happened in the States because the central banks
behaved diVerently. Would you care to comment?
Mr Sants: I think it is logically true and I have
already indicated that, and I would agree with you,
from the narrow question of would we be in the
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position we are now in with regard to Northern
Rock, it clearly is the case that if liquidity in smaller
amounts had been made available to Northern Rock
earlier, then it is quite possible it would not then
have subsequently needed to apply to the lender of
last resort facility. In terms of that narrow question
of that particular institution, for the reason I have
just said, namely the public markets were closed to
it. Its problem was a liquidity problem—we have
discussed that—and therefore if it had been able to
find a source of liquidity prior to applying for a
lender of last resort facility then it might not have
needed to have done that, and that absolutely has to
be case.
Q286 Mr Mudie: That is the situation, if there had
been the liquidity engineered by the central bank,
you would not have needed to be seen or classed as
a lender of last resort. You would have gone to the
market the same way as any other bank could have
gone, taken the money, freed yourself from your
short-term financial diYculties and got on with life,
and we would not have had these queues and this
crisis.
Mr Sants: I think, as I have just said, I am agreeing
with you with regard to the narrow point of
Northern Rock. There are two particular ways that
could have been addressed, either a facility where
wider collateral should be more generally available,
or some specific approach taken with regard to less
general facilities but nevertheless still of a more
generic nature, however, questions are rightly to be
taken by the Bank in the context of their overall
policy framework, as to your question for Northern
Rock, I think the answer is yes.
Q287 Mr Mudie: It goes beyond Northern Rock. Let
us take the Tripartite arrangements, did at any time
the FSA, as part of that, raise the question of the
central bank putting some liquidity into the system
generally? Yes or no? I think we are entitled to know
what the FSA’s view is. You have been hauled over
the coals today for a situation which was maybe
somebody else’s creation, so did you at any time
during these arrangements as the crisis developed
say this could be sorted if you come oV your high
moral platform and just do what the Fed did or the
ECB did?
Sir Callum McCarthy: May I make two points. One
is I would point out—
Q288 Mr Mudie: No, Sir Callum, just answer the
question in terms of was this specific approach/
strategy raised?
Sir Callum McCarthy: One of the things that was
done was, as you would expect us to do, after
meetings that were held at chief executive level with
some of the major British banks where they
expressed their views (meetings that were attended
by Bank of England oYcials) we reported the views
of those people very clearly to the Bank.
Mr Sants: We clearly are very aware of our
responsibility to interface with the market. I think
you rightly point out that the majority of the market
held the view you have just described and we very
properly made sure, as the banks expected us so to
do, that those views were communicated on to the
Bank on a regular basis.
Q289 Mr Mudie: And would you not agree that for
the Governor to spell out in written form in such a
lengthy way to this Committee the fact that liquidity
would not be given, when you all knew you were in
an advanced stage of a crisis, was not helpful?
Sir Callum McCarthy: I would point out that at the
time the Governor wrote to this Committee he knew
that there was the probability of a lender of last
resort facility being made available and his paper for
this Committee specifically discussed that. I am
sorry, I do not have the Governor’s paper with me.
Q290 Mr Mudie: But that is the point, if the
Governor knew that the various pieces of legislation
stopped him acting as a lender of last resort or
stopped a rescue of a specific institution, another
alternative would be to do what the Fed had done
and the ECB had done, and put liquidity into the
system. What stopped the Governor doing that or
what stopped it happening?
Sir Callum McCarthy: Could I point out that on the
problems that the Governor identified of a legal
nature, I think his points were specifically about that
preventing a confidential covert lender of last resort.
Q291 Mr Mudie: Sir Callum, I understand all that,
and I had words with the Governor, but it seemed to
me the Governor was saying, “I can’t do this; I can’t
do that” and my criticism of the Bank if England is,
fine, if we accept all these arguments, what were you
suggesting you would do other than just watch the
crisis develop? The obvious thing, which was done
within a week, is put liquidity into the system, and
since he has taken that decision, in fact the last
tranche was not taken up such is the confidence of
the banks in liquidity. Does that not prove if that
decision had been taken earlier you would have been
spared this sort of inquisition and the Northern
Rock depositors would have been spared all that
worry?
Sir Callum McCarthy: I am not sure if I can say
anything other than the point that Hector has
made—
Q292 Mr Mudie: Well, Hector agreed with me! I will
settle for that. It is all right, Chairman, he is a
good man!
Mr Sants: I think I said that the market agreed with
you and we properly reflected the market’s views.
Mr Mudie: The market is king!
Q293 Chairman: Following Mr Mudie’s point, were
you just an interface or did the FSA support the
banks in their plea for additional liquidity?
Sir Callum McCarthy: We made it quite clear to the
Bank of England the strength of feeling that was
being expressed, but I would say that I believe that
that was well-known to the Governor.
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Q294 Chairman: Okay, so let us get a straight
answer, Sir Callum, we are looking for one this
morning, give us one. Did you support the banks in
their plea for more liquidity?
Sir Callum McCarthy: In terms of the position of the
FSA, the responsibility for making decisions on
monetary policy (of which this is one) lies with the
Bank and it is for them to make—
Q295 Chairman: Sir Callum, this is getting absurd, it
really is, because here we have a situation where
some people are saying if you had put extra liquidity
in would not have had this run and we would not
have had deckchairs outside the 76 Northern Rock
branches. We are just asking you in terms of an
orderly and eYcient market (which is your
responsibility) did you support the banks in their
plea for more liquidity? Give us a “yes” or give us a
“no” or say “we are not going to answer”, but make
it simple.
Sir Callum McCarthy: Of those three choices,
Chairman, I am afraid I am not going to answer
Q296 Chairman: That is better, that is fine; it is on
the record.
Sir Callum McCarthy: Because in relation to the
conversations that we had within the Tripartite
group I think it is proper that they should be
conducted in private.
Chairman: It is dead easy, Sir Callum, if you do
answer a question simply. We understand it now.
Sally?
Q297 Ms Keeble: In terms of going forward, to what
extent do you think the current problems in the
credit market mean that there should be a re-think
of the regulation of the credit ratings agencies?
Mr Sants: I think we should definitely take a look at
our credit ratings agency regime. There are a number
of diVerent issues around that. There is the perennial
one of course of whether or not the credit ratings
agencies conflict in the sense that they are being paid
by those who they are rating, but of course that issue
has been around for some time, and there has been
a code of practice put in place by IOSCO which we
supported. I think the question obviously that has
been raised by more recent events is two-fold: one,
to some degree as to how eVective are their processes
in reaching the conclusions which they reach; and
also, just as critically actually, how eVective are the
institutions in using that information and fully
understanding what it is they are being told about.
They are being told essentially about a credit rating,
of course, not a liquidity rating, and I think there is
also a risk to some degree that there has been far too
great a reliance placed on credit ratings by
institutions and investors as a shorthand way of
reaching quick judgments, and that is one of the
reasons why the market-place froze up, I think.
Q298 Ms Keeble: There are a couple of things. You
said that the issue about the conflict of interest
between the advisory and the risk assessment
functions are a problem that has about been around
for a while. There have been discussions in the
United States obviously about regulation and also in
Europe. Given the fact that it has to be done
internationally, have you talked with your partners
elsewhere about what is happening, and how quickly
would it be moved forward so that we are not left
then several years down the line with still nothing
being done?
Mr Sants: We certainly have been talking to our
partners and I think, as you rightly point out, this is
not an issue that could be addressed nationally, not
least because these credit ratings agencies are not
even based here.
Q299 Ms Keeble: Could you just detail the
discussions that you have had and the timetable
for action?
Mr Sants: We had a discussion last month. There
already is a working group within IOSCO, which is
the main securities global co-ordinating agency,
which had a meeting this month, and we are working
on taking forward those issues. They have a code of
practice and it was agreed in the IOSCO fora that we
would be looking again at that code of practice to see
what lessons could be learnt from recent events.
There has also been debate here within the CESR
context and the European context as well. There will
be a number of diVerent strands but we will be
looking to take them forward as quickly as possible.
International work does not happen as quickly as
national work but I agree with you, it should be
treated as a matter of urgency.
Q300 Ms Keeble: The code of practice is presumably
voluntary. Given the issues that have been raised
about people not being aware of the risk and the
comments that you have made this morning about
risk assessment, do you think there is a need for
something more substantial and robust than a code
of practice?
Sir Callum McCarthy: I think you will find since we
are dealing with a limited number of credit ratings
agencies that there will be no problem, once we
identify what we want, getting them to accept it. I do
not think that is going to be a problem.
Q301 Ms Keeble: Sorry, that kind of agreement
between a small number of people can have other
names other than a code of practice: it can be a
gentlemen’s agreement, a cartel, it can be all kinds of
things. If we are talking about transparency of
information and certainty, do you think there is a
need for something that is more robust?
Sir Callum McCarthy: If we get a robust code of
practice I believe that we will be able to implement it
eVectively.
Q302 Ms Keeble: Okay. Do you think that there is a
need, and Hector you have hinted at this, for a look
again at the liquidity rules, because Northern Rock
was within the rules and a number of other banks
have got similar profiles to Northern Rock?
Mr Sants: There are two separate points. On the
credit agency point, we completely agree with you,
there is work needed to be done as to what use are
the institutional investors making of credit agency
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
material, how do they engage with it, and is that
properly understood and is there proper
transparency with regard to the purposes and
backdrop to the conclusions of the credit agencies’
work. If—and I may be misunderstanding and I
apologise if that is the case—you are referring back
to my earlier comment about are we satisfied with
the way that we approached the stress testing work
that was done in Northern Rock, I think I have made
clear, no, we are not satisfied with that, and I think
we need to address that, and that will be something I
will place as a priority agenda from my point of view.
Q303 Ms Keeble: It was just that you referred a bit
earlier to the need for a look at the rules around
liquidity requirements to which the Governor also
referred?
Mr Sants: Yes.
Sir Callum McCarthy: There is work going on, led
by the Bank of England in the Basle Committee on
trying to establish what should be the basis for a new
liquidity regime. One of the diYculties about doing
that on a national basis, which goes back to Hector’s
comment about it takes longer to do things
internationally than nationally, if you look at any of
the major institutions which operate internationally
they run their liquidity on a global basis and they are
very hostile to having separate national liquidity
regimes. We believe it is a good thing to try and get
an international agreement on it, and that is what we
are working to do, and that is what we will intensify
our eVorts to do.
Mr Sants: We should try to use the regrettable
circumstances that have occurred to get fresh
impetus behind that initiative. It is one that we have
been supporting, and indeed the Bank of England
co-chairs the key Basle Committee here, but I think
there is clearly an opportunity to use this regrettable
set of circumstances to put fresh impetus behind
the agenda.
Q304 Ms Keeble: Obviously what everybody wants
to make sure of is that this does not happen again. I
wondered how you see the risk if there is future fallout from the risks of the sub-prime market in the US
and if you feel that you have got a proper assessment
of where the risks are in the system, and if you have
got a proper way of managing them. I think it comes
back to perhaps some of the points that Siôn Simon
was raising about who is going to take the lead on
this and how are you going to make sure that you
have got robust enough systems in place. So far you
have only talked about the stress testing as being the
one real, substantial lesson that you have learned
from this.
Sir Callum McCarthy: I think you raise a lot of very
big issues in your question. One is that we have long
recognised that risk is now much more widely
distributed than previously through the origination
and distribution model that many banks adopt. One
of the issues that has always concerned us was what
was the mechanism for reconcentration of that risk.
One of the things, for example, that has become clear
in relation to major financial institutions is their use
of conduits or special investment vehicles. One of the
things that Basle II will help with is a better
identification of the way in which risk can come back
from that on to the major banks, and that, for
example, is an area where (quite apart from the work
on stress testing which Hector described) that we will
want to do a lot more work on.
Mr Sants: We should not underestimate the specifics
of Northern Rock and the implications there for
consumer confidence and the FSCS scheme of
administration. The FSCS scheme is within the
remit of the FSA and we have committed ourselves
to re-review that. Those issues to do with the
wholesale market were components of what
happened and at the end of the day I repeat the point
that the retail run was the critical element that placed
Northern Rock in the situation it is now in, but
absolutely, we need to look at a number of aspects
of the framework of the wider wholesale market.
Q305 Mr Dunne: I would like to probe a little bit
further the comment you just made, Hector,
because, as you explained, the Northern Rock crisis
was essentially a liquidity problem, not a problem
with the asset base, and the problem stemmed
internationally from the drying up of wholesale
markets due to the extreme uncertainty over
liquidity, security and value of AAA-rated oV
balance sheet paper. Do you agree that the wider
collateralised debt obligation market was the
primary trigger to the drying up of the wholesale
market?
Mr Sants: Yes, and I think your point identifies the
other aspect of this which was singular and unusual
which is what actually happened as a result of the
problems you have graphically described was the
mainstream
institutional
investors,
who
traditionally purchase commercial paper, which is a
fairly vanilla sort of product, lost confidence in the
system, so it is a curious combination not just of
structural elements of actual credit failure but then
we had a confidence failure in mainstream investors
which then led to a liquidity problem. Of course your
analysis of the origins of this confidence failure is
absolutely right, and I think that takes me back a
little bit to the credit point that when they lost their
confidence, because these are very complex
instruments (which I think takes us back to where we
were a minute ago) they were very nervous to go out
and buy the related revenue flows dependent on
those complicated instruments.
Q306 Mr Dunne: So when was the FSA first
concerned about price and risk within the CDO
market?
Sir Callum McCarthy: I think you will find that the
FSA has been concerned for some time about the
pricing of risk generally, because one of the
problems that we have encountered over the last two
years is, because of the extent of liquidity in the
world, there has been a mispricing of risk, and that
has been repeatedly a point we have made. It applies
to CDOs but it applies more generally than that. The
work that we did for example on leveraged buyouts
was concerned about that and other pieces of work
were also concerned.
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Mr Sants: And, as you know, we have done a huge
amount of work with regard to operational risk in
relation to the credit derivative market, reflecting
our understanding that where you had a credit issue
one potential knock-on eVect was operational
concerns. This aspect of the crisis was not the
unexpected part; it was the confidence—
Q307 Mr Dunne: In that case, you did not answer the
question as to when you identified this problem?
Mr Sants: We were clear in our February Financial
Risk Outlook, which is one of our more recent
publications. I was clear, I believe, in the press
conference in July. I believe my predecessors have
been clear in various other publications prior to that
really for the last couple of years that there was a
significant build-up of risk in this area and a gradual
mispricing of that risk that needed to be corrected.
Q308 Mr Dunne: Had you discussed these concerns
with the SEC and other international regulators?
Mr Sants: Absolutely.
Q309 Mr Dunne: Throughout this period?
Mr Sants: Yes.
Q310 Mr Dunne: So why was nothing more done by
yourselves and other international regulators to
slow the growth of this market if you had such
fundamental concerns about it?
Sir Callum McCarthy: I am not sure what
mechanisms you believe are available to us to
actually constrain global markets.
Q311 Mr Dunne: Possibly Basle considerations.
Mr Sants: I have made the point that under Basle II
the treatment of oV balance sheet capital in SIVs and
conduits will be brought back and more accurately
reflected, so that will be done.
Q312 Mr Dunne: Are you saying that the regulators
have no powers to control the spread of derivative
instruments, which are not well understood either by
the market or by the regulators, there are no tools in
your toolbox?
Mr Sants: As a national agency there are clear
limitations on our ability to address those risks.
What we seek to do—and I think this is an
explanation I oVered the Committee when we were
talking about financial stability earlier in the year—
is to control and regulate the central transmission
mechanisms within the UK economy, which are the
large banks and, as Sir Callum himself said, recently
the large banks have gone into this period of market
turbulence well capitalised and well set up to
withstand these market shocks. We also place
increased emphasis on our banking sector having
eVective stress tests, which takes us back to where we
were earlier in the discussion, but our ability to
actually curtail the growth in OTC credit derivatives
markets are clearly limited by our national—Indeed,
you have to argue it is debatable whether that is
necessarily desirable given the wider arguments
about risk dispersion. I think we need to be clear
here that what has happened was a collapse in
confidence, particularly of CP purchasing, and we
need to be careful that we do not undermine some of
the beneficial aspects of the growth in the derivative
market as a result of looking at the lessons learned
from this particular period.
Q313 Mr Dunne: Within your risk management
specialist teams do you have individuals who have
direct experience of trading in these derivative
markets and understand the nature of security and
risk?
Mr Sants: Yes.
Q314 Mr Dunne: Good. You have touched on the
low probability of Northern Rock getting into
diYculty given the quality of its loan book. Given
the role that you have as banking supervisors, what
emphasis do you place on looking at a bank’s share
price as a determinant of concerns in the market
about its performance? Would you like to comment
on the fact that the Northern Rock share price
declined some 40% in the period from April to the
middle of August in a pretty straight line, against the
bank sector indices, as an early warning sign that
something was going seriously wrong?
Mr Sants: Yes, I think that share prices are
indicators of a variety of diVerent potential issues
and should be scrutinised by regulators. Share prices
also, may I say just in passing, impact retail
confidence as well, so there is a variety of the reasons
why we should be properly focused on the share
price. Clearly we saw acceleration of that trend with
the profits warning, to use a colloquial term, and we
significantly intensified our regulatory engagement
with Northern Rock at that point. I completely
agree with you that share prices should be closely
monitored by regulators, and they are.
Q315 Mr Dunne: The business model of Northern
Rock was heavily reliant, as we know, on the
wholesale markets and you have just touched on
commercial paper. The commercial paper market is
of a one to three-month duration typically. For a
bank as significant as this with long-term obligations
stretching out many years in the mortgage market,
do you think it is wise for funding sources to be so
reliant on the short end, and is this not one of the
fundamental tenets of bank practice that you do not
borrow short to lend long?
Mr Sants: To some degree of course, that maturity
transformation does have its uses but actually in the
context of Northern Rock the figures do not suggest
that it was an outlier in respect of its dependency on
very short-term funding. We have discussed
previously the fact that—and I am happy to go back
over the ground if you would like me to—its bigger
risk factor was its dependence on the use of the
securitisation products which was the market that
froze. The actual percentage of its funding which
was dependent on three months or under was not a
particular outlier, and also just to remind us again,
I think it is important to remember that it did not
actually fail to fund itself is this period. What
happened was its maturity shortened back into the
overnight period to the point at which the Board
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
thought it prudent to seek the lender of last resort
facility, and we are all aware of the regrettable
consequences of that in terms of consumer
confidence, but it was not actually an outlier in
respect of short-term funding ratios, it was an outlier
in respect of overall wholesale funding, as Sir
Callum indicated earlier, which included the
securitisation component.
Q316 Mr Dunne: If it is not an outlier, does that not
suggest that there are many other banks that are
overly dependent on short-term sources of funding
and if these dry up there could be contagion across
the sector?
Mr Sants: I tread very carefully in this space, but of
course, as I have mentioned before, it was
specifically the short-term funding failure which was
the problem here, it was the absence of the
securitisation market, which is a widespread
phenomenon, and we need to remind ourselves they
were oVering good-quality paper, this was not a
Northern Rock-specific problem, and it is because
they are an outlier in that respect that they put
themselves in a position where they became
concerned. As a general point, you are right, and
now we are back to our stress testing point, it has to
be right that our banking sector gives proper
consideration to having a diversified set of funding
sources across the whole spectrum of maturity which
it properly gives consideration to even in extreme
circumstances so that they can remain funded for a
reasonable duration of time. I am mindful of the
other point earlier, that we are not a regime that
guarantees there are no failures and we need
innovation in financial markets. To say that we
should not have had securitisation would not be a
good conclusion to draw from this.
Q317 Mr Dunne: Just changing tack a little bit and
picking up a point that Siôn Simon made, obviously
confidence in regulators is critical during a financial
crisis. Has the FSA or other members of the
Tripartite group leaked information to the press
during the course of the last month specifically in
relation to Northern Rock?
Sir Callum McCarthy: I do not believe that any
member of the FSA has leaked any information to
the press in relation to Northern Rock.
Q318 Mr Dunne: So are you suggesting then that
either the Bank of England or the Treasury leaked
information about Northern Rock to journalists?
Sir Callum McCarthy: I am being rather careful
about taking the responsibilities which I have, which
are for the FSA, and you should not infer from my
statement that I am making any comment at all
about either the Treasury or the Bank of England.
Q319 Mr Dunne: So if the BBC website was able to
report, for example, a decision by the Northern
Rock Board as to their dividend announcement
recently before the board meeting had even started,
you would be prepared to investigate whether that
had come through the FSA?
Mr Sants: In that particular case, I am fully aware of
the extremely small number of people in the FSA
who had the information that it was possible the
Board might reach that conclusion, and I have
already personally satisfied myself that they did not
make any communication with the press in that
period.
Q320 Mr Dunne: So I should address that question
to either the Treasury, the Chancellor or the Bank of
England?
Sir Callum McCarthy: Could I make it clear that
that would be a fair inference if those were the only
people who had information and the assumption
that any leak must come from one of the Tripartite
authorities is an assumption which I do not believe
is necessarily true.
Q321 Mr Dunne: I will have the opportunity to ask
Northern Rock themselves next week. If you will
indulge me a little bit, Chairman, just turning to the
specifics of the regulatory challenge that the
Northern Rock situation provided. As we have had
the first run on a bank for 150 years and you are the
regulators responsible and this has come on your
watch, the hard-earned reputation of this country
for its financial supervision is essentially at stake at
the moment. We have received evidence from the
Governor of the Bank of England that following his
appearance before this Committee he sought to
clarify discussions between the Tripartite
Authorities in the run-up to the decision not to
extend facilities to Northern Rock whilst they were
in the midst of whatever discussions. He confirmed
specifically that before 10 September special
facilities would not be made available to a purchaser
of Northern Rock, and that was based on a
discussion which he had with the FSA and with the
Chancellor. Can you confirm that those discussions
took place and that was a decision that was reached?
Sir Callum McCarthy: I can confirm both of those.
Q322 Mr Dunne: What attitude did the FSA take in
those discussions as to whether it would be
appropriate to provide a facility to a purchaser given
that you had the most detailed knowledge of the
situation that Northern Rock was in?
Sir Callum McCarthy: We made clear—and I think
I answered this in previous questions—that if a
private sector solution was to be pursued, the
requirements that we thought would have to be
requirements from a potential bidder that would
have to be satisfied, so we identified what would have
to be done if a private sector solution was to be
pursued.
Q323 Mr Dunne: Was a request made by a potential
purchaser of Northern Rock for such a facility
before 10 September?
Mr Sants: Before 10 September, I was just going to
elaborate a bit and say I am clear in my mind that
we properly discharged our responsibility to bring a
private sector solution to the table, and that the only
one that was available was the one you correctly
describe, which included public sector funding, and
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I do not believe any subsequent events, including the
various discussions that had been going on, suggests
there was some other solution out there that could
have been reasonably found in the time in question.
We brought the only solution on the table, we made
clear what was required to deliver it and there was a
decision by the Tripartite not to take that
suggestion up.
Q324 Mr Dunne: But what was your
recommendation?
Mr Sants: I think I am back into the answer I gave
a little bit earlier. From the narrow perspective of
avoiding the set of circumstances with regard to
Northern Rock which then transpired, clearly a
private sector solution at that point would probably
have avoided that outcome; I make that clear.
Sir Callum McCarthy: Could I also add, because I
think it would be incorrect to regard the private
sector solution as being a firm, cut and dried oVer,
it was still at an exploratory stage and there were a
number of other issues which would have to be
dealt with.
Mr Sants: If it had been a firm approach it would
have had to have been declared to the market, so we
should be clear about that point.
Q325 Mr Dunne: It is clear that it would have been
subject to shareholder approvals and regulatory
approvals, et cetera, but it might have provided the
comfort to those who were both depositors and
shareholders in Northern Rock that there was a
solution on the table, and even if it was a contingent
that might have settled and reassured the markets
and avoided a run on the banks. Sir Callum, you said
earlier it was the Chancellor who made the decision
to extend facilities at the end of that week. Do you
accept that had a diVerent decision been made by the
Chancellor we would have avoided a run on the
bank?
Sir Callum McCarthy: No, the only diVerent
decision by the Chancellor would have been to have
not extended facilities.
Q326 Mr Dunne: No, excuse me, there was the
opportunity—we have just discussed it—before 10
September when there was a contingent bid on the
table for the facilities that were extended a week later
to have been available to the bidder and had that
happened there would not have been a run on the
bank: question?
Sir Callum McCarthy: If there had been an oVer
which had been carried through successfully, by
definition, this problem would not have occurred.
That must be true.
Q327 Mr Dunne: But any oVerer was not in a
position, given the constraints in the credit markets,
to be able to take potentially up to £100 billion or so
of debt onto its books on an unconditional basis,
and therefore operating in the world that we are in
with public companies it was inevitably going to be
contingent and so you could not have had a
completely deliverable bankable proposition, but in
terms of providing comfort to the markets that there
was a solution in sight, would that not have provided
suYcient confidence to depositors and the market
alike to have prevented what we are now in which is
a calamitous situation where the whole regulatory
regime of the United Kingdom is in question? In
terms of moral hazard surely that is a more
significant issue than allowing the bank to go to
the wall?
Sir Callum McCarthy: I go back to describing the
position which is as I have described it and as the
Governor set it out in his letter to the Committee.
Q328 Mr Dunne: I have got two more quick
questions. How many banks in other countries have
requested similar liquidity facilities from their
regulatory authorities with no distress to their
depositors?
Sir Callum McCarthy: I do not know that. I do know
that there have been at least two banks which have
had serious problems, one of which has resulted in a
bail-out and the other an acquisition in the US.
There have been significant problems in the
Canadian CP market. There have been other
problems in France in diVerent aspects of this, so
this has been a global problem.
Q329 Mr Dunne: Are you aware of market rumour
that some 150 banks have applied to their regulators
around the world for special funding?
Sir Callum McCarthy: All I would say is that the
discussions that I have had repeatedly with
regulators in other major countries of the world give
me no reason to believe that figure.
Q330 Mr Dunne: Is it the case that had Northern
Rock had a European subsidiary and was active in
the markets on Continental Europe, it would have
been able to apply to the EU facilities for suYcient
funding to deal with its liquidity crisis?
Sir Callum McCarthy: It could have, I believe,
through its Danish branch have done some things; it
was a question of the length of time that would take.
Q331 Mr Dunne: So that is a yes?
Sir Callum McCarthy: Sorry, I beg your pardon, I
am not trying to be diYcult.
Mr Sants: If it had been set up to access the ECB
liquidity provision it could have tendered diVerent
types of collateral to that which it would have been
able to so do in the UK.
Q332 Mr Dunne: So that is another illustration of the
failure of our system, in eVect, because had it been a
slightly larger organisation, it might have been able
to apply to the facilities that existed in Continental
Europe?
Sir Callum McCarthy: If it had had the capability of
organising its assets in the right form.
Q333 Mr Dunne: Looking forward, there is
considerable concern in the markets as credit
conditions remain tight that another institution
might fail. How comfortable is the FSA about the
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renewal of borrowing facilities for smaller lenders
dependent on wholesale funding and how confident
is it that we will not see another failure?
Sir Callum McCarthy: I think the answer that both
of us have given to the Chairman in terms of not
commenting on individual institutions is one I go
back to. I would repeat that, on the whole, the
British banking sector is well capitalised and has had
the benefit of five years of very good, profitable
business.
Q334 Chairman: Sir Callum, just a couple of
questions arising from that. You raised the issue of
takeovers and there have been banks in the news
allegedly wanting to take over Northern Rock.
There are two issues here: the bidding bank receiving
support and the terms of that support. Were you in
agreement with the banks on the parameters that
should have been oVered or should be oVered on
these two issues?
Sir Callum McCarthy: In terms of the discussions
that weekend?
Mr Sants: I think we are back to the answer, at least
from my point of view, that I have already proVered
that we made clear what the terms were—and they
were indicative terms if I may just say—that would
possibly lead to the discussions becoming more
serious, and those terms were declined by the
Tripartite.
Q335 Chairman: Let us make it simple: did you agree
no support or did you agree the terms of the support?
That is really what we are looking for. It is a “yes”
answer or a “no” answer or “no answer”.
Sir Callum McCarthy: The Tripartite decision was
that it would be wrong to advance assistance to the
bidding bank. It was subsequently made clear after
the lender of last resort facilities had been made
available to Northern Rock that those facilities
would remain available to a bidding bank, if there
were a bidding bank.
Q336 Chairman: So you were in agreement with the
Bank of England on those two issues regarding the
parameters which should be oVered, namely the
bidding bank receiving support and the terms of that
support; you were at one with them?
Sir Callum McCarthy: We explained what would be
required if things were to go forward.
Q337 Chairman: So you were at one with them, Sir
Callum, you were at one with the Bank on that?
Mr Sants: It was not our decision.
Q338 Chairman: This is a “no answer” again. This is
getting really, really unsatisfactory. You are one of
the Tripartite Authorities but what seems to us here,
Sir Callum, is that you are crawling into your den
and you are not answering anything, and if we want
to sort out this issue and this problem for the future
we really need to know what one of the eminent
authorities thinks, so is that another no answer?
Sir Callum McCarthy: I am trying very hard,
Chairman, to answer your questions as clearly as I
can. The FSA does not have a balance sheet which
enables us to oVer assistance and so what we did,
which is what we are required to do, was to try and
identify what would be needed, and a decision was
taken that it was inappropriate to proceed on that
basis.
Q339 Chairman: The reason why I am asking this,
Sir Callum, is very simple, the authorities did not
agree to do this and, as a result, the taxpayer is now
at risk for £9 billion secured on mortgages which the
Bank would never normally accept as adequate
collateral, so other than lending to, say, a bank that
came in—and from the name of the bank that came
in it indicates that they are one of the world’s largest
and best capitalised banks—the taxpayer has this
risk now. If you are interested in orderly markets
and seeing them function eVectively you should have
a view on it, Sir Callum.
Mr Sants: You could say—
Q340 Chairman: If you are not going to answer the
question tell us and then it is on the record.
Sir Callum McCarthy: I do not think I have anything
else to say.
Chairman: So you are not going to answer the
question. Okay, you are not going to answer it.
There are three or four people who want to finish up
on the Northern Rock thing before we go on to
others, so Colin, Mark, George and Michael
quickly.
Q341 Mr Breed: We have got the problems of
liquidity and all that sort of thing and hopefully for
the next few months that might calm down.
However, is there not a real further problem on the
horizon that if the pricing of risk becomes stricter, if
we have more write-oVs, if we have lower profits, as
seems likely, then capital adequacy rules are going to
be under real pressure, and we are going to find
ourselves in a few months’ time with many lending
institutions finding themselves up against capital
adequacy rules, which is going to produce another
potential crisis all the way through?
Sir Callum McCarthy: We have clearly been much
concerned to look forward as to how this will
unwind. We have been particularly concerned, as
have our counterparts in other countries, to look at
the eVect of bringing back on balance sheet the assets
which are at the moment in conduits and special
investment vehicles. I have no doubt that there will
be pressure on capital, but equally I go back to the
fact that these banks are well capitalised and that
they have the benefit of—
Q342 Mr Breed: They are well-capitalised under
existing rules and existing risk profiles. Once you
apply those stricter risk profiles, once they have
lower potential profitability, once we have higher
write-oVs, all of which will aVect the capital base as
well as bringing in the new rules next year, are we not
going to find that a significant—and I am not talking
about the very big banks, of course they are—
number of potential lending institutions, and I am
not going to put it much higher than that, are going
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
to find themselves up against capital adequacy rules
which they will not be able to meet and they will not
be able to find the capital to continue?
Sir Callum McCarthy: I do not believe that that is
the central case at all.
Q343 Mr Todd: You can correct me, Sir Callum, but
I recall you described the behaviour of he people in
the queues to take out their money from Northern
Rock as being “irrational”. I think that is right.
Sir Callum McCarthy: Could I correct you, if I may,
because I have huge sympathy with the anxieties of
the people who queued on that Friday, Saturday
(and would have queued on Sunday) and queued on
Monday. The comment that I made was made only
after the Chancellor had given his guarantee and at
that point the situation absolutely changed. As from
5 o’clock, or whatever the time was, on 17 September
there was no purpose in anybody queuing because
there had been a clear and absolutely unequivocal
guarantee given by the Chancellor. That changed the
event and I did say that there was no rational cause
for anybody after that statement to queue.
Q344 Mr Todd: And I think we all agree with that
but you made no comment on their behaviour before
that point?
Sir Callum McCarthy: Absolutely not.
Q345 Mr Todd: Fine. One of the things that certainly
struck me out of this whole exercise was that
however we discussed this issue, the reaction of the
consumer was not properly predicted or understood,
and that the signals given by actions taken by the
Bank and yourselves were not properly understood
always by the consumer who had their money
invested in Northern Rock. Do you think there is
some work to be done in the future—and I can see
Mr Sants nodding—in trying to understand better
both the information that consumers require to
properly appraise the risk of what they are doing and
also what the consumer understands the
responsibilities to be of various people who regulate
the institutions in which they place their money?
Sir Callum McCarthy: I agree entirely with that line
of argument. I would make one point that one of the
things that was particularly diYcult in relation to
Northern Rock was the sheer logistics. It had 72
branches which normally were very small, perhaps
with a couple of counters, you had oYces where if
you got as many as ten customers arrive there was a
queue outside. You had a problem about the band
width of their Internet banking. Everybody who
actually got to the front of the queue got paid oV at
100 pence in the pound and everybody who got
through on the Internet got their money out. I think
the logistics were a problem but much more widely
than the logistics was a general problem of first of all
the fact that the compensation scheme only gave you
100% up to the first £2,000 and also the need for a
facility which produces rapid pay-oVs rather than
people having to wait for an extended period. I think
all those are questions that we have to address and if
we address them I think people should have greater
confidence in comparable events.
Mr Sants: I would just add, because you noticed me
nodding, we have a role in consumer confidence, we
have a role here to communicate with your
constituents, with the customers, and clearly I think
the messaging was not very eVective. Our phrases
along the lines of “this bank is solvent” and “lender
of last resort”, this type of terminology—
Q346 Mr Todd: Were not understood?
Mr Sants: It is a technical terminology and there is
a challenge here for us to connect properly with the
consumers and there is a consumer confidence issue
that goes into the communication.
Q347 Mr Todd: Can I just interrupt and say one of
the reasons why other banks have chosen not to take
up the oVerings of the Bank of England’s rather
penal liquidity is partly because they quite readily
understand the signal that might possibly give to
their customers of doing such a thing, so I think what
is required is a better understanding of the
mechanics of decision-making that consumers take
in these sorts of matters, is it not?
Mr Sants: Absolutely.
Mr Todd: Good, okay, that is fine.
Q348 Peter Viggers: Is your supervision of banks,
exercised jointly with the Treasury and the Bank of
England, weakened by the ability of banks to have
access to the European Central Bank or other
external financial facilities?
Sir Callum McCarthy: No, I do not believe that our
supervision is in any way weakened by that. It is
important that we should understand whether any
particular institution does have access because it
aVects the liquidity available to them.
Q349 Mr Simon: Sir Callum, I have revised my view,
you are not the Herol “Bomber” Graham of the
financial world; you are the Sugar Ray Leonard of
the financial services sector; a world-class ducker
and diver, bobber and weaver, but let me try one last
straight left, if I may. You said that if the person who
briefed the FT against the Bank that day turned out
to be from the FSA you would sack them. Given
how glib and dismissive you have been about this
before this Committee today, if that person can be
shown to have been from the FSA will you not only
sack them but sack Mr Sants and resign yourself?
Sir Callum McCarthy: First of all, can I make clear
that I do not believe that I have been glib. If I have
been glib I apologise to all this Committee. I have
tried very hard to deal with very serious issues as
seriously as I can, so can I just put that on the record.
Mr Simon: From what the Chairman has said and I
have said that it is very obvious to all of us that this
briefing against the Bank has clearly happened and
it has clearly come from the FSA, you have just said
“Not true, I don’t believe a word of it. It simply is not
the case. Unless you can prove it I am not having
anything to do with it.” If that is not glib, what is it?
Q350 Chairman: I am writing to the FSA and that
will be public information.
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Sir Callum McCarthy: Can I just be clear,
Chairman, that I have said that if I found that any
member of the FSA had briefed against the Bank I
would fire them, and I do not regard that as a glib
remark nor an irresponsible remark.
Q351 Mr Simon: The question was whether you
would resign yourself having been so glib about it
today.
Sir Callum McCarthy: I am sorry, I have repeatedly
said I do not regard myself as having been glib.
Chairman: I got the feeling that you want you can
come along here resigning, Sir Callum, we have still
got an inquiry to be getting on with, so do not worry
about that. Andrew?
Q352 Mr Love: I am still trying to search out the
essence of the Memorandum of Understanding
between the three diVerent organisations. We have
pressed on is there a leadership role for one of them
in certain circumstances and that does not seem to
apply. We have also been pressing on who takes
responsibility and it would appear that what
happens is each of the three organisations runs away
from things that are not its responsibility. You have
said quite clearly in response to all the questions that
that is the responsibility of the Governor of the Bank
of England. Is there a role for collective
responsibility and would the Memorandum of
Understanding work better if there was some
collective spirit amongst the three organisations?
Sir Callum McCarthy: If I look at what we have been
trying to do since these problems generally
developed in August, and in relation to this period
of Northern Rock, I think there has been very close
and collective work. That is point one. Point two: the
point I have made repeatedly is that there are certain
decisions which are not decisions for the FSA but are
decisions for the Bank of England where we have the
responsibility to give information, and I believe that
we have done that, and where we may express views
to the Bank, but those views, I am afraid, I am going
to keep private, and that is I think the position that
I have, I hope, explained repeatedly.
Q353 Mr Fallon: Sir Callum, you have implied this
morning that you have discharged your
responsibilities throughout properly with a rather
feeble caveat where I think you said you should have
been “more forceful a little earlier”. Can I put it to
you that you have been responsible for supervising a
bank whose business model you yourself described
as “extreme” that then became completely illiquid,
was then subject to the first run on a bank for 150
years, has now in eVect been nationalised, with all
the damage to the British banking system that results
from that. Is it not the case that the FSA has
fundamentally failed in its supervisory duty?
Sir Callum McCarthy: No I do not think we have
fundamentally failed in our supervisory duty. I think
we have discharged our duties in particular ways and
I think, as both Hector and I have repeatedly made
clear, that there are absolutely things that we have to
do diVerently and better than we have done.
Q354 Mr Fallon: So you do not accept responsibility
for this fiasco?
Sir Callum McCarthy: I am sorry, I accept
responsibility in the terms in which I have set it out
because I think there are things which the FSA had
responsibility for which, as we have both made clear,
were not done well enough.
Q355 Chairman: Sir Callum, I looked at the FSA
Annual Report which you have given us and in table
5.2 on page 56 is a list of those attending the Risk
Committee. Everyone has full or perfect attendance
on that Risk Committee other than Sir John Gieve,
who attended only two out of four of the Risk
Committee meetings. In your correspondence to us
will you indicate exactly what dates Sir John missed
those Risk Committee meetings please?
Sir Callum McCarthy: If you would like me to I will
certainly, sir.7
Q356 Chairman: Thank you. The FSA handbook
incorporates the concept of approved persons,
including executive and non-executive directors; am
I correct?
Sir Callum McCarthy: Yes.
Q357 Chairman: In assessing fitness and propriety
the FSA has regard to competence and capability;
correct?
Sir Callum McCarthy: Yes.
Q358 Chairman: So do you regard the Northern
Rock Board as competent and capable and do you
still regard them as that given that all these members
are still at the driving wheel?
Sir Callum McCarthy: As you say, we authorised, as
we authorise non-executives and executives of major
banks, all those people. We took a view on the
overall corporate governance, and I would point out
that for example the Risk Committee or the
Liabilities and Assets Committee of Northern Rock
was actually chaired by an extremely experienced
banker. We looked at all that. We will of course,
whatever the shape that Northern Rock evolves
into—and there has been an announcement this
morning in relation to that—wish to look at the
continued authorisation that we have granted, as we
do with all people.
Q359 Chairman: Okay, if I could just ask you that
again: do you regard all the Board on Northern
Rock at the moment as competent and capable?
Sir Callum McCarthy: We believe that they were
properly authorised under the processes that we had.
Q360 Chairman: Again, is this a non-answer, Sir
Callum? Were they competent and capable? It is a
very simple question.
Sir Callum McCarthy: They met our authorisation
criteria, including the criterion of competence.
Q361 Chairman: So they were competent and
capable?
7
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Sir Callum McCarthy: Under the terms of the
authorisation, yes.
Q362 Chairman: Does that mean you thought they
were competent and capable and Mr Sants thought
they were competent and capable. For God’s sake,
give us an answer.
Sir Callum McCarthy: Sorry, neither of us was in
any way involved in the individual decisions.
Q363 Chairman: But the FSA thought they were
competent and capable?
Mr Sants: Clearly the FSA did and where we stand
at the moment, just to be quite clear, in respect of the
current situation that Northern Rock is in we deem
that it is appropriate for them to remain in place and
I think that would be a readily understood point that
in these sorts of circumstances it is useful to have a
management team who are fully understanding of
the set of circumstances the firm is in.
Q364 Chairman: We are pulling teeth to get the
answer, Sir Callum, we are focusing on Northern
Rock and we will come back to you in terms of the
non-Northern Rock issues with the FSA, but maybe
some of my colleagues would like to ask a quick
question to you on that. I do not think we will give
due justice to it given the amount of time we have
spent on Northern Rock, but if I can try and sum up
what you have said to us this morning you would say
the lessons learned are: the FSA needs to push the
extreme stress testing in banks; is that correct?
Sir Callum McCarthy: Yes.
Q365 Chairman: So there was an element of
supervisory failure in that?
Sir Callum McCarthy: In terms of not pushing it
further than we did, we should have done more, yes.
Q366 Chairman: So it was inadequate, that is fine.
There is also low consumer confidence in the
authorities; you have said that. I picked that up as I
went along.
Mr Sants: As was demonstrated by the events
surrounding the announcement of the lender of last
resort facility.
Q367 Chairman: Okay. There are problems with the
Financial Services Compensation Scheme deposit
protection; that is correct?
Mr Sants: Yes.
Q368 Chairman: Okay. The three-year period
between the full regulatory analysis of “high impact”
firms is too short?
Mr Sants: No, I said in specific regard to Northern
Rock that period proved to be too short and we need
to do a lessons learnt exercise more generally on the
implications for our overall supervisory regime.
Q369 Chairman: We are talking about Northern
Rock this morning. You said it was too short for
Northern Rock.
Mr Sants: Yes.
Q370 Chairman: So we can forget your first negative
answer there; it was too short?
Mr Sants: I thought you were asking about general
supervisory lessons.
Q371 Chairman: It is Northern Rock we are on
about.
Mr Sants: I beg your pardon. Three years should
have been a shorter period.
Q372 Chairman: That was a trick question. Thank
you. Basle II liquidity requirements need
modernised; is that correct?
Mr Sants: Basle II and liquidity is a diVerent point.
The overall international liquidity regime needs
modernising.
Sir Callum McCarthy: Something which we are
already working on.
Q373 Chairman: Okay. You perhaps took a diVerent
view from the Governor on the four pieces of
legislation?
Sir Callum McCarthy: Sorry, I think the main
diVerence which we have discussed is whether the
problem of a covert lender of last resort is a legal
problem or a practical problem, and we would place
greater emphasis on the practical problems whilst
not neglecting the legal consequences.
Q374 Chairman: So perhaps you had a diVerent
view.
Sir Callum McCarthy: A slight diVerence of
emphasis.
Q375 Chairman: That is fine. In terms of supporting
the banks for more liquidity and in takeovers
supporting the bidding bank and the terms of
supply, that question remains unanswered here?
Sir Callum McCarthy: Yes.
Q376 Chairman: The Tripartite system in your
opinion worked, everyone played their part?
Sir Callum McCarthy: Yes.
Q377 Chairman: So the question I have got then is if
the first bank run for 140 years is success, what is
failure?
Sir Callum McCarthy: Sorry, Chairman, I do not
think that any of us has described what has
happened in terms of a success. You manifestly have
not as a Committee and we manifestly have not.
Q378 Chairman: You are telling us everything
worked, the Tripartite system worked, and yet we
have had the greatest cock-up for 140 years.
Sir Callum McCarthy: We have had a problem of
global lack of liquidity which has resulted in this
country in one bank—a major bank—having an
acute liquidity problem and there have been
problems, as I have pointed out, in other countries
round the world.
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9 October 2007 Sir Callum McCarthy and Mr Hector Sants
Chairman: Okay, we will be coming back to these
issues and we look forward to your correspondence
certainly before next Tuesday. We are coming back
to other non-Northern Rock issues but have any
colleagues any particular questions on it just now?
Q381 Chairman: We understand that. Could I finally
quickly ask you about inherited estate. How
important on the list of FSA priorities is the £14
billion up for reattribution in the Prudential and
Norwich Union with-profit funds?
Mr Sants: Very important, and indeed I did write on
this very subject only yesterday to convene further
meetings and discussions on these issues.
Q379 Ms Keeble: I have one and it was really about
the sale and rent back schemes, which are not part of
your remit currently but are becoming increasingly
important. There are complaints about them but
also I have had clear evidence of diYculties with
them. Do you have concerns and do you foresee
being able to regulate those?
Mr Sants: As you know, I have only taken on this
remit at the end of July having previously been on
the wholesale side. I am fully aware of the concerns
that have been raised and have seen that—
Q382 Chairman: Do you accept that policy holders
would be dismayed if the outcome of either of these
two reattributions left them as badly oV as the AXA
policy holders?
Mr Sants: I think there are some serious questions to
be addressed and we are in the middle of doing that
and, as I say, I yesterday indicated that I wished to
take a direct personal interest in the matter and I will
happily return to the Committee with the
conclusions I draw.
Q380 Chairman: You are going to have a letter on
your desk from me on that.
Mr Sants: I have had a briefing on that and I think
it should be looked at. I will have to send you a letter.
To be frank, I have been looking at some other
things but I will come back to you.
Q383 Chairman: Are you confident that your rules
changes mean that this will not happen?
Mr Sants: I think that is an issue to be looked at.
Chairman: I will tell you what, we will write to you
on that as well and if we can get an answer on that
that would be very helpful. Sir Callum, Hector
Sants, thank you very much for your evidence this
morning. We will be having you back on the Annual
Report questions, and no doubt we could have you
back on this issue, but thank you very much for
your answers.
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Ev 47
Tuesday 16 October 2007
Members present
John McFall, in the Chair
Mr Graham Brady
Mr Colin Breed
Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr George Mudie
Mr Siôn Simon
John Thurso
Mr Mark Todd
Peter Viggers
Witnesses: Dr Matt Ridley, Chairman, Mr Adam Applegarth, Chief Executive, Sir Ian Gibson, Senior NonExecutive Director, and Sir Derek Wanless, Non-Executive Director, Northern Rock, gave evidence.
Q384 Chairman: Good morning and welcome to our
inquiry into Financial Stability and Transparency.
Can you introduce yourselves, please, for the
shorthand writer.
Sir Ian Gibson: Ian Gibson, I am a Non-Executive
Director and Senior Independent Director at
Northern Rock.
Dr Ridley: Matt Ridley, I am Chairman of
Northern Rock.
Mr Applegarth: Adam Applegarth, I am Chief
Executive.
Sir Derek Wanless: Derek Wanless, Non-Executive
Director.
Q385 Chairman: Good morning to you. Mr Ridley,
how were you given the Chairman’s job?
Dr Ridley: The Board chose me as Chairman three
years ago. I had been on the Board for 13 years
before that and in 2004 they chose me as Chairman.
Q386 Chairman: What competences and experience
did you bring to the job?
Dr Ridley: I am a businessman and I am on a number
of diVerent boards involving a number of diVerent
businesses. I had spent at that point ten years on the
Board of Northern Rock, including during the
transition from a building society to a bank.
Q387 Chairman: Were you involved in any banking
businesses?
Dr Ridley: Apart from Northern Rock I was not
involved in any other banking businesses.
Q388 Chairman: Are you at ease with the business
model that Northern Rock has adopted?
Dr Ridley: The Northern Rock business model was a
good one in that it allowed us to achieve good credit
quality on our loan book and steady growth for a
number of years. That business model proved
unable to cope with an unexpected, unpredicted
seizure of the money markets in August.
Q389 Chairman: Were you aware of the risks to the
business at any time? When did you start becoming
aware of the risks to the business?
Dr Ridley: I was fully aware of the risks throughout.
We have a Risk Committee and we are continually
assessing the risks to the business and stress testing
against diVerent risks. We were aware earlier in the
year of the risk of tightening in the credit markets
and we expected that our good credit quality and our
diverse funding platform would stand us in good
stead under those circumstances.
Q390 Chairman: So when were you aware of the
risks? What date did you really start discussing the
risks to the business?
Dr Ridley: As I say—
Q391 Chairman: When did you start discussing the
one that got you into this jam?
Dr Ridley: I started discussing it with the Chief
Executive on 10 August, the day after the markets
first froze, and during the next few days we discussed
it in increasing detail as it became clear that this
freezing was less and less and likely to be temporary.
Chairman: Okay. Michael?
Q392 Mr Fallon: Dr Ridley, you wrote to Members
of Parliament on 24 September saying: “We have no
sub-prime loans.” Can you explain why this
advertisement appeared by Northern Rock saying:
“Open for sub-prime business” in the summer?
Dr Ridley: Yes I can.
Q393 Mr Fallon: Including an advertisement for
“sub-prime
products,
dedicated
sub-prime
underwriting and processing teams: call our subprime support unit”. How can you say that you had
no sub-prime loans? Do you know what is going on
in your bank?
Dr Ridley: Yes I do. We introduce sub-prime loans
to a third party. We do not hold those sub-prime
loans on our balance sheet.
Q394 Mr Fallon: So the statement “We have no subprime loans” can be reconciled with saying “Open
for sub-prime business”, can it?
Dr Ridley: Yes it can. We are an introducer of subprime loans to a third party and that is what that
advertisement is about.
Q395 Mr Fallon: You make money out of sub-prime
loans then?
Dr Ridley: We have made a small amount of money
out of a very small range of sub-prime loans during
this year.
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Ev 48 Treasury Committee: Evidence
16 October 2007
Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q396 Mr Fallon: You are playing with words here; I
thought you were a journalist. You have a sub-prime
business?
Dr Ridley: I said in my letter that we have no subprime loans; it is true—we introduce sub-prime
loans to a third party.
Q397 Mr Fallon: So you are running a sub-prime
business?
Dr Ridley: We have no sub-prime loans on the
balance sheet of Northern Rock.
Q398 Mr Fallon: Mr Applegarth, why was it decided
a month after the first profits warning, as late as the
end of July, to increase the dividend at the expense
of the balance sheet?
Mr Applegarth: Because we had just completed our
Basle II two and a half year process and under that,
and in consultation with the FSA, it meant that we
had surplus capital and therefore that could be
repatriated to shareholders through increasing the
dividend.
Q399 Mr Fallon: Was that not exactly the wrong
time to weaken the balance sheet?
Mr Applegarth: No, what hit us was a liquidity
squeeze, not a credit crunch, and really dividends
and capital are to do with credit. It was a global
liquidity squeeze that hit us.
Q400 Mr Fallon: You do not now regret that
decision?
Mr Applegarth: It was a very sound decision. It had
no relation to what hit us. What hit us was the
freezing of global liquid markets.
Q401 Mr Fallon: Your business model, Dr Ridley,
was described by the FSA Chairman as “extreme”.
You were borrowing 75% of your funding from the
capital markets; you failed to insure against any
increase in the inter-bank rate; you failed to hedge
the period between taking out a mortgage and its
completion, because presumably you thought rates
had peaked. This was not banking; this was a heavily
leveraged bet on interest rates was it not?
Dr Ridley: I think it is worth clarifying what the
funding side of our balance sheet was. It is true that
we had a smaller retail deposit book than many
other institutions, although there are many like us
overseas. As the Chairman of the FSA also said, in
terms of the short and medium term wholesale
funding, as a ratio of our balance sheet assets, we
were not an outlier. Most of our wholesale funding
was in the form of securitised bonds and covered
bonds, which are long-term funding. The average
maturity is longer than the average life of a mortgage
on our books.
Q402 Mr Fallon: But why did you not see the risk of
capital markets closing to you? Why did you not
insure against the danger of illiquidity?
Dr Ridley: We saw that there was a risk of tightening
in the credit markets and we prepared for that. What
we did not expect was that there would be no flight
to quality in that process. In other words, we
expected that as markets became tighter and as
pricing for risk changed that low-risk prime UK
mortgages (and we have below half the industry
average of arrears on our mortgage book) and such a
low-risk book would remain easier to fund than subprime mortgages elsewhere. That is why we were
very determined to keep the credit quality of our
book high, in order to be able to attract funding.
Q403 Mr Fallon: But a very high proportion of your
funding was dependent on the capital market, a
much higher proportion than other lenders?
Dr Ridley: We were dependent on, as I said, the
wholesale markets but also the securitisation market
and the covered bond market. We deliberately
diversified our funding platform so that we would
have those three diVerent types of funding and
indeed a diversified programme within the wholesale
funding, and geographically we had programmes in
the United States, Europe, the Far East, Canada and
Australia. That was deliberately so that if one
market closed we would still have access to others.
The idea that all markets would close
simultaneously was unforeseen by any major
authority.
Q404 Mr Fallon: But a heavily leveraged bet on the
movement of interest rates and on capital markets
remaining open for an over-exposed model like this
seems to me a fairly basic banking error, is it not?
Dr Ridley: We were subject to a completely
unpredicted and unpredictable closing of the world
credit markets. Our model was entirely transparent
to the market and to the regulator. It was discussed
regularly with both and it was not at the time seen as
running a particularly high risk in terms of liquidity.
Q405 Mr Fallon: But it was your duty as Chairman
and as a Board to ensure that your bank was liquid.
Dr Ridley: We reviewed liquidity regularly and we
reviewed our policy on liquidity and our policy on
funding regularly.
Q406 Mr Fallon: But you were wrong?
Dr Ridley: We were hit by an unexpected and
unpredictable concatenation of events.
Q407 Mr Fallon: So you are the Chairman of a bank
that ran out of money and that caused the first bank
run in this country for 150 years; you have had to
borrow billions of pounds of public money from the
Bank of England; you have damaged the good name
of British banking; why are you still clinging to
oYce?
Dr Ridley: I would like to say that what has
happened has been extremely distressing to us, as it
has been to our other stakeholders, shareholders,
employees and creditors. In view of what has
happened I am extremely keen to try and turn the
situation round and develop a stable future for
Northern Rock. I am working night and day to
achieve that. I serve at the behest of the Board and
if they think that they can do better by asking for my
resignation, it will be available to them.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q408 Mr Fallon: But this is a humiliation. Has none
of the Board any sense of honour? Has nobody
oVered to resign?
Dr Ridley: I would like at this point perhaps to
suggest that Sir Ian Gibson answers that question.
have a successful strategy, is that correct, or
otherwise you would not have found yourself in this
position?
Dr Ridley: We were not warned of a complete
freezing of all global liquidity markets.
Q409 Chairman: No, you answer it Dr Ridley, that
is what you are here for.
Dr Ridley: Yes indeed, I was going to say I will give
a quick answer to it first. I have made it clear to the
Senior Independent Director, as is his role, that my
resignation is available to him as soon as he thinks it
is in the interests of the company, its shareholders,
creditors, employees and other stakeholders that I
go.
Q417 Chairman: Let me just read it to you again. It
says here “ . . . how participants can be hit by sharp
reductions in market liquidity”. If that is not a red
alert warning I do not know what is a red alert
warning.
Dr Ridley: There were sharp reductions in liquidity
after 9/11 in 2001. That lasted for a matter of days.
Our model was extremely robust in those conditions.
What was not expected was that all global markets
would shut down and remain shut down for as long
as they have.
Q410 Chairman: You did say that you discussed the
risk on this issue with the Chief Executive on 10
August; that is correct?
Dr Ridley: Correct.
Q411 Chairman: And that this was unpredicted. You
have said that two or three times to Mr Fallon.
Dr Ridley: Yes.
Q412 Chairman: But were you aware of the Bank of
England’s April 2007 Report on Financial Stability
and were you aware of the Financial Risk Outlook
from the FSA in January 2007?
Dr Ridley: Yes, I was aware of both of those reports.
Q413 Chairman: Did it influence Board decisions?
Dr Ridley: It did influence Board decisions.
Q414 Chairman: What did you do from January to
April?
Dr Ridley: We did a number of things. We prepared
to sell some of our asset books, as you will know
because of announcements we made at the half
year—our commercial loan book and our unsecured
loan book and—
Q415 Chairman: I would suggest to you, Dr Ridley,
you failed because if you look at the Bank of
England statement it is very clear, in late April it says
that: “Recent developments in the US sub-prime
mortgage market have highlighted how credit risk
assessment can be impaired in these markets and
how participants can be hit by sharp reductions in
market liquidity. It is important therefore that firms
stress test and we take them into account . . . ” That
was in April so what you did from April to 10
August seemed to have no eVect whatsoever on the
position that you found yourself in, so you did not
take corrective action that was successful?
Dr Ridley: As you say, that report was about the
pricing for credit risk in the markets as well as
liquidity and we ensured that our funding was—
Q416 Chairman: But Dr Ridley, let us forget about
the words here, this talks specifically about
reductions in market liquidity. You are telling us
that this was unpredicted, but this was informed to
you by the Bank of England in April, you were
warned, and from April to 10 August you did not
Q418 Chairman: So really what you are saying to us
is that the corrective action you took from April, if
there was corrective action, was not suYcient to
avert this crisis?
Dr Ridley: The corrective action we took from April
was designed for a tightening of the credit markets
and a tightening of liquidity in those markets; it was
not designed for a complete shutdown of the
global markets.
Q419 Chairman: It said “sharp reductions in market
liquidity”. In other words, it is a real warning and
you did not seem to take up what that meant and
therefore found yourselves in this humiliating
position on 10 August. That is really the answer to
the Committee.
Dr Ridley: We were in constant dialogue with the
FSA.
Chairman: We will go on to that later on. The main
point is made there. Colin?
Q420 Mr Breed: Mr Applegarth, can you just
confirm a few things. Did you and do continue to
lend up to 125% of the value of the property
valuation on mortgages?
Mr Applegarth: No, we lend secured up to 95% but
then we also sell unsecured lending as well.
Q421 Mr Breed: So the total borrowing that
somebody has can be as much as 125% of the
underlying value of the security?
Mr Applegarth: It could but only 95% is actually
secured against the property.
Q422 Mr Breed: And do you lend up to five or six
times the income of an applicant?
Mr Applegarth: Theoretically yes, but it has to be a
very high-quality applicant to get that loan. It
accounts for about 1% of our lending.
Q423 Mr Breed: Do you consider the lending
policy prudent?
Mr Applegarth: Yes I do because there is a great deal
of diVerence between phoning up and asking the
maximum you can get and actually going through
and applying and qualifying for a loan, so all
applicants are very heavily credit scored, both at
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
point of sale and on a monthly behavioural rescore,
and I think the evidence shows up in the actual
quality of the loan book and the fact that our arrears
for the last 15 years have been consistently around
half the industry average.
Q424 Mr Breed: Your arrears in the past have been
below the industry average. Bearing in mind the
increase in the volume of your business is in the first
six months of this year, it is fairly unlikely for arrears
to start to appear within a few months of advancing
a loan, do you believe that the quality of your loan
book is going to continue to reveal in the future
arrears and defaults at half or so the industry
average, based upon the significant amount of
business that you have taken in the first six months
of this year?
Mr Applegarth: I do because one of the exercises you
have to do in order to get your Basle II approval is to
actually go through your credit scoring dynamically
and take a loan from point of sale and go through
arrears and possessions and feed it back. I think the
last 18 months can be characterised for us as learning
the lessons from our lending and applying them back
into front end loans. You can track each time cohort
of lending as you go along, and it looks like the last
18 months lending is actually better quality than the
previous two to three years.
Q425 Mr Breed: Do you think it is believable that
any institution which advances up to 125% of
property value and lends to people five or six times
their income is actually likely to have a record of
arrears and defaults of something like half the
industry average?
Mr Applegarth: It depends if you are a picky lender
or not and, yes, we are a picky lender. If you take the
extremes of lending policy, it sounds racy; if you
look at what happens in practice, it is not, so for the
last 15 years our arrears have been around half the
industry average.
Q426 Mr Breed: On that basis it would not have
been too diYcult to oZoad your loan book on to a
welcoming market with such a fantastic record?
Mr Applegarth: That is what we started doing,
following up the answer the Chairman gave before.
On the back of the warning signs, you saw us
announce a change in strategy with the interim
results that were slowing down the rate of asset
growth, which we had done from the third month of
this year, and we announced that we were going to
sell various higher risk asset books on the balance
sheet. We completed the sale of the commercial loan
book, which is about a £2 billion loan book, over
three stages, with the third stage actually taking
place after 9 August.
Q427 Mr Breed: So in the third month of this year
you began to realise that things were not going
very well?
Mr Applegarth: In the third month of the year we
picked up the warning signs that the US sub-prime
position was meaning a tightening in pricing and
therefore we slowed down the rate of growth and we
gave new guidance against our profits for the year,
recognising the tightening in pricing.
Q428 Mr Breed: So in the five months between
March and August, when obviously things were
getting tighter and more diYcult, you still had not
managed to successfully ensure that the bank did not
run out of money?
Mr Applegarth: We slowed down the rate of lending,
we announced a strategy where we were removing
higher risk assets oV the balance sheet but, in the
event, it could not cope with the complete closure of
markets on a global basis.
Q429 Mr Breed: When was the first time that you
contacted the FSA and expressed your concerns
about this possible problem that you would have?
Mr Applegarth: Our traders first noted a dislocation
in the market on 9 August. We first formally
contacted the FSA two working days later.
Q430 Mr Breed: So in the third month, in March,
and presumably in April, May, June and July, you
did not advise the FSA and at no time during that
period of time did you have to complete a return to
them which might indicate certain liquidity
problems?
Mr Applegarth: Sorry, I answered the question
thinking that you meant when did we first inform the
FSA after the dislocation of the markets on 9
August.
Q431 Mr Breed: When did you first inform that FSA
that felt you might have a particular problem? I
might have assumed it would have been in March?
Mr Applegarth: We notified the FSA about a change
in our strategy. We are on something called a close
and continuous relationship so as we changed the
strategy so we told them. We are in very regular—
Q432 Mr Breed: Was that in March?
Mr Applegarth: It will have been in March and
before because we were discussing with the FSA as
part of our Basle II process and they came to our
Board meeting in January, I think it was, and we
took them through what we were intending to do
going forward in terms of moving to a slower
growth model.
Q433 Mr Breed: So they came to your Board
meeting in January and they satisfied themselves
that it was all right. You kept in close and
continuous touch with them, so between March and
August you and the FSA between you still failed to
ensure that the bank was able to continue to trade
with a liquid liability book?
Mr Applegarth: We certainly failed to foresee the
global closedown in liquid markets.
Q434 Mr Breed: And the FSA did not point that out
to you at any of the meetings between March and
August?
Mr Applegarth: I do not know of anybody who
foresaw the global freeze.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q435 Mr Breed: Do you have a Risk Committee?
Mr Applegarth: Yes we do.
Q436 Mr Breed: Who is the Chairman of the Risk
Committee?
Mr Applegarth: Sir Derek is.
Q437 Mr Breed: Sir Derek, were you entirely happy
that during that period of time the Risk Committee
operated satisfactorily and reviewed its risks so that
it could ensure that the bank could continue to
trade?
Sir Derek Wanless: The Risk Committee and the
Board discussed the strategy on a continuing basis.
I am perfectly happy, yes, with that.
Q438 Mr Breed: You are satisfied that you had the
right strategy for that particular period between
March and August?
Sir Derek Wanless: We talked from the time about
the funding strategy, which was an annual look at all
of our funding sources, about both retail and
wholesale funding, and we talked about the ways in
which that strategy was robust against many
circumstances.
Q439 Mr Breed: Were you in contact with the FSA?
Sir Derek Wanless: I was not personally in contact
with the FSA. The Risk Committee is a Board
Committee which meets three times a year.
Q440 Mr Breed: The FSA did not contact you or
talk to you about the risk profile of the bank?
Sir Derek Wanless: The FSA at this stage were
talking extensively to the executive about the
ICAAP process and Basle II and the executive were
talking to the Board on a regular basis on where that
process had got to.
Q441 Chairman: Mr Ridley, what was the business
plan agreed in 2006 regarding the amount of
mortgage lending that the company would do in
2007?
Dr Ridley: We planned in 2007 to grow our
mortgage lending at a slightly slower rate than we
had in 2006 to increase the assets on the balance
sheet by about 20%.
Q442 Chairman: So what was the mortgage lending
in terms of share of the market in 2006?
Dr Ridley: We did not target a particular share of the
market but at the end of 2006 we had, I think 7.5%
of the UK mortgage market.
Q443 Chairman: And you ended up in 2007 with
about 19% of the market?
Dr Ridley: No, those are two diVerent figures. 7.5%
is the share of the total UK mortgage market; 19%
is the share of net new lending that was done in the
first half of 2007.
Q444 Chairman: The reason I am asking that is that
I looked at HBOS—they are one of the largest
lenders—and they took 8% net lending in the first
half of 2007? Is that correct?
Dr Ridley: If you are right, yes.
Q445 Chairman: But you ended up taking 19% at the
end of the day, so was it not a case of looking at the
market and then taking a punt to increase the
amount because other big mortgage lenders had
more conservative estimates about what they would
take in the market?
Dr Ridley: As I say, we did not increase the rate of
mortgage lending in the first half of 2007. It was at
exactly the same growth rate as the average had been
over the ten years since we converted from a
building society.
Q446 Chairman: But it grew three times as much as
any other company. That is general knowledge.
Dr Ridley: One of the reasons for that is because we
have become very good over the past few years at
retaining our customers. We are unique in this
industry in oVering the same mortgage deals to
existing customers—
Q447 Chairman: One of the questions is, Sir Derek,
have you the funding in place to support this? Where
were the cautious voices?
Sir Derek Wanless: The plan that was put to the
Board, which the Board approved, was a funding
and a lending plan, it was a complete plan for the
business, and on the funding side we opened up new
retail sources of funding, in Denmark for example.
We had products in the UK, too, which were being
successful, as well as having the diverse range of
wholesale lending which meant that eVectively we
were funding around the world.
Q448 Mr Todd: I may have misheard you, Mr
Applegarth, but I think you said that after the
warning signs appeared in the spring you took action
to slow the growth of loans; is that right?
Mr Applegarth: It is.
Q449 Mr Todd: How do you reconcile that with
what your Chairman has just said about the market
share that Northern Rock were achieving in this
period, which he said was much the same as in
previous years and according to the business plan? It
does not sound as if any slowing action was
communicated to him. It is hard to visualise, bearing
in mind the fact that you were taking 19% of the new
mortgage market, that that indicated slowing down,
but perhaps you can tell us how that is reconciled.
Mr Applegarth: Yes, surely they are consistent. Our
market share of the gross market is under 10% and,
as the Chairman said, we retain our customers
increasingly well, and that is what gave you the net
lending market share. We started slowing lending
down but, as you know, it takes about two and a half
to three months to move house and therefore the
actions you take have a delayed impact, so by the
end of the year our balance sheet growth, once we
had completed the asset sales, would have been
somewhere around 16% or 17% versus the figures of
the half year, which are higher.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q450 Mr Todd: So we will not really see the eVects
of the actions that you may have taken in the spring
until the end of the year? Is that what you are
suggesting?
Mr Applegarth: You saw some of the actions in the
pipeline of new business waiting to come through at
the half year, and that was ironically one of the
things we were criticised for at the half year—
because we were going to deliver lower growth than
the markets had been assuming.
Q451 Mr Todd: So what sort of growth were you
attempting then in this period after March when you
were taking this remedial action that you referred
to earlier?
Mr Applegarth: We would have ended the year with
an asset growth of around 16% or 17% but that was
dependent on removing—
Q452 Mr Todd: And that is not an aggressive
growth rate?
Mr Applegarth: It is a noticeably slower rate of asset
growth than the previous ten years where we had
averaged between 20% and 22%.
Q453 Mr Todd: I suppose I must have been running
dull businesses in the past, but certainly a growth
rate of 16%, which in real terms is 12% or 13%,
would have seemed pretty aggressive to me.
Mr Applegarth: It depends from where you start. If
you start as a small lender the percentage sounds a
big number. It would be diVerent if you had a much
greater balance sheet.
Q454 Mr Todd: I am hearing incredulity around me
but, anyway, can we turn to the stress-testing
exercise. You probably have read the evidence of the
FSA to us on this. The FSA did do a full stress test
on you in late 2006/early 2007 and actually
combined their stress-testing exercise with their
Basle II exercise with you; is that correct?
Mr Applegarth: It is indeed, and as part of Basle II,
which is a two and a half year process, you have to
run a whole series of stress tests, including for
example a 40% house price fall. Of course I read the
FSA evidence, but what was not stress-tested was the
event that was deemed implausible of the global
markets all freezing at the same time, with rapid
speed and for a long duration.
Q455 Mr Todd: No, the FSA have not said that they
alerted you to that possibility, however, they did—
quoting Mr Sants—say that they had advised you
that you needed to take into account more extreme
scenarios than the ones you were presumably using
at the moment. Did you a) take any note of what that
they said and b) if you did, what in concrete terms
did that suggest to you?
Mr Applegarth: Yes of course we did because we had
to satisfy them in order to get our Basle II approval.
The extra tests they asked us to do were primarily to
do with credit, such as the example I gave of the 40%
house price fall. What we did not stress test and did
not foresee was what was deemed implausible, which
was the rapid and long-lasting closure of global
markets. That was not stress-tested, no.
Q456 Mr Todd: But nevertheless I think it is fair to
say the FSA did not feel that your stress testing
model was adequate at the time they reviewed you
under the Basle II process?
Mr Applegarth: There are always things you can do
better and that was a continual process and had been
for the previous ten years with them.
Q457 Mr Todd: So it was a rather mild “there are
things we can do better” but no specific criticisms or
suggestions were made? However, they did suggest
various other tests which included a dramatic fall in
house prices, which I must admit I would have said
was rather less likely than some of the events we have
seen but still those were the only concrete proposals
they made?
Mr Applegarth: I think you would describe it as
work in progress as opposed to a red flag.
Q458 Mr Todd: Just turning to Sir Derek, did the
Risk Committee review the advice that the FSA had
given in the Basle II process on risk stress testing?
Sir Derek Wanless: The Risk Committee in fact
the Board—
Q459 Mr Todd: You said they only met three times
a year.
Sir Derek Wanless: The Board looked at what the
FSA said when they gave us the accreditation under
the Basle II arrangement and they made an
adjustment to the capital. It is an assessment of
Northern Rock’s own model so they made an
adjustment to capital in respect of credit
concentration risk, which was their major concern.
They also mentioned pension risk, securitisation risk
and stress-testing, in that order of priority.
Q460 Mr Todd: Right. You have emphasised to us
how unpredictable and unpredicted the events have
been. Can you explain why you are the only
substantial business of this kind that has
encountered this diYculty?
Mr Applegarth: I do not think we are the only
business to encounter this diYculty.
Q461 Mr Todd: Of substance and scale. I recognise
there are some smaller operators who have
struggled too.
Mr Applegarth: I think one of the features is the fact
that it was a global—
Q462 Mr Todd: —In the UK and under the
governance of the regulatory system here in the UK?
Mr Applegarth: It has been reported that over 150
banks in Europe were able to access the ECB, and
that will of course include bigger UK operators who
have franchises across in Europe, so they have been
able to access ECB funds.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Q463 Mr Todd: But that is of course a mechanism of
risk management, is it not, that they are able to gain
access to other markets? Is that not so? You
emphasise the diVerence between themselves and
yourself, but that would of course be a matter of risk
which your Board might have considered, the fact
that you would not have had the access that was
available to some of your competitors; is that right?
Mr Applegarth: Indeed, and that is why we have
worked very hard over the previous decade to try
and diversify our funding platform by geography
and product. That is why we moved to having four
funding platforms—retail cash deposits, covered
bonds, securitisation and traditional wholesale—
and it is why in each of those markets we look to
diversify by geography. So for securitisation for
example not only did we tap the UK but we tapped
Europe, the Far East and America. If you look at
traditional wholesale, we tapped American,
European, Asian and Australian markets. Cash
deposits, as Sir Derek has already said, we moved
across to Ireland and across to Denmark, so we
broadened our funding platform to try and
increase stability.
Q464 Mr Todd: Just one last thing, you will know
that the Governor when he saw us emphasised the
message of moral hazard in taking action to deal
with a crisis of this kind. Do you think he has
perhaps a moral message for the way in which your
bank has been governed, that this is an
inappropriate model which should not receive
support on a free basis?
Mr Applegarth: The facility of lender of last resort is
there for businesses that are solvent and viable but
have a short-term liquidity squeeze, so the lender of
last resort is designed for the situation we find
ourselves in. Of course what severely hammered us
was the retail run that followed the announcement
of that.
Q465 Chairman: Mr Wanless, if I could ask for
clarification, 7.5% was Northern Rock’s share of the
total mortgage lending market at the end of 2006; is
that correct?
Sir Derek Wanless: Our share of the total mortgage
market, yes.
Q466 Chairman: And at the present time it is just
under 10%?
Sir Derek Wanless: The discrepancies are about
gross and net and the share of the stock. In terms of
net share, we have had 19% in the first half of the net
change in the mortgage market.
Q467 Chairman: Of new mortgage lending.
Sir Derek Wanless: Of the new mortgage market,
which is the gross mortgage market; on how much
new lending is done, we had less than 10%.
Q468 Chairman: That is quite an aggressive
approach, is it not?
Sir Derek Wanless: Less than 10% of the market.
Q469 Chairman: But 19% of new mortgage lending,
that is what you had.
Sir Derek Wanless: No, we had less than 10% of
gross mortgage lending, that is to say new
mortgage lending.
Q470 Chairman: What I am saying to you is 19% of
new mortgage lending—
Sir Derek Wanless: 19% of net which is the diVerence
between the new lending and what is repaid.
Q471 Chairman: Was that not an aggressive
approach?
Sir Derek Wanless: As I think the Chairman said
earlier, the target that we had was an asset growth
target, not a market share target.
Q472 Chairman: The reason I am asking that, Mr
Wanless, is I looked up the BBC website before I
came and you are the only one with experience of
retail banking but it was with NatWest, and what the
BBC were saying in their website was that you “were
seen as having driven NatWest into an ill-advised
series of deals, in particular a foray into the highly
competitive US market, and a move to expand its
financial market presence.” They said during his
tenure at NatWest, Wanless made ill-advised forays
into investment banking in US markets whilst losing
market share. In 1997 a £90 million trading loss was
uncovered in NatWest Markets, the bank’s
investment bank, which many commentators
blamed on the investment bank’s quality of
management. The trader who ran up the £90 million
loss had been trading since 2004, which meant that
he was overlooked by NatWest’s review of its risk
control in 2005, but at the time you insisted that
things were going well generally. As we know,
NatWest was taken over in a hostile takeover by the
Royal Bank of Scotland, so I am putting it to you
maybe the risk you missed here was the risk that you
missed with Northern Rock, and your voice should
have been a cautious voice against this aggressive
strategy.
Sir Derek Wanless: The strategy has been a strategy
in place since I joined the Northern Rock Board in
2000. It is a strategy which the Board discussed and,
as we have said, we discussed the funding aspects of
that and indeed the credit control aspects of that on
a very regular basis.
Q473 Chairman: But there was an aggressive
strategy?
Sir Derek Wanless: The strategy was a growth
strategy which was communicated to the market so
that everyone knew what Northern Rock was
seeking to achieve, and it was a strategy where we
put in place on the funding side of the business a
diverse series of funding sources.
Q474 John Thurso: Mr Applegarth, listening to you
all here today, you sound like frightfully reasonably
chaps who have been the ghastly victims of some
unforeseeable financial tsunami, yet the plain fact is
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you are in charge of the only bank that has had a run
on it for 150 years. Do you actually accept you have
done anything wrong?
Mr Applegarth: I feel great regret for the anxiety our
retail customers have seen. It was a good business
model but, clearly, it could not deal with the
unforeseen global freezing of the liquid markets.
Q475 John Thurso: You keep saying it was
unforeseen yet this Committee has been discussing it
for six months. We discussed it when we were in
America. We discussed it in open session. Lots of
people were talking about the risks that were
coming. Why is nobody else in this crisis? Why are
you the only ones?
Mr Applegarth: I do not think we are the only ones,
as evidenced by the number of banks who had to
approach the ECB for exactly the same type of
borrowing facility—
Q476 John Thurso: None of them has lost their
brand; none of them is up for sale; none of them is,
frankly, destroyed by what has happened. You are
the only real, serious casualty. Was it a question of
the way you were running the bank? Was it a
question of the way we regulate? What caused this?
Mr Applegarth: I think the fundamental cause was
the speed and duration and the global nature of the
liquidity freeze, heightened for us by the fact that we
did not have access to the same type of borrowing
facilities that have been available for American
banks from the US Reserve and for the European
banks from the ECB.
Q477 John Thurso: So there was nothing you could
have done to mitigate this risk?
Mr Applegarth: No.
Q478 John Thurso: No action you could have taken
that could have mitigated this risk?
Mr Applegarth: No.
Q479 John Thurso: Sir Derek, how did you set about
in your Risk Committees of 17 April and 17 July
examining the future risks? What is the process your
Committee had to look at risks that were coming up?
Sir Derek Wanless: There was not a meeting in
April; there was a meeting in July of the Risk
Committee.
Q480 John Thurso: There was no meeting in April?
According to the letter we had from the FSA there
was a meeting on 17 April, but they have obviously
got it wrong.8
Sir Derek Wanless: There was no meeting of the
Risk Committee then. It may be they are referring—
Q481 John Thurso: There was one in July?
Sir Derek Wanless: It may be they are referring to
meetings of the Asset and Liability Committee,
which is an executive committee which meets
monthly in Northern Rock.
8
Note by John Thurso: The information provided by the FSA
in fact related to the dates of the meetings of the FSA’s own
Risk Committee.
Q482 John Thurso: I am sorry, I have got letter here
from the FA and in it they said under the heading
“Risk Committee” that the Committee met on the
following dates in 2006 and 2007. I will not quote the
2006 dates but 13 February, 17 April and 17 July are
the quoted dates for the Risk Committee meetings in
2007, so they got that wrong?
Sir Derek Wanless: Yes, and we can confirm to you
if you wish the precise dates of the meetings.
Q483 John Thurso: Your meeting was in July.
Sir Derek Wanless: We met in July.
Q484 John Thurso: What discussions did you have?
Sir Derek Wanless: At that meeting in July we talked
about, sorry in June, we met in June. You gave me
two months and neither of them was right. We met
at the end of June and we discussed the quality of the
credit portfolio, we discussed the Treasury position
and we discussed operational risk. We took a report
from the head of risk management in the company,
as we always did, about the activity he had underway
and particularly about the ICAAP activity, which
was the main focus of his activity at the time.
Q485 John Thurso: Did you discuss liquidity and the
way in which you would be refinancing at all? Was
that seen as a risk at that time?
Sir Derek Wanless: Treasury management was there
and discussed it at each of the meetings. Not long
before that meeting we had had our second Granite
transaction of this year, which was heavily
oversubscribed. Although the Committee this
morning is talking a lot about what happened after
March, in fact in May this year we had a Granite
issue of over £4 billion, which was heavily
oversubscribed, so there was no indication that our
paper, which we regarded as high quality (which is
why the Risk Committee paid such attention to
credit risk) was damaged by what was happening.
Q486 Peter Viggers: What would your advice be for
other institutions in the light of the experience you
have gone through in liquidity and how they should
assess risk?
Sir Derek Wanless: Clearly, as with every other
aspect of risk, you take everything that has
happened in the world that you can look at looking
backwards, and it is much easier with hindsight, but
I suspect the way other organisations will look at
their risk management in respect of liquidity will
depend very much on how the authorities react to
what has happened, and what happens, both on a
global and a UK basis, in terms of the way the
authorities are going to handle liquidity in future.
Q487 John Thurso: Do you think that the
regulations should be amended to have tighter
liquidity rules?
Sir Derek Wanless: I think the BBA has sent to this
Committee its thoughts about the matter, because
clearly there is a great deal of work to be done to
work out how a sub-prime crisis in the US became a
run on a bank in the UK, and the whole chain of
events, and what could have been done by whom at
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
which stage in that chain of events is something that
the authorities are clearly giving a great deal of
attention to.
Q488 Chairman: If I could add on to John’s
question, the Annual Report for 2006 at page 51
talks about the liquidity risk question. It says here
clearly that the FSA liquidity rules require the group
to be able to meet its sterling obligations without
recourse to the wholesale money markets for period
of at least five business days. On 9 August how many
days’ liquidity did you hold?
Mr Applegarth: We were still funding from 9 August
until 14 September but the duration came down, so
based on the levels of funding we had, we still had
two or three months’ worth of funding. The reason
we went to the Bank of England for a facility was as
a backstop facility. We had not intended to draw
down but of course we had to in the light of the
retail run.
Q489 Chairman: So you had two or three months’
liquidity?
Mr Applegarth: Yes—
Q490 Chairman: So there was no problem then?
Mr Applegarth: The problem we had was you could
not tell how long the markets were going to be closed
and it was a reasonable and proper thing to do to put
a backstop facility in place.
Q491 Chairman: Had that increased or decreased
since the start of the year?
Mr Applegarth: It had actually increased since the
half year because we increased our liquidity by £2.3
billion at the half year stage.
Q492 Chairman: I would like a note on that please.
Mr Applegarth: Of course.9
Q493 Peter Viggers: Who is currently running
Northern Rock?
Dr Ridley: The Board is running Northern Rock and
Adam and his executive team are managing the
operations.
Q497 Peter Viggers: Exactly?
Dr Ridley: No particular conditions.
Q498 Peter Viggers: So this amount of public money
was advanced to the people who had put the bank in
this position without any management controls
being put on you at all?
Dr Ridley: The authorities recognised that it is for
the Board, and through the Board responsibility to
its shareholders, to run its own business.
Sir Ian Gibson: Could I comment there, Chairman.
The FSA in particular but also the Bank are at
present involved, as you would expect, in a
considerably closer relationship with all the
executives of the bank and they have been visitors to
and demanders of information from the bank in
considerable detail since before the issue of the
facility and right through including today, and
therefore whilst the management of the bank
remains with the executive and the supervision of the
executive with the Board, we would not suggest that
the authorities are not involved in considerable
detail in overseeing what we do.
Q499 Peter Viggers: Drawing on my own ministerial
experience, in a similar situation we bound the
company in question hand and foot so that the
management could not take executive decisions
without our authority. Has something like that
happened to Northern Rock?
Dr Ridley: We are certainly, as Sir Ian said, in close
consultation on every decision of significance with
the authorities, yes. It would be foolish not to be.
Q500 Peter Viggers: Has a formal structure been put
in hand which would prevent you from taking
certain executive decisions without the FSA’s
authority?
Dr Ridley: I would not say a formal structure has,
but there are regular and formal links which enable
the authorities to consult with us and us with them
on every decision.
Peter Viggers: Would it be in order, Chairman, to
ask for a note on this in due course?
Chairman: Yes of course.10
Q496 Peter Viggers: And what conditions in terms
of management were put on the company on that
money being advanced?
Dr Ridley: In terms of who was to be in charge of the
company and so on?
Q501 Peter Viggers: One specific question:
Countrywide, a US mortgage bank, relied in a
similar fashion to Northern Rock on short-term
funding but chose to take out insurance against
liquidity drying up. Is liquidity insurance available
here? Did you consider it and why did you not take
it out?
Mr Applegarth: I think the first thing to say is that
our funding platform is broader than Countrywide’s
in that we have the four funding vehicles. We did
have some insurance in place but clearly it was
inadequate to cope with the retail run. It was not the
same volume of insurance as Countrywide had put
in place but we did have swing-line and standby
facilities put in place. They were smaller because we
have a more diverse funding platform.
9
10
Q494 Peter Viggers: And how much public money
has been advanced to Northern Rock?
Dr Ridley: The borrowings have been reported in the
press and the sums involved—
Q495 Peter Viggers: Perhaps you would tell us.
Dr Ridley: I think the sums involved that have been
reported of around £13 billion are approximately
correct.
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Q502 Chairman: Just to add on to the question from
Peter, you say you have £13 billion presently from
the Bank of England?
Dr Ridley: Correct.
Q503 Chairman: Do you have an idea of the
maximum amount you may need to borrow in the
future?
Dr Ridley: I do not think that is a number that we
would publicly wish to divulge. It depends
enormously on how things turn out and on diVerent
scenarios.
Q504 Chairman: Do you think you will have to go
back to the Bank of England?
Dr Ridley: We are talking continuously to the Bank
of England.
Q505 Chairman: But my question is do you think
you will have to go back to the Bank of England
for more?
Dr Ridley: We put in place a second facility about a
week ago, as was announced by them and by us,
which gives us the opportunity to draw down on that
until February.
Q506 Chairman: So you could be going back to the
Bank of England for more?
Dr Ridley: As I say, it is a continuous process.
Q507 Chairman: But you could be going back to the
Bank of England for more?
Dr Ridley: Yes.
Q508 Chairman: That is fine. The point about
Countrywide that Peter made, it was the Governor
of the Bank of England who made that speech in
Belfast last week. He is very clear here when he says
“It is a Tale of Two Banks—of similar size and
facing similar diYculties—just a few weeks apart.
On 17 August Countrywide was able to claim on
that insurance and draw down $11.5 billion of
committed credit lines. Northern Rock had not
taken out anything like that level of liquidity
insurance”. So that was really a failure on your part?
You got yourself into a situation which
Countrywide did not get themselves into; is that
correct, Dr Ridley?
Dr Ridley: As the Chief Executive said, we took steps
to ensure that we would not need so much insurance
by diversifying our funding platforms more than
Countrywide.
Q509 Chairman: But Countrywide did not get
themselves into this situation; you got yourselves in
this situation; there is a lesson there for you, surely?
Dr Ridley: Yes.
Chairman: So you failed. Sally?
Q510 Ms Keeble: I wanted to ask some more about
the liquidity and the wholesale borrowing. Dr
Ridley, you said that your borrowing on the
wholesale market was long term. What was the
profile of your borrowing exactly?
Dr Ridley: The covered bonds have an average life of
something like seven or eight years.
Q511 Ms Keeble: And what percentage did you have
of that?
Dr Ridley: They were about 7% or 8% of the
funding. Securitised bonds, which is what we call the
Granite programme, had an average maturity of
about three and a half years. That is about 46% of
our borrowing. The rest of the wholesale borrowing
was in the medium-term markets. Its maturity
profile was fairly long by the standards of most
banks, ie mostly 90 days plus.
Q512 Ms Keeble: Exactly, it was three months plus.
You obviously were able to fulfil the requirements
on liquidity of 5% in five days, and you had two to
three months, Adam Applegarth said, but after that
you had a very large amount of loans falling due, did
you not? Your profile looks like that?
Dr Ridley: We had a high level of wholesale
maturities in August. That was because we were
expecting to do a securitisation in early September
which would have brought in £3 or £4 billion worth
of liquidity, so inevitably you tend to slightly run
down your other wholesale book as the
securitisation approaches.
Q513 Ms Keeble: But you actually had a problem—
and I am not sure if this was by volume or by
number—in that just over 50% was between three
and seven years, so the other 50% of your exposure
in the wholesale markets was very much shorter?
Dr Ridley: I think that 50% refers to the proportion
of the balance sheet and of course there is a large
retail deposit book in there which technically is
short-term funding, as we saw during the run.
Q514 Ms Keeble: But your exposure to the wholesale
markets was 75%, was it not, and about half of that
was three and a half to seven years, you are saying,
and half of that was longer and it was just over the
three months; is that not right?
Dr Ridley: Rather more than half of that was in
securitisation and covered bonds.
Q515 Ms Keeble: You said earlier that your
borrowing on the wholesale markets was longer than
your lending, but most mortgages must be longer
term than three and a half years or three to six
months?
Dr Ridley: One of the features of the mortgage
market recently has been that people re-mortgage
fairly often and this means that the average length of
time that a mortgage stays on our balance sheet and
on most banks’ balance sheets has recently come
down and I think—and the Chief Executive will
correct me—it is about three years at the moment.
Mr Applegarth: The average life of a mortgage
product is three years.
Q516 Ms Keeble: And what number are actually
three years?
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Mr Applegarth: That is the average life of our
mortgage book. You will have something like 60% in
our two-year fixes and the rest are obviously longer
than three years, they tend to be five-year fixes. The
average life of our funding was about three and a
half years. As the Chairman said, of our funding,
50% was securitisation, which had an average life of
three and a half years; 10% was covered bonds,
which had an average life of about seven years; and
of our wholesale borrowings, which is 25%, half of
that had a duration longer than one year and the
other half was less than one year’s duration.
Q517 Ms Keeble: I agree that the profile of some of
your wholesale borrowing is similar to some other
banks and building societies, but the diVerence is
that your exposure was greater because it was 75%
so it actually looks that you were not borrowing long
and lending short; you were actually borrowing
short and lending long.
Mr Applegarth: I would not agree with that. The
average life of a mortgage product is three years and
one month and the average life of our funding was
three and a half years.
Q518 Ms Keeble: But you had half of your
borrowing falling due round within round about
three to six months, did you not?
Mr Applegarth: We had 10% of our borrowings
which had a maturity of less than one year; we had
10% of our borrowings that were over one year; we
had 50% of our borrowings that were three and a
half years; and we had 10% of our borrowings with
an average life of seven years.
Q519 Ms Keeble: And what were the diVerent
interest rates involved?
Mr Applegarth: The average rate on securitisation
for the stock was about LIBOR plus ten basis points;
the average price for covered bonds, which is the
seven year, was about LIBOR plus one basis point;
the average price of longer term wholesale was about
LIBOR plus five; the average rate for shorter, ie less
than year, was about LIBOR flat.
Q520 Ms Keeble: How did that compare with the
interest rates on the lending that you were doing?
Mr Applegarth: The interest rates on our lending,
including fees that are eVective interest rate were
about LIBOR plus 90 basis points.
Q521 Ms Keeble: Because looking at the profile of
the business falling due, I have to say again it would
be helpful if we could see the graphs as you had them
because looking at the profiles it looks very much as
if you were borrowing short on the markets and that
business was falling due at the same time as you were
lending quite long, or longer, which obviously looks
unsustainable?
Mr Applegarth: If that was the case it would be, but
it was not, and maybe I can write and give you the
liquidity level.
Q522 Ms Keeble: If we can have the figures and if we
can have the exact profile of the business, I think that
would be very helpful.
Mr Applegarth: I am very happy to.11
Q523 Ms Keeble: Moody’s Investors Services noted
in August 2006 that your funding profile remained
your biggest challenge and the relative lack of retail
funding was the one that was most likely to put a
negative pressure on your ratings in the future. How
did you react to those concerns and what assessment
did you make of those?
Mr Applegarth: One of the things we have been able
to do with Moody’s, by moving into securitisation
and lengthening the maturity of our funding, is to
encourage Moody’s and we actually got upgraded
by Moody’s to Aa3 on the back of our longer
funding profile.
Q524 Ms Keeble: When you said you lengthened it,
what by and when?
Mr Applegarth: EVectively by adding securitisation.
We started securitisation back in 1999 and then we
introduced covered bonds in 2004. Both of those
have maturities considerably longer than traditional
wholesales. On covered bonds in particular we have
only done deals of a minimum of five years’ duration
and a maximum of 15, which is how you get the
average life of seven years, so it was by introducing
securitisation and covered bonds that lengthened the
maturity of our funding that Moody’s actually
upgraded us.
Q525 Ms Keeble: Also your share price fell by 20%
between February and June this year. What
assessment did you make of that?
Mr Applegarth: I think you can ascribe the share
price fall to the matters that the Chairman was
highlighting earlier in terms of the tightening of the
credit markets, so you saw the price of funding
increase, you saw a slowdown of our lending in the
second quarter and therefore clearly people were
assuming that in volume terms our profits would be
lower over the next two years than had previously
been the case, and indeed that was confirmed when
we did a pre-close statement to the market at the end
of June.
Q526 Ms Keeble: You had some warnings then that
there was suspicion about your business model and
how robust it was, and you were already seeing the
impact of that on the business, so what did you do
as a result of that?
Mr Applegarth: We had certainly some warnings
that the credit markets were tightening and therefore
the price of funding was increasing, so the action was
to change our strategy and announce that publicly to
the market. That was one of the reasons why the
share price was coming down around the half year
because we had made extremely transparent the
change in strategy, so we were slowing down
lending, we were removing high-risk assets from the
11
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
balance sheet and we had announced a programme
to sell commercial lending; our unsecured lending
books and our commercial buy-to-let books.
Q527 Ms Keeble: Do you regret now with hindsight,
which is always a wonderful thing, that you put so
much reliance on wholesale funding?
Mr Applegarth: Hindsight is a wonderful thing. It is
distressing that the global freeze was not in a year’s
time when we had slowed down the lending and
removed assets oV the balance sheet.
Q528 Ms Keeble: Would you accept that to some
people it looks suspiciously like gambling?
Mr Applegarth: No I do not accept that because I
think we reacted reasonably and properly to what
we were seeing in the market place in terms of the
tightening of the credit spreads, and therefore we
slowed down the rate of asset growth and publicly
announced a change in strategy, even though we
knew that would mean lower profit growth going
forward, because it was the right thing to do.
Q529 Chairman: But other banks’ share prices were
not falling at the same rate as yours. You mentioned
my comment on the credit crunch but it does seem a
wee bit unreal to us. It seems that you were out of
step with all other banks here, you say that it was
only because a global credit crunch, which nobody
foresaw by the way, that you find yourselves in this
position. It does seem a wee bit unreal to us as a
Committee that you are the only bank in this
country to have precipitated a bank run in 140 years,
so there really must be something deeper at stake
here. If I could extrapolate from your point, at the
end of the day I think you are blaming the Bank of
England because you did not get a credit line early
on?
Mr Applegarth: We certainly did not have access to
a facility that is available to European banks and
American banks, and that would have helped us, but
it was a sensible and prudent thing to do to put the
backstop facility in place. Ironically, it was the
announcements and the leaking of the backstop that
caused the retail run and it was the retail run that
reduced our liquidity.
Q530 Chairman: It had to be announced. At the end
of the day you are blaming Mervyn King.
Mr Applegarth: I am not blaming anybody. The
cause was the chain of events from worries about the
credit quality on US sub-primes linked all the way
through to a UK-only prime lender.
Chairman: At the same time, Mervyn King points
out that Countrywide in Los Angeles had a diVerent
strategy from yourself and did not get into that
position. Andy?
Q531 Mr Love: Dr Ridley, would you agree that
whatever else happens in the future that the good
name of Northern Rock will be a casualty of your
failures?
Dr Ridley: I would agree that there is some damage
to the brand of Northern Rock and that is a matter
of enormous distress to me and my colleagues. I am
part of the group, so is Adam, who took Northern
Rock through flotation in 1997 and we were very
proud of the decisions we took on that occasion to
make Northern Rock into a good corporate citizen.
We have created 3,500 jobs since then. We have set
up the Northern Rock Foundation and Adam and I
were on the Board that took that decision.
Q532 Mr Love: I understand all of that but with all
the financial services organisations and others that
you are now talking to about the future of Northern
Rock, are any of them suggesting that they will
retain the name “Northern Rock” into the future? Is
there anybody that is suggesting that Northern Rock
will survive as a name?
Dr Ridley: That is a matter for them, not for us, but
it is true to say that on the retail funding side, the
name Northern Rock is unlikely to continue. It is
worth pointing out that on the mortgage lending side
all our feedback from other brokers is that they
know we are a good and responsible and careful
lender, and that has not changed.
Q533 Mr Love: I think you are accepting that
Northern Rock is now finished as a name. I have just
returned from the United States and New York and
Washington and all they wanted to know about was
Northern Rock. They have not heard of any other
British banks but they know about Northern Rock
and they know about the queues outside your bank
over a period of time. Do you fully understand the
depth of the reputational damage you have done to
the banking system in the United Kingdom?
Dr Ridley: I fully understand and it causes me
enormous distress. As I said, we had tried very hard
to be a good corporate citizens, creating jobs in this
country, delivering fair and good deals to customers,
and giving 5% of our profits to charity.
Q534 Mr Love: Where does your share price stand
today compared with the high earlier this year? Is it
a quarter, is it a fifth, is it a tenth, where do you stand
in terms of your share price?
Dr Ridley: I think it is about a sixth.
Q535 Mr Love: So your share value is about a sixth
of what it was; your name is in the dustbin of history;
the reputational damage you have done to the
British banking industry is severe. Can I turn to Sir
Ian Gibson, why have you not accepted his
resignation, thinking about all of those things that
have happened in the last few months?
Sir Ian Gibson: Perhaps it would be helpful at this
point Chairman, if I explain the process that I have
followed about resignations from the Board.
Q536 Chairman: Sure.
Sir Ian Gibson: First, back on 30 August I asked
Board members, both executive and non-executive,
if they would be willing and would present their
resignations because that might well have aVected
the ability to reach some corporate solution, which
we were actively seeking at that time. All of them did
and those have been on the record in the Board
minutes from that point. Later, in the days of the
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run, the Chief Executive to the Chairman and the
Chairman to me similarly said they would be willing
to resign. In the week following the run, starting on
the Monday following, I consulted with brokers,
with shareholders, with other board colleagues and
said, “Is this what you believe is right because if it is
it is clearly what the Board is prepared to do?” At
that point there was no contradictory feedback, the
overwhelming feedback was: “You can worry about
that later. What you need to do right now is direct
the bank through a crisis, find a way to keep people
motivated within the place, and respond to
customers through that crisis, and when the
immediate crisis is passed, Ian, then that is the time
you think about the make-up of the Board.” That is
what I shared with colleagues, that is what I shared
with the authorities, and that is what I continue to
do with the Board. It is an issue I discuss weekly.
Q537 Mr Love: When you come to share that with
the shareholders at the annual meeting, do you think
they will be as sympathetic?
Sir Ian Gibson: Yes I do.
Q538 Mr Love: We will find out when you get to
that. Can I move on to Mr Applegarth. We have
already heard that over the first six months of this
year one in five of all mortgages, including
remortgages, were sold by Northern Rock, and if
you just take new mortgages I think it was one in ten.
By anybody’s estimation that is aggressive lending.
You said earlier on that the quality of your book for
that six-month period was probably better than it
was previously because of lessons you had learned.
Would you like to think again about that statement?
Are you putting your name and your reputation on
the quality of the lending you have done earlier
this year?
Mr Applegarth: Yes, it is really a fallout from the
work we had to do over the previous two and a half
years in order to get a Basle II waiver. You have to
show that you dynamically manage scorecards from
new lending all the way through to arrears and
possessions and put that information back into your
front end score cards, so, yes, I am quite happy with
that statement.
Q539 Mr Love: We mentioned earlier the Together
product that you have where you give up to 95%
secured against a home and the rest, 30% I think it
is, in unsecured lending. What is the level of loans
you have as a result of this Together project?
Mr Applegarth: The Together project, you are quite
right, is a first-time buyer product which allows them
to buy their home and also pay for furniture, so it is
a secured loan bundled together with an unsecured
loan. There are two separate products. It accounts
for about 20% of our share of stock. Its three month
plus arrears at the half year stage were 0.84% which
is still lower than the industry average for secured
from the CML, which is 1.06, so it is for us a higher
risk book and therefore it is charged at a slight
premium but it still performs better than the
industry average.
Q540 Mr Love: So far, one has to say. Can I just ask
you, it is said that the management of Northern
Rock were incentivised through the growth in the
volume of the business that you were undertaking.
Do you see any problems related to that, the fact it
was that aggressive lending on which was based the
salaries of the senior management and the
organisation?
Mr Applegarth: The salaries incentives were linked
to profit growth and total shareholder returns and
whether that is judged as shareholder returns or as
earnings per share—
Q541 Mr Love: It was mentioned earlier that some
of the products that you sell are multiples of up to
six times income, we have talked about Together at
about 125% including the unsecured part of the loan.
If we look at the experience in the United States—
and I know that that is not always apposite—if we
take that experience and the incentives towards
aggressive lending and the securitisation process
that you were heavily involved with, what is now
emerging (and they are at a further stage than we are
in this process) is some very imprudent lending. Are
you totally confident that there has been no
imprudent lending within all of these diVerent
products that you have been selling over the recent
period?
Mr Applegarth: Yes I am in that somebody phoning
up to ask for your maximum lending criteria is not
the same as somebody going all the way through a
loan application. We are renowned as a picky lender.
One of the frustrating things about this is I had
always assumed that if there were liquidity problems
there would be a flight to quality and therefore the
more transparent you could be about the quality of
your assets and the higher quality assets you had
then you would be in a better position which is, why
for example on the Granite securitisation that you
mentioned we provide so much data on it on a
monthly basis. We provide management
information of something like 250 pages on all the
details of the credit quality behind Granite and you
have to do that in order to get the AAA rating.
Q542 Mr Love: Can I ask you finally in relation to
going forward, there have been quite a lot of reports
about Northern Rock not being as competitive as it
was. Partly that is related to the tightening of your
lending criteria but also in relation to some of the
benefits that you gave—£500 or £1,000 towards the
costs. Are you confident that in the climate going
forward the levels of profitability you have seen in
the past will continue or are you projecting a
significant reduction in the profitability of
Northern Rock?
Mr Applegarth: We are forecasting lower profits
than previously, and that is what we announced at
the half-year stage, and that is why you saw the share
price come down because an aftermath of the
tightening of the credit markets was that the price of
funding went up. Clearly we have slowed our lending
because we are short of liquid funds.
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Q543 Mr Love: But these additions that you gave in
the past, the £500 and £1,000 depending on the type
of mortgage, the free valuations and all the other
incentives, to take out a mortgage with Northern
Rock, have you stopped doing that simply because
of the tightness of your liquidity or is that a
reassessment of the amount of risk that you were
taking on in relation to some of the mortgages?
Mr Applegarth: No, the prime driver has been the
lack of liquidity and therefore we have had to slow
down lending. You adjust price and policy to slow
down the lending and that is exactly what we have
done.
Q544 Chairman: To get back to you, Sir Ian, it seems
to me anyway to be an arrogant view here from
Northern Rock in that you are not really out of step
with anyone else and you just found yourself in this
position because of the global markets, and to a
number of us it seems that you are in denial. The
gossip that I have picked up in the past few weeks
with lots of people talking to me is that as the NonExecutive Director you are the only one with any
shred of credibility here and people are depending
on you to see this situation through. Given that is the
case, and I have respect for your past business
background, is there not a case here for more
humility in your approach about how Northern
Rock got into the situation and how we are going to
see this bank coming out at the end of the day so that
the interests of shareholders, including those of
ordinary people in the North East who have invested
in it, are secured?
Sir Ian Gibson: Chairman, there is absolutely no
arrogance, let me assure you, on my part and on the
part of the Board of which I am part. There is shock
and there is distress. That is reflected in part,
although with high morale, in the workforce in
Gosforth and in Sunderland. These are people who
are trying damned hard to serve their customers and
secure their future, and we are very aware of that.
Are there lessons to be learnt? I am very sure there
are. I think those lessons go far beyond this
institution. As you all know, we can only deal with
the world as we know it. We dealt pretty well with
the world as we knew it; and the world has changed.
That has been an enormous shock and one that this
Board has not finished coping with yet. It has
acquired time until February next year to create the
best solution for its shareholders, for its
stakeholders, for its employees as best it can, and
that it will do and it will do it whether it comprises
some or all of the individuals that are there now or
some others, but it will do it. There is no arrogance;
there is shock and dismay.
Q545 Chairman: You will understand there is shock
and dismay throughout the country as well.
Sir Ian Gibson: Yes.
Q546 Mr Simon: Dr Ridley, we hear talk about an
inquiry or even a public inquiry into the Tripartite
arrangements. Were there to be such a “dodge-theblame” fest what would be the main things that you
could imagine yourself telling it?
Dr Ridley: The Tripartite arrangements are not
really a matter for me obviously; they are for the
Government and for those institutions. As far as we
understand it, we were perfectly clear that our
supervisor was the FSA and it was the FSA that we
were to keep informed about our position and
through them they would inform the Treasury and
the Bank of England. Additionally, we felt it
important to get our view directly to the Bank of
England as soon as we could about what would help
avoid a disaster for ourselves.
Q547 Mr Simon: Get your view to them?
Dr Ridley: In addition to speaking to them through
the FSA, it was our view that it was important to
speak to them directly, and the FSA knew about that
and that was quite above board.
Q548 Mr Simon: When did you start speaking to the
Bank directly?
Dr Ridley: I spoke to the Governor of the Bank of
England on 16 August.
Q549 Mr Simon: Were you speaking to the Treasury
directly as well?
Dr Ridley: I was not speaking to the Treasury
directly, no. We knew that our views were being
communicated to the Treasury directly through the
FSA.
Q550 Mr Simon: Was anybody at Northern Rock
speaking directly to the Treasury?
Dr Ridley: In due course, yes, we did have direct
contact with the Treasury. In the initial stages it was
through the FSA.
Q551 Mr Simon: So when and who began to speak
to the Treasury?
Dr Ridley: During the period of the retail run we
were speaking to them but I cannot remember when
the exact first contact was.
Q552 Mr Simon: Who is “we”?
Dr Ridley: I think it was probably me that made the
first call to the Chancellor’s oYce during the retail
run.
Q553 Mr Simon: So initially you were speaking
directly to the Bank from the 16th, not at that stage
to the Treasury, although later, and generally felt
yourself to be communicating with the Treasury via
the FSA?
Dr Ridley: Correct.
Q554 Mr Simon: When talking to the Bank and the
Treasury, did you feel you were speaking to diVerent
beasts, to whom you had to speak in a diVerent way?
Dr Ridley: Inevitably, they have diVerent
responsibilities and there were diVerent issues to
discuss with them.
Q555 Mr Simon: Did you get the sense that there was
a poisonous relationship between the two of them?
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Dr Ridley: No.
Q556 Mr Simon: When the FSA were here, they were
very clear that the Tripartite arrangements had
worked admirably well. Do you think that the
Tripartite arrangements worked extremely well and
successfully and ought to be admired and perhaps
recommended as a model throughout the world?
Dr Ridley: I really cannot comment on that
because—
Q557 Mr Simon: Why not? Clearly, you are not
responsible for the Tripartite arrangements and that
is a matter for them and you are a matter for you but,
obviously, as a matter of public policy, you have had
an interaction with these arrangements in a way that
nobody else has, an importance that is absolutely
remarkable, with a whole set of outputs which
everybody wants to avoid. Obviously, your view on
the Tripartite arrangements—you are not just a
bloke; it is a particularly important view and we
would like to hear it.
Dr Ridley: As I said, it is up to them how their
arrangements worked among themselves. As I have
said, we were quite clear that we had a good
communications link with the FSA, with the Bank
and later with the Treasury.
Q558 Mr Simon: How did their arrangements work
for you? How did they work for the country?
Dr Ridley: Inevitably, as we have discussed, the leak
of the announcement of the facility and the eVect
that had on our retail depositors was not a happy
outcome. I am not here to blame that on the
particular Tripartite arrangements. That is about
events.
Q559 Mr Simon: I am not suggesting that you are
trying to blame anybody and I am not trying to get
you to blame anybody. The problem with this whole
debate is that nobody wants to take responsibility
for anything and nobody wants to talk about what
anybody else might or might not do diVerently. So
far all we have is a whole series of people saying
“Everything went fine. Nothing that anybody did
could or should have been done any diVerently.”
You have said today that there is no way that you
could have done anything diVerent, the FSA could
not have done anything diVerent, no-one could have
done anything diVerent, in which case, with the same
set of circumstances again, it will happen again.
Mr Applegarth: I think the actions we took since 9
August were entirely reasonable and proper. One of
the problems we had is that it was not a UK
problem; it was a global issue, and I think there are
lessons to be learned about, if you have a global
issue, how you get coordination between each of the
geographic areas. Clearly, the extremely distressing
retail run is not a success although, because it was
not a UK-only issue, it is diYcult to judge—
Q560 Mr Simon: It only happened in the UK
though, did it not?
Mr Applegarth: No, the global freezing happened
worldwide.
Q561 Mr Simon: No, the retail run on the bank,
your bank.
Mr Applegarth: Absolutely, and it is a chain of
events from—
Q562 Mr Simon: If you cannot tell us what to do
about this, and the FSA cannot tell us and the Bank
cannot tell us, who is going to tell us? What is the
answer?
Mr Applegarth: I was trying to suggest that perhaps
one of the issues—and I have to say that I would like
to agree with big chunks of BBA memorandum to
you,12 particularly the globalisation aspect, because
if each individual geographic area acts on its own,
you will get dislocations in actions and facilities
between diVerent geographic areas. Because this was
a global issue, the Tripartite being judged against a
global issue is somewhat unfair but I think there are
major lessons to be learned in how you tie up each of
the diVerent geographic areas.
Q563 Mr Simon: You think that is the answer?
Mr Applegarth: For this particular set
circumstances, it has to be part of the answer.
of
Q564 Mr Simon: Who is going to do this tying up?
Mr Applegarth: Really, that is a matter for the
authorities, is it not? I would imagine it would be led
by the Treasury and the Bank of England.
Q565 Mr Simon: The Treasury and the Bank? Not
the FSA?
Mr Applegarth: I do not think I know enough to
comment as to who should be the right person.
Q566 Mr Simon: Somebody must know something
about this. You said, Dr Ridley, that you are quite
clear that the FSA was the regulator, although you
would never know that to talk to the FSA. You said
you were quite clear that it was them you were
talking to mainly, because they are the supervisory
body. The next group that you spoke to was the
Bank, and last, and presumably least, the Treasury.
Do you think this might have been avoided if it had
been the other way round, if, instead of a Tripartite
arrangement where nobody was responsible for
anything, the Treasury was responsible for dealing
with you, sorting out the liquidity early and making
sure that this did not happen?
Dr Ridley: I think that is a hypothetical question
and—
Q567 Mr Simon: Clearly it is a hypothetical
question. You are a scientist. There is no other way
to seek to make sure that this does not happen again,
is there?
Dr Ridley: No, there is. As Adam has suggested, the
British Bankers Association has made suggestions
which we think are sensible for looking at these
issues and for learning lessons from them. There is a
division of responsibility between managing
liquidity in the markets between the Bank and
supervising individual institutions in the FSA. As far
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as we were concerned, there was not a problem of
communicating our position between those two
institutions. We were able to communicate to both.
tried to repo assets, once we had gone down the
route of trying to find a safe haven for the company,
because we started that on 16 August—
Q568 Mr Dunne: I would like to pursue some of the
line of questioning of Mr Simon as to what could
have been done in the specific circumstances to have
prevented the run on the bank in the case of
Northern Rock. If we can start by the relationship
between the Bank and the FSA and reporting the
liquidity constraints, can you tell us when you first
identified to the FSA a specific liquidity problem
emerging for Northern Rock?
Dr Ridley: I will let Adam answer that because he
had the first contact with them.
Mr Applegarth: Yes, of course. We first noticed
dislocation in the market on 9 August and we waited
one working day before contacting the regulator, so
that would be 13 August. From then it was a very
close relationship, including two formal calls a day
to update them on the position.
Q572 Mr Dunne: Stop there then. At what point did
you start seeking an acquirer for the business?
Mr Applegarth: 16 August.
Q569 Mr Dunne: So neither the Risk Committee,
chaired by Sir Derek, nor the Board, nor the
operations of your own internal treasury had
noticed any tightening in market conditions between
April and 9 August?
Mr Applegarth: No, I am not saying that. We
certainly noticed the tightening of conditions and
that is why we announced to the market publicly a
change in strategy for lower growth and removing
assets from the balance sheet. What we did not have
any foresight of is the closure of the markets. We
have managed and lived through various closures.
The chairman has already mentioned we were doing
a securitisation issue in the middle of 9/11. I
remember going back to the Asian banking crisis,
but this is the first time that you had seen a very rapid
and very widespread, both in terms of geography
and in terms of product, closure of the market. So
yes, of course we noticed the fact and we reacted to
it. What we had not foreseen is the complete closure
of liquid markets on such a wide basis, whether it is
commercial paper, asset-backed commercial paper,
securitisation, covered bond, medium-term note and
even the cash deposit markets in the UK and US
eVectively closed.
Q570 Mr Dunne: At what point did you first discuss
with the FSA or the Bank of England the
opportunity to tap the lender of last resort facility?
Mr Applegarth: We first contacted the FSA on 13
August, and then—
Q571 Mr Dunne: To discuss that issue?
Mr Applegarth: No, to discuss the issue of liquidity,
and then I have to say we did a vast range of things
to try and get liquidity, whether it was raising it in
diVerent markets, because at that point you could
not tell that the markets were completely closed.
You actually did see two small covered bond issues
get away in August before that market closed. On 9
August you could not foretell the extent and depth
of the closure. In terms of the facility of lender of last
resort, once we tried to raise liquidity, once we had
Q573 Mr Dunne: Those discussions ran in parallel
with all of these other events?
Mr Applegarth: We were trying to do all things at the
same time, yes.
Q574 Mr Dunne: You have not given me a date yet
when you discussed the lender of last resort facility.
Could you do that, and could you tell me whether or
not a third party approached the Bank of England
to secure a similar facility?
Mr Applegarth: Yes, we had been talking with the
Bank of England from the middle of August in terms
of what if, what would be a backstop facility, so we
were talking, as you would expect, because it is a
prudent thing to do to put a backstop facility in place
in case of all the other actions in place. That would
have been the middle of August.
Dr Ridley: Can I just interject there? In my first
conversation with the Governor of the Bank of
England on 16 August the lender of last resort was
mentioned as a theoretical possibility at that stage.
Q575 Mr Dunne: What was the response of the Bank
of England at that stage?
Dr Ridley: It was mentioned by him.
Q576 Mr Dunne: That that was an opportunity
which they might make available?
Dr Ridley: If we got to the point where liquidity
continued to be a problem and the markets remained
closed, then of course that was available and would
need to be discussed.
Mr Applegarth: But as a last resort, so their
encouragement to us was the work we were doing to
try and find liquidity or find a solution. It was lender
of last resort. It had to be a last resort.
Q577 Mr Dunne: What I am trying to get to is that
the decision to provide that facility was taken after
it was too late, after you had had a run on the bank.
Why was that decision not confronted before the run
on the bank, either by yourselves or a third party?
Mr Applegarth: It was actually taken before the run
on the bank. It was the announcement of the facility
being leaked that actually was the start of the run.
The run eVectively started on 14 September. Our
corporate activity ceased on 10 September and
therefore between the 10th and the leak late on the
13th, that was when we were putting in place the
lender of last resort. We had intended to announce
that on the following Monday but clearly, the leak
meant we had to rapidly accelerate and therefore our
communication plans had to be rapidly accelerated
and they were not as smooth as they would have
been had there been a Monday announcement.
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Q578 Mr Dunne: Had a third-party acquirer been
granted the facility, in your opinion, would that have
prevented the run on the bank?
Mr Applegarth: Had a facility been granted, I am led
to believe that we would have had a bid to consider
and I suspect that, had an oVer been made with a big
retail brand, then the run would not have taken
place, yes.
Q579 Mr Dunne: So with hindsight, you would be
recommending that the Bank of England consider
relaxing its arrangements; the moral hazard
argument that prevented that decision from being
taken would have stopped the run on the bank.
Mr Applegarth: I have a little diYculty
understanding the moral hazard argument. All I
know is from Northern Rock’s point of view, and
avoiding the shock and the huge distress of a retail
run, it would not have taken place, in my view, for
what it is worth, if we had been able to announce an
oVer with a big retail brand.
Q580 Mr Dunne: Can we just touch on the leak for a
moment? Where do you believe the leak came from?
Mr Applegarth: That is a hugely diYcult question
because I cannot answer it. All I know is we had not
even signed the facility when the leak took place. My
treasurer was going down with the company
secretary to go through the negotiations through the
night of the 13th. The facility was actually only
signed late in the night of the 13th or early in the
morning on the 14th, and yet the leak took place on
the evening of the 13th, so it caused immense
diYculties.
Q581 Mr Dunne: Do you believe it is likely to have
come from the people in the know within the bank
or its advisers?
Mr Applegarth: All I know is it did not come from
us.
Q582 Mr Dunne: Or your advisers?
Mr Applegarth: Or our advisers. It is massively not
in our interest.
Q583 Mr Dunne: Is there any evidence of any other
information that you supplied to either your
regulator or to the Bank of England getting into the
public domain?
Mr Applegarth: Yes, there have been things
appearing in the public domain that have been
provided to third parties but I cannot say where the
leak was because, as you can imagine, there are a
huge number of advisers on both sides. I am not just
talking about PR advice; I am talking about banking
advisers, accountants, lawyers. It is impossible to tell
where they have come from. All I know is that there
have been three leaks that have been massively
damaging to the business and it has not been in our
interests to leak them. So I am confident it has not
come from us.
Q584 Mr Dunne: Had the facility existed, as we have
discussed earlier, in the US or the Continent to have
covert funding lines available to you, would we have
avoided the run on the bank?
Mr Applegarth: I think if we had been able to borrow
on the lines that we did, which is basically using our
mortgage and our mortgage assets as collateral,
which is what they do across in—I will just take the
ECB as an example. The ECB has had over 150
institutions borrow on a similar line and, because it
is not public, then clearly you have not had the
shocking retail run that we have had to experience.
So I suspect the answer is yes.
Q585 Mr Dunne: You had no mechanism available
to you because you were not regulated by the ECB
to be able to approach them yourselves as an
alternative?
Mr Applegarth: No. We have a branch across in
Ireland and had we had more time, we might have
been able to put in place the legal documentation
and provide the collateral through the Irish branch.
The trouble is that would have taken two or three
months and in trying to put the backstop facility in
from the Bank of England, we were trying to put a
sensible and prudent backstop in place that we
thought we might not have to draw down on because
we were actually still funding—not fully funding,
and duration was noticeably shorter but we were still
funding until 13 September, but I think it would
have been a gamble to have relied on getting
documentation and collateral in place through the
Irish branch. Had we done that a year ago, then we
would have been able to do that, but we had not.
Q586 Jim Cousins: I wonder if I could just ask you,
Dr Ridley, before the matter was raised with the
Bank and the FSA on 13 August, that is to say, the
sustainability of your situation, did the Bank or the
FSA ever approach you with questions about the
sustainability of your situation?
Dr Ridley: Not in relation to a particular change of
liquidity. The FSA was in continuous contact with
us, as we have made clear, throughout the Basle II
process and we were talking about risk and stresstesting throughout the process, so there was a twoway dialogue but no, we did not take a particular
course saying “Markets are getting particularly
diYcult, we think liquidity is going to dry up” or
anything like that, if that is what you are referring to.
Q587 Jim Cousins: So the first doubt about the
sustainability of your situation came from you to
them?
Dr Ridley: Correct.
Q588 Jim Cousins: The Chancellor, in his statement
on the 11 October, Mr Applegarth, said “We”—and
by that I think he meant not just the Treasury but the
FSA, the Bank and Treasury together—“did
everything that we could to try and resolve the
situation without special support becoming
necessary.” In your answer that you have just given
to one of my colleagues it is plain that you take the
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view that there were other things that could have
been done that might have avoided special support
becoming necessary.
Mr Applegarth: I think it is undoubtedly true that in
the period from 9 August to 14 September we went
through a wide programme of attempts to get
liquidity, whether it was by raising liquidity, repoing, but additionally, before we went to the Bank as
a lender of last resort, we did start on 16 August
corporate activity. It is my view that, had the facility
had been granted to a major high street retail bank
ahead of us having to get the facility, that would
have stopped a retail run, but that is my view.
Q589 Jim Cousins: I would now like to ask you, Dr
Ridley and Mr Applegarth, about the guarantee to
depositors, which of course was given by the
Treasury, and subsequently of course extended to
new deposits that had been created. What was asked
from you in return for this guarantee to depositors?
Dr Ridley: I do not quite follow the question.
Q590 Jim Cousins: The question is a very clear one.
A depositor guarantee was given by the Government
to existing depositors and subsequently it was
extended to new deposits. What was asked of you in
exchange for that guarantee?
Mr Applegarth: The first guarantee was for existing
customers and that was later clarified to include
customers returning to their account. That was
important to us, because that allowed us to refund
penalties to the customers, and that facility is still
available until the end of October to make sure that
customers who paid a penalty have not been
disadvantaged. For new customers, in order for us
not to be advantaged versus our competitors, we
have to pay a fee for each new deposit coming to us
to make sure that we are not at a commercial
advantage versus our competitors, who do not have
such a guarantee for new customers.
Q591 Jim Cousins: Apart from that fee, nothing was
asked of you?
Mr Applegarth: Explicitly, no.
Q592 Jim Cousins: Implicitly?
Mr Applegarth: As Sir Ian and the Chairman made
plain, our communication to the regulator is
extremely close, of course, as our contact in the
Tripartite. They passed that information to the
Bank of England extremely swiftly—
Q593 Jim Cousins: I am talking here about the
Treasury, the Government’s guarantee to
depositors. What implicit understandings were
reached between the Treasury, the Government and
yourselves at the time that the deposits were
guaranteed?
Mr Applegarth: For the facility and guarantee to be
in place we had to provide a viable business plan,
which is extremely closely monitored and
scrutinised—that is where the “implicit” comes
from—to make sure we are performing as per the
plan we had to provide to make sure we are viable
and solvent for the facility and guarantee to be
given. The only explicit requirement for the
guarantee is for the new depositors.
Q594 Jim Cousins: Can I stop you? I want us to be
clear about this. I am not talking about the facility
guarantee that was given by the Bank. I am talking
about the guarantee to depositors which was given
by the Government.
Mr Applegarth: It is to do with new deposits and it
is the fee we have to pay to attract new deposits.
Q595 Jim Cousins: What implicit understanding was
reached between you and the Government at the
time that guarantee to depositors was given?
Mr Applegarth: It is the same as we had to put in
place for the facility to be granted, which was the
delivery of the viable and solvent business plan.
Q596 Jim Cousins: So there were no additional
requirements asked of you in exchange for the
guarantee to depositors?
Mr Applegarth: For existing customers, no. For new
customers, yes.
Q597 Jim Cousins: At the time the guarantee to
depositors was given, was any indication given to
you that that guarantee might in any way be time
limited?
Mr Applegarth: Yes. The form of words used was
“during the current financial diYculties”.
Q598 Jim Cousins: What did you understand by
that phrase?
Mr Applegarth: The foreseeable future, during the
period when markets were dislocated.
Q599 Jim Cousins: Let us be clear about this. The
lending facility is clearly time-limited at February
2008. Is the guarantee to depositors subject to any
such time limit?
Mr Applegarth: It does not have such an explicit time
limit. The phrase of words used both in the public
announcement and to us was “during the current
financial diYculties”.
Q600 Jim Cousins: At the time the deposit guarantee
was given was there any indication that if there were
to be a merger, break-up, takeover, what you will, of
the company, a safe haven, to use Dr Ridley’s earlier
term, that the guarantee to depositors would be
terminated or limited?
Mr Applegarth: I think that will be a matter between
any such party and the Treasury. Therefore I do not
think I am able to comment on that.
Q601 Jim Cousins: You submitted your business
plan to the Treasury at the same time as the
guarantee to depositors was given but at that stage in
your discussions with them, in the event of merger,
break-up, takeover, call it what you will, no
indication was given that the guarantee to depositors
would be terminated?
Mr Applegarth: No. The form of words used was
“whilst the financial diYculties continued”.
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Q602 Jim Cousins: Do you recognize there must be
an early settlement of the future direction of the
bank?
Dr Ridley: The benefit of the second facility is that it
gives us until February 2008 to sort out the future of
Northern Rock. Yes, that gives us the time to make
sure that there is not a precipitate solution to the
future of Northern Rock and it gives us the time to
keep all our strategic options open and to discuss all
of the options, including sale of the bank, or sale of
part of the bank, or an independent future with a
diVerent funding arrangement.
Q603 Jim Cousins: What is going to guide you?
Dr Ridley: What is going to guide me?
Q604 Jim Cousins: In the period between now and
February 2008, what is going to be the priority?
What is your guiding light going to be?
Dr Ridley: My guiding light and the guiding light for
the Board is going to be responsibility for the
interests of the shareholders, the creditors, the
employees and all other stakeholders.
Q605 Jim Cousins: How many of your employees are
actually shareholders as well?
Dr Ridley: Approximately 75%.
Q606 Mr Mudie: Since we are near the end, can I just
give you a last chance, certainly in my eyes, to come
away from denial, because even that eloquent speech
of Sir Ian referred to things happening, lessons being
learned, and then he went worldwide. You can
accuse us of hindsight. You now have hindsight.
What would you have done diVerently to avoid what
happened?
Mr Applegarth: The trouble with hindsight is, if we
had had it, other people would have had it too and
you would not have had the events take place. As for
the denial, I do not think the Board, certainly none
of the executives, are not in denial at all. We are
deeply scarred by what has happened.
Q607 Mr Mudie: I know you are scarred and I know
you regret it and I accept that you sincerely regret it.
The Chairman is distressed and I accept that and I
accept the sincerity of it but what have you learned
and what would you have done? People looking at
you would say—you must be used to it in Newcastle,
the manager comes out: it is all somebody else’s
fault. At the end of the day somebody says to him
“Aye, but what are you going to do to make sure it
never happens again?” Newcastle managers do not
seem to learn that lesson. What would Northern
Rock do? What would you do? What are you saying
to us as a Committee? What lessons have you
learned, not about the world, not about Europe but
about Northern Rock?
Mr Applegarth: I think in essence it is to follow the
revised strategy we announced to the market at the
end of June in terms of moving to a lower growth
model, because life has changed; you will not see the
level of liquidity and pricing that you have seen over
the previous decade be repeated going forwards.
Therefore, I think the answer to the question is
pursuing the revised strategy we put in place at the
end of June/start of July, even though it meant the
share price went down because the profits were likely
to be lower.
Q608 Mr Mudie: That just suggests lower growth.
What about the total lack of liquidity that you keep
coming back to that caused your problem? Even
with a lower rate of growth that could still happen.
It has been put to you; no higher authority than
Mervyn King has pointed out that you should have
insured. You say you had some insurance.
Mr Applegarth: We had some insurance. We had the
equivalent of about $3 billion and it was plainly
insuYcient. I think an additional lesson to be
learned is that we had already begun the process of
diversifying by geography and product all our
funding streams. Had we had more diverse retail
funding, including in particular funding through a
branch within the euro zone, that would have
allowed us access to the ECB facilities and not
simply to be dependent on the UK facilities. That is
an additional lesson for me.
Q609 Mr Mudie: That is something that I have some
sympathy with. If you had realised earlier your Irish
connection to Europe, and used it, do you think if
you had had the facility European banks had and
which the Bank of England later on, after your run,
actually gave British banks, would you have gone
through this crisis?
Mr Applegarth: It seems to have worked in Europe.
Within Europe there are a number of business
models that actually have a greater dependence on
wholesale funding than we do and they have not had
the same issues we have had, so I would suspect so,
yes.
Q610 Mr Mudie: Just let me go to something Jim and
Philip raised, this question of when you realised you
were in trouble in August, you said you looked,
obviously, at trying to open up lines of liquidity, you
started discussions with the Bank in terms of last
resort. Did you look for a market solution during
August?
Mr Applegarth: Yes, we did. In terms of looking for
liquidity, it was not simply—
Q611 Mr Mudie: No, I am really after a market
solution. Did you look for a market solution in
terms of, as Jim referred to, takeovers and mergers?
Mr Applegarth: Yes, we looked at two types of
commercial solution. The first was using our assets
to borrow and to get greater liquidity. I would
describe that as repo-ing and we did a limited
amount of that. The second was what I would
describe as corporate activity, trying to find a safe
haven, and we started that on 16 August, so a week
after the markets became dislocated.
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Q612 Mr Mudie: Did you have any interest?
Mr Applegarth: Yes.
Q613 Mr Mudie: Could you enlarge?
Mr Applegarth: Yes, there was one main high street
clearer, which is why the question I was asked
before, if you were able to find a safe haven, in my
view, had it been an oVer—not a completed
transaction but an oVer—from a major high street
clearer, I think you would not have seen the retail
run, in my view.
Q614 Mr Mudie: Why did you not get one? You
have told us how sound your business is, which I
accept. You have a very largely sensible lending
policy. It was your borrowing policy that was to
blame. You had a very good book. Why could you
not secure a safe haven?
Mr Applegarth: Primarily because the main high
street clearer concerned would also have wanted it.
Equally they could not tell, because it still has not
finished, how long the markets were going to be
closed and therefore they asked for a backstop
facility in case the markets remained closed for X
months to make sure they had suYcient liquidity to
cover the liquidity issues we had.
Q615 Mr Mudie: Who did they ask?
Mr Applegarth: The central bank.
Q616 Mr Mudie: When?
Mr Applegarth: The corporate activity talks broke
down on 10 September, so I imagine just before 10
September.
Q617 Mr Mudie: So specifically on 10 September the
bank—and I presume the Bank of England—said
no?
Mr Applegarth: That is what we were led to
understand, yes.
Q618 Mr Mudie: Then seven days later they would
have said yes.
Mr Applegarth: We were on the night of the 13th, so
it is only three days later, going through the process
of putting the documentation in place in order to be
able to announce the Monday after, which I think is
a week after, yes.
Q619 Mr Mudie: After the 13th, was your safe haven
still interested if they could have got the guarantee
from the Bank? Did you keep lines open to the safe
haven?
Mr Applegarth: The Bank made it explicit after the
retail run had started, the facility to us would be
transferable. Understandably, in the middle of a
retail run it is diYcult to find a safe haven.
Q620 Mr Mudie: Specifically when did they tell you
that the facility was transferable?
Mr Applegarth: The Governor made it clear on that
weekend, so that would be 15-16 September.
Q621 Mr Brady: The Governor of the Bank was very
clear with us that the freedom of manoeuvre the
Bank had was severely constrained by EC
legislation, including the Market Abuses Directive,
the Takeover Code and some other things. Could
you talk us through the discussions you had with the
Bank and the FSA specifically about the disclosure
requirements relating to the lender of last resort?
Mr Applegarth: We were in the process of taking
legal advice about whether such a facility would
have to be covert or overt. The Board had not
actually made that decision but our advisers were, I
think, giving us clear advice that it would have to be
overt and the FSA told us that their view was the
same. So both our legal advisers and the FSA came
to the same guidance for us.
Q622 Mr Brady: So you had both come to that
conclusion independently. It was not that Northern
Rock was saying “We will have to disclose this even
if others want it to remain covert”?
Mr Applegarth: I think that is fair, yes.
Q623 Mr Brady: Looking again at the question of
why the run happened, there has been some talk
about the leak of the facility. Do you think the run
would have been avoided had the leak not happened,
if you had had those extra few days?
Dr Ridley: Yes, the answer to your question is that
had the leak had not happened and we had been able
to announce on the Monday the facility with the
Bank of England in a measured fashion, with full
communication plans in place, undoubtedly there
would have been some concern—a lot of concern—
to many of our customers but we think it would have
been considerably less than it was in the way that it
came about. Nonetheless, I think it is worth
reflecting that all of us, both here and in the
authorities, were surprised by the degree to which
the announcement of a facility from the Bank of
England—not the use of it but the existence of a
facility—and the reassurances that went with it
about us being a solvent and profitable business did
not have a suYciently reassuring eVect on
customers.
Mr Applegarth: I slightly disagree with that. I think
there are three things that would have stopped the
run. The first is had we found a safe haven with a
major retail brand and had that oVer in place. The
second is had we been able to borrow using the same
type of facility that we have used but general. So had
the facility not been bespoke to us but a general
facility, I think that would have stopped it. Had the
bespoke facility been covert, that would have
stopped it but I do not think that last one could have
happened. I think the chairman is right in that the
probability of a retail run would have been lessened
had we been able to do the announcement as we had
intended on the Monday, to be able to put facilities
in place and also to actually improve our ability to
get the money to the customers. One of the things we
had intended to do over that weekend was to widen
the bandwidth on the internet account so you would
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
not have had so much frustration from our internet
customers. We would have been able to get the
money back to customers better. I still think it would
have been unsettling for retail customers just based
on the language used. As soon as you have language
used in terms of “lender of last resort” and “liquidity
problems”, that would frighten me as a retail
customer.
Dr Ridley: I agree.
Q624 Mr Brady: You say that a covert facility would
not have been possible—not possible because of the
legal or regulatory requirements or not possible for
the purely practical reason that it simply would have
come into the public domain by one means or
another?
Mr Applegarth: I think both of those. Firstly, the
legal advice that we were getting that it was most
probably announceable, and that was the FSA’s
view as well, and secondly, and secondly, because
there were so many people involved, in practical
terms it would have leaked, and having seen what
has happened since 13 September and what has got
in the public domain, I think that is a pretty strong
probability.
Q625 Mr Brady: Albeit despite sensible clarification
of the position that the leak was not solely
responsible for the run—
Dr Ridley: I am sorry. I did not mean to imply that
at all.
Q626 Mr Brady: No, I completely accept that. Given
the clarification that took place, if the leak was not
solely responsible for the run, it did clearly
exacerbate it; it did take some of that time away from
you and clearly therefore it is a hugely important
factor in the way events developed. You said in
response to an earlier question that you are very
confident, you know the leak did not come from you,
you are very confident, I think the implication was,
did not come from Northern Rock. What kind of
inquiry have you mounted within Northern Rock,
including presumably your advisers, to establish
with absolute certainty that the leak did not
originate there?
Mr Applegarth: I do not think you can establish with
absolute certainty that it did not, because you do not
have monitored telephone calls and whilst you can
ask to see written correspondence, that does not stop
somebody briefing. Given that it was massively not
in our interests or our advisers’ interests to leak it,
and given the clear answers we have been given when
we asked the people concerned, because we kept it
down to as small a bunch as possible within the
company advisers who knew, as far as is certain, I
am sure that it did not come from us.
Q627 Mr Brady: What steps have you taken to
establish where it did come from?
Mr Applegarth: None outside our company.
Q628 Mr Brady: Do you propose to?
Mr Applegarth: I do not see how we can.
Q629 Mr Brady: Sorry, you said not outside the
company. What steps have you taken within the
company?
Mr Applegarth: Clearly, we have gone to the people
who knew about it, who were employed by us, either
on our payroll or as advisers, and asked them. You
cannot prove or disprove that somebody gave a
verbal briefing.
Q630 Mr Brady: Do you have a view as to where the
leak did come from?
Mr Applegarth: Other than I am pretty damn sure it
did not come from inside Northern Rock or our
advisers, no.
Q631 Chairman: Could I just go back to Sir Derek
Wanless and ask about the Risk Committee which
he chaired: did it have the specific policies for
managing liquidity risk?
Sir Derek Wanless: The Risk Committee is a
strategic level committee of the Board which meets
three times a year. The issues about liquidity and
treasury risks were set out by the Board and the Risk
Committee monitored that on a regular basis at each
of its meetings.
Q632 Chairman: Did you have an active
management policy for measuring liquidity risk?
That is what I am asking you.
Sir Derek Wanless: We have reports on liquidity risk
which the committee sees.
Q633 Chairman: If you had an active policy, why did
it not work? The thing is, I want to get back to the
Bank of England and the FSA. The Bank of England
said in April, “It is important that firms stress-test
and take those stress tests into account.” Secondly,
the January 2007 FSA report says about risks for
firms and markets that “if economic conditions were
to deteriorate, this could lead to crowded exits,
draining liquidity from the market and causing
erratic price swings in commodities, etc.” Did you as
a Risk Committee study those comments?
Sir Derek Wanless: We looked as a Board at the
issues of our funding strategy and what the risks
were.
Q634 Chairman: I am asking specifically were the
FSA and the Bank of England reports discussed by
your committee in terms of liquidity and how it
could seize up?
Sir Derek Wanless: Those reports were discussed as
part of the ICAAP work. For the whole of this
period we were working with the FSA on our
ICAAP.
Q635 Chairman: So what did you do when the FSA
in January said that it could lead to crowded exits,
draining liquidity from the markets?
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Sir Derek Wanless: As we explained earlier, we—
Q636 Chairman: No, you see, your explanation is
not suYcient because at the end of the day, you
found yourself in a position where no-one else in the
UK found themselves. That is what we are talking
about as a Committee, that this is unreal. What did
you do as a committee in terms of that liquidity?
Sir Derek Wanless: We were going through a process
at the time of scenario stress-testing which involved
looking at 20 scenarios which the Board had signed
oV. Fifteen of those scenarios involved liquidity risk,
including two where securitisation became a
particular problem. What did not happen was that
we stress-tested the scenario of what has actually
happened, which is, as we said earlier, that there was
an unprecedented and unpredictable change in the
market basis.
Q637 Chairman: Can I ask then, in terms of stress
tests, do you think stress tests should now include
more extreme scenarios such as the one you that you
have recently faced?
Sir Derek Wanless: Clearly, this now having
happened to everybody will stress-test—
Q638 Chairman: So your stress tests were
insuYcient?
Sir Derek Wanless: Our stress tests at the time were
exactly what they should have been, that we agreed
with the FSA—
Q639 Chairman: No, no, no. At the end of the day,
here we find ourselves in a situation where you are
the first bank to have a run in 140 years. Were your
stress tests suYcient? That is the question.
Sir Derek Wanless: Our stress tests at the time were
suYcient. That is the point I am making.
Q640 Chairman: So they were suYcient and you got
yourself into this situation. Why did not other banks
in the country not get themselves into it? Why are
you alone? This is the question we as a Committee
are asking. Why are you alone here, Sir Derek?
Sir Derek Wanless: What we are required to do is to
look at—
Q641 Chairman: Why are you alone, of all banks?
Sir Derek Wanless: I think we went earlier through
the issue of what might have been happening in
other banks.
Q642 Chairman: Why are you alone? That is the
question. Why do you stand on your own? Why are
you an orphan in the banking sector?
Sir Derek Wanless: We do not know precisely what
the position was in other banks. Clearly, we are the
only bank that has had a run.
Q643 Chairman: You are the only one who went to
the Bank of England.
Sir Derek Wanless: We are the only bank who have
had a run. That was crystal clear.
Q644 Chairman: You see, I put it to you that—and
this was mentioned in one of the newspapers this
morning—when rival mortgage banks were scaling
back their lending in 2007, you were accelerating
yours. As the Daily Telegraph said this morning,
almost one in five loans in the first half were
provided by yourselves, and therefore that decision
to expand aggressively is key to this situation. You
as a Risk Committee and you as the Chairman of the
Risk Committee did not do your job, Sir Derek. If
you had done your job, you would have brought to
the attention of the Board the comments of the FSA
in January, the comments of the Bank of England in
April and then had a strategy early on in that year to
deal with the situation where you did not find
yourself in the iniquitous position of being the only
bank in the United Kingdom to face this situation
and going cap in hand to the Bank of England, to
end up in a situation where your bank is eVectively
nationalised; it is the taxpayer that is supporting
your bank at the moment.
Sir Derek Wanless: The position is not like that at
all. The position is we were stress-testing, plausible
stress tests—
Q645 Chairman: You were stress-testing but your
stress-testing was not enough, because you ended up
in this inglorious situation.
Sir Derek Wanless: Our stress-testing was, as stresstesting, plausible and—
Q646 Chairman: This is unreal.
Sir Derek Wanless: No. The position is, and it was
confirmed to you by the FSA, who said no
reasonable professional would have forecast the set
of circumstances that happened. They also—
Q647 Chairman: The FSA never said to us that noone could have found themselves in this position but
Northern Rock, so the FSA did not come here and
give you support as Northern Rock so do not try and
kid us on that.
Sir Derek Wanless: I am not. The FSA said, and
others have said too, that what has actually
happened, the sequence of events, was not
something which was regarded as a plausible stress
test at the time. The FSA were talking to us all
through that period. We as a Board were looking at
the scenarios which we were stress-testing. Of
course, since this has happened people will do
diVerent stress tests but the stress—
Q648 Chairman: The FSA said to us that they have
to learn lessons on stress-testing. Implicit in that is
the fact that your stress-testing was not enough and
that is how you found yourself in this embarrassing
situation, and you, as the chairman of the Risk
Committee, should have been alert earlier on in the
year when the FSA and the Bank of England were
giving these warnings, and I put it to you that you
were not doing your job.
Sir Derek Wanless: No, we have made it clear that
the stress-testing was tested against a tightening of
the credit markets, which we expected, and our
strategy, as Mr Applegarth explained earlier, was
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actually slowing down the growth of assets and
selling books, for example, the commercial lending
book. So we were taking action through the halfyear. We did not foresee the unprecedented and
unforeseeable changes and the sequence of events
that have happened. That is very clear.
happened in May, when we raised £4 billion through
a Granite issue, it was oversubscribed and at
attractive prices. There was no indication at that
time, as late as May, that good-quality UK
mortgages, put into a securitisation vehicle, was
going to be a diYculty in terms of raising funds.
Q649 Chairman: So at the end of the day your
answer to us is unsatisfactory. You do not really
know how you got yourself in this situation where
you are alone in the United Kingdom.
Sir Derek Wanless: No, we know exactly—
Q655 Mr Fallon: So there was no increase possible in
the interbank rate that you did not stress-test?
Sir Derek Wanless: We have not had a problem with
change in the interbank rate since August. The issue
certainly aVects profitability but that is not the issue
we are here to talk about. Certainly our underlying
profitability is impacted by changes in margins but
we had actually taken a good deal of action as early
as January of this year to prevent any mismatch in
interest rates from hitting our bottom line.
Q650 Chairman: You, as the chairman of the Risk
Committee, did not do your job.
Sir Derek Wanless: The Risk Committee and the
Board did its job, in my view, properly through
this period.
Q651 Chairman: It did its job and it ended up in this
hugely embarrassing situation, causing pain to
people in the North-East, not least your employers
in the community. But you did your job. That is
what you are saying to me this morning.
Sir Derek Wanless: What I am saying to you is there
is a sequence of events that go through from subprime problems in the States to the run on Northern
Rock which requires a good deal of careful analysis
to find out what the issues are.
Q652 Chairman: You are out of step with every
other retail organisation in this country and you
have no adequate answer to this Committee as to
why you stand on your own.
Sir Derek Wanless: We were an outlier in terms of
wholesale lending in total, securitisation in total.
That is true and the figures show that. We were not
an outlier in terms of maturity, the structure of the
wholesale lending.
Chairman: You ended up in disgrace. That is the
issue.
Q653 Mr Fallon: You have made it clear that you
stress-tested some aspects of securitisation, Sir
Derek. Because you were over-dependent on the
wholesale markets, what you did not stress-test were
movements in the interbank rate. That was the
position, was it not? This whole business model was
a gamble on interest rate movements.
Sir Derek Wanless: No, it was not and is not a
gamble in that sort of way. The issue that has
happened is a complete drying up of liquidity, not an
issue about price. We expected the price would
change in the marketplace and that the tightening
that the chairman referred to would be a tightening
of pricing in the marketplace and therefore it would
cost us more to raise securitisation. That was
something we expected and it was something that we
were planning for.
Q654 Mr Fallon: You mean you were ready for any
kind of increase in the interbank rate?
Sir Derek Wanless: We were ready for foreseeable
changes in our securitisation pricing. If you look at
the prices of our securitisation, if you look at what
Q656 Mr Fallon: It was your job and your Risk
Committee’s job to assess properly the risk of
illiquidity and to ensure the Board was prepared
against it. You failed and that is why you have ended
up dependent on £13 billion worth of public money.
Sir Derek Wanless: We take at each time, because we
only have foresight, not hindsight . . . When we
looked at our funding strategy and had a very clear
strategy which said the first line of defence is good
credit quality. The first line of defence is to make
sure we have available so we can securitise or put
into covered bonds good-quality mortgage assets
and that we have. Nobody has criticised, in fact
people have indicated to you, I think, that we have
good-quality assets. That was the first issue, so that
the markets would distinguish between what were
clearly very poor US sub-prime loans and goodquality UK loans. The first line of defence. The
second line of defence was to increase our retail
deposits, which we did both in the UK through a
diVerent product range and also in Denmark
through opening a subsidiary there which was
successful in raising funds. We then opened up a
securitisation covered bond and wholesale markets
geographically round the world. To have tested the
scenario which said that what would happen was all
of those markets and all of those geographies would
close and be closed for a prolonged period—because
clearly we can cope with short periods of closure of
those
markets—was
unprecedented
and
unforeseeable and therefore it was not in our stress
tests.
Q657 Mr Fallon: Do the four of you realise the
damage you have done to British banking?
Dr Ridley: We realise very acutely the pain and
distress that has been caused to our customers and
to others in the banking industry, yes.
Q658 Chairman: Can I just ask Sir Derek again, to
follow that up, 75-80% of your business is depending
on mortgage. Is that right?
Sir Derek Wanless: On securitisation, on non-retail.
Q659 Chairman: These are public figures. Let us
look at HBOS. They are the biggest mortgage lender
and only 20% of their profit is gained from it, so
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diversification is important. You were not
diversified enough, Sir Derek. That was how you got
yourself as a company into this situation. It was
too late.
Sir Derek Wanless: The company has had a very
successful strategy, which—
Q660 Chairman: You were not diversified the
enough. That is the point I am making to you.
Sir Derek Wanless: The company strategy has been
very clearly articulated and it is to concentrate on
mortgage and—
Q661 Chairman: Exactly, so you were not diversified
enough in the case of a crisis.
Sir Derek Wanless: No, that strategy has been a very
successful strategy.
Q662 Chairman: You only had one well to go to
where other companies had a number of other wells,
HBOS and others, and that is the situation, and that
is what you did not see as a company or you ignored
as a company. You only had one well from which
to drink.
Sir Derek Wanless: That is simply not true, and
those who comment on the shares, the analysts, talk
about our well-diversified funding stream. Retail,
wholesale, covered bonds, securitisation gave us
channels which opened up markets around the
world and nobody has foreseen that all of those
markets would close at the same time.
Q663 Chairman: Sir Derek, again, this is unreal. You
depended for 75–80% of your business on
mortgages. Other reputable companies were
diversifying and, as I say, in the case of HBOS, they
only depended on it for 20% of their profits. If you
had diversified, if you had sat with an ambitious
chief executive and said, “Look, Adam, don’t put all
your apples in the one basket because we are going
to end up in a car crash here” and things could
have helped.
Sir Derek Wanless: That is simply not the way that
we saw it or any—
Q664 Chairman: It is the way everybody else in the
way UK sees it.
Sir Derek Wanless: No commentators saw that. The
model that we described for the business, which was
a concentration on mortgage business, was a very
clear, transparent model—
Chairman: Sir Derek, I have spoken to chief
executives of major banks—
Jim Cousins: Which ones, Chair?
Chairman: I am not saying which ones.
Jim Cousins: We have had 20 minutes grandstanding
from you. Do you not think that is quite suYcient?
What other banks have you talked to, Chairman?
Chairman: I am saying diversification is important.
Jim Cousins: You are telling this Committee you
have talked to other banks who are cleverer. Please
tell this Committee what other banks they were.
Q665 Chairman: I am not saying. The point is, Sir
Derek, they are saying that diversification is
important.
Sir Derek Wanless: We had a model which was
simple and well understood. It was sold to the
market as a model which concentrated on
mortgages. A few years ago we sold our credit card
business because it was a risky business. We have
this year sold our commercial finance business.
There is a concentration on mortgage assets. That
concentration was well known to all of those people
with whom we do business.
Q666 Mr Breed: Mr Applegarth, when did you
qualify as a banker?
Mr Applegarth: I am not a qualified banker.
Q667 Mr Breed: The period that I am most
interested in is the period between March and
August, during which time you had certain changes
of policy, you sold oV the commercial book, and you
issued a profits warning. The Risk Committee
seemed to carry on as normal; it did not have any
increased meetings. Everything was going along as if
you thought it was normal. There was the so-called
close control of the FSA, which seemed to me
anyway to be non-existent, and in the end you
contacted the FSA on 13 August. During the whole
of this period of time what discussions or meetings
took place with your external auditors?
Mr Applegarth: Our external auditors’ first point of
contact is the finance director and they have a series
of regular meetings with the external auditors, so
there would be at least monthly formally, but the
contact was much more frequent than that.
Q668 Mr Breed: So the external auditors were well
aware of the situation on at least a monthly basis
between March and August, yet it appears to me that
they sent a letter expressing their concern about the
liquidity and everything else, I think, on 11
September, which seems to be somewhat late.
Sir Derek Wanless: If I may, as the chairman of the
Audit Committee, answer that—
Q669 Mr Breed: So you are Chairman of the Audit
Committee as well as the Risk Committee?
Sir Derek Wanless: Yes, I am. The auditors did the
normal job in the interim results signing oV. There
were no liquidity issues which the auditors needed to
pay special attention to at the time of the interim
results in July.
Q670 Mr Breed: So the auditors felt no need at any
time to alert the FSA or the Bank of England as such
about any concerns they might have had in the
figures that they were seeing from Northern Rock?
Sir Derek Wanless: You would have to ask the
auditors but I would be astonished if they did
because they did not alert us to any issues at that
stage.
Q671 Mr Breed: Do you think their letter of 11
September was timely?
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Sir Derek Wanless: I am not quite sure exactly which
letter you are referring to.
Q672 Mr Breed: Bearing in mind you had a liquidity
crisis on 9 August, it seems about a month later they
decided to send a letter.
Sir Derek Wanless: The auditors were in contact
with the company and knew well that the company
were keeping the Tripartite informed, as we
mentioned earlier.
Q673 Mr Breed: So they felt no need whatsoever to
express an opinion.
Sir Derek Wanless: You would have to direct that
to them.
Q674 Mr Breed: Who are your auditors?
Sir Derek Wanless: PWC.
Q675 Mr Love: I am going to make a very big
assumption, which is that you, as the operators of
Northern Rock, understand Northern Rock
depositors better than anyone else. What I am trying
to get to the bottom of is the psychology of what
happened on that Monday morning. I am going to
make the assumption again that there is some
evidence, that you have got your employees to talk
to these depositors about why they were
withdrawing their money. I want to be clear first of
all, because there seems to be a diVerence of view
between the chairman and the chief executive about
whether or not the BBC leak was instrumental in
what happened. I think you were saying Mr
Applegarth that you thought that the diYculties you
would have had would have probably led to that
although it might have been exacerbated by the
BBC. Dr Ridley, you said that you thought if you
could have handled it, it would have been okay. Can
we get clarity? Are we moving towards Mr
Applegarth’s view of things?
Dr Ridley: Just be clear, I never said that if there had
been no leak everything would have been okay. I
simply said, which was exactly what Mr Applegarth
said, that the management of the communication on
the Monday morning would have enabled the shock
to depositors to be slightly less.
Q676 Mr Love: You mentioned, Mr Applegarth, a
number of things that you thought could have
helped. Let me ask you about one of the ones that
was raised by us with the Governor of the Bank of
England and subsequently now by the Chancellor,
deposit insurance, both in terms of time and in terms
of the coverage. Would that have made the
diVerence?
Mr Applegarth: I think it must be true that if the
depositors’ scheme guaranteed 100% at a higher
level, that would have reduced the probability of
withdrawals. That must be true.
Q677 Mr Love: How about the time? Were people
coming to you? This is anecdotally what we have
been told through the media. The rational view was
“There is a run started on the bank—better get your
money out early otherwise it’s going to be tied up for
months on end.” Is that what your employees were
being told by depositors who came for their money?
Mr Applegarth: I can understand readily the logic of
somebody who has their life savings invested in an
institution and who sees pictures of people queuing
outside the door and they go and join that queue.
That is quite a logical reaction. One of the problems
with the depositors’ scheme was it is not simple to
explain, in that the existing scheme was until recently
guaranteed up to £2,000 and then a certain
percentage up to another. It does not lend to sound
bites when you are trying to deal with customers
either on the telephone or queuing outside your
branch.
Q678 Mr Love: Was that an issue that was raised
consistently by those depositors who were queuing?
I am just asking. I do not know whether you
gathered any evidence from this process. It might
help with the psychology of all of this.
Mr Applegarth: The first set of evidence we tried to
collect was what issues they were having actually
getting the money out. It was not just queuing
outside the branches, because that was actually the
least money going out, although it was the most
visible sign of a retail run. It was what was
happening with internet withdrawals, what was
happening with postal and telephone withdrawals.
The logic was at the time, and I perfectly understand
it, “We have seen pictures. You have got our life
savings. I want it back. I do not really want to
withdraw it and I’ll bring it back.” In fact, that is
what we have seen. We have actually seen depositors
returning cheques but I perfectly understand the
reaction they took. I would have probably done the
same thing if I was in their shoes.
Q679 Mr Love: You talked about a safe haven. The
Governor of the Bank of England said to us that the
Takeover Code made it impossible to do what
traditionally the Bank of England has done. Do you
think it was an institutional arrangement like the
Takeover Code or were there failures in the way that
the bank interacted with Northern Rock and the
possible high street bank that you mentioned that
could have taken over Northern Rock?
Mr Applegarth: I think the Bank of England acted
remarkably smoothly within the constraints it had.
Clearly, it would have been impossible to get a
completed transaction over a weekend but it is my
view that, had you had an announceable oVer over
the weekend with a major high street brand, that
would have provided suYcient confidence so a run
did not happen.
Q680 Mr Love: That did not happen. Was that
because of something that the Bank did or was it the
Takeover Panel rules that precluded that from
happening?
Mr Applegarth: I understand in the first instance it
was because a facility similar to the one we got was
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
not available to the main high street bank at the
time. It was subsequently made available in the first
weekend of the run but, unsurprisingly, in the
middle of a retail run it is diYcult to find a safe
haven.
Q681 Mr Love: The final thing I want to ask you is
about whether it should be overt or covert. The
Governor told us it is a Directive from the European
Union on market abuse. There are many reasons
why we would want to make overt lots of things that
would be covered by a Market Abuse Directive.
Would you be suggesting, from your experience,
that we should be thinking seriously about changing
that and making it covert in the very specific
circumstances that you were facing?
Mr Applegarth: I think a general rule that
transparency is good I would sign up to, but there
are occasions where discretion of being able to make
something covert might have helped. The problem
the bank would have faced even if it could have made
it covert is in practical terms because, as proved by
the leak to the BBC, in practical terms, there will be
so many people involved in terms of advisers, etc,
that it would have got out and that in itself would
have been damaging. If you think it is going to go
out, you might as well try to manage the
communications well, and this is where I am in
agreement with the chairman: the probability of a
run would have been lessened had we been able to do
the full communication over the Monday morning
as intended as opposed to having to rush the
communication on the Thursday morning.
Q682 Chairman: Sir Derek, when you were Chief
Executive of NatWest the Bank of England
supervised you. What was the diVerence in approach
between the Bank of England supervision and the
FSA’s now?
Sir Derek Wanless: The supervision in the 1990s was
a good deal more informal. The procedures which
exist under the FSA tended not to be there at that
time and there was a good deal more personal
discussion.
Q683 Chairman: Would you say they monitored
liquidity and funding more in the Nineties?
Sir Derek Wanless: No.
Q684 Ms Keeble: I have a couple of questions. What
percentage of your mortgages were taken out in the
last couple of years, during your big expansion
programme?
Mr Applegarth: We have been growing our assets by
20% plus or minus 5% for the last 17 years.
Q685 Ms Keeble: If you could just say the percentage
by value, not by number, because presumably they
are a bit larger now.
Mr Applegarth: Yes. I would imagine over the last
two years—and I will provide the exact number for
you in writing—it probably accounts for around a
third of our current lending.13
13
Ev 233
Q686 Ms Keeble: Earlier you said that the average
mortgage life on your books was three years.
Mr Applegarth: Three years one month, yes.
Q687 Ms Keeble: If you say a third of them are very
new, what is the profile for the rest of them? The
point is really the length of time that people hold a
mortgage before they either pay it oV or remortgage
rather than the average lifetime of the mortgage as
you have got them now. They are obviously two
diVerent things.
Mr Applegarth: Yes, of course they are. The average
life of a mortgage product is three years one month.
The length of time a customer stays with us,
however, is back up to seven years. Because, as the
chairman said, we are very good at retaining our
mortgage customers, the average life a customer is
with us is extended but his mortgage product is
short. So what you are finding is mortgage
customers are increasingly having two or three or
four products with us during their life before they
leave us. The mortgage product—and it is the
mortgage product that you are funding—has an
average life of three years one month.
Q688 Ms Keeble: Perhaps we can have that profile
when we get the figures. The other thing is that you
said much earlier on in the questions—and I might
not have got the wording exactly right—that you
had some more risky investments that you moved
oV-balance sheet.
Mr Applegarth: Yes.
Q689 Ms Keeble: Can you just explain what that
was? It was just a throw-away phrase.
Mr Applegarth: Of course I can. Under Basle II,
when you get your Basle II approval, the relative risk
weighting of certain assets in your balance sheet
changes. So what we had, because of the quality of
the loan book, was you saw our risk weighting for
residential mortgages come down from 50% to 15%.
That clearly required less capital behind it, so that
links to why we were able to increase the dividend.
We had some assets whose risk weighting did not
change. Commercial lending is a good example. It
remained 100% risk weighted. Relative to the
mortgages, which had gone down to 15%, they were
therefore less capital eYcient and therefore it made
sense to remove that type of asset oV the balance
sheet. It also tied in well—
Q690 Ms Keeble: Can you just say again what they
were? I did not catch it when you went through it.
Mr Applegarth: Commercial lending, unsecured
lending, commercial buy-to-let. Those were the
three prime areas.
Q691 Ms Keeble: Those you moved oV-balance
sheet?
Mr Applegarth: Those we announced publicly that
we were going to. We had only completed the three
parts of the commercial sale.
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Sir Derek Wanless: We sold them.
Q692 Ms Keeble: I see. You sold them. All of them,
or you got through part of them?
Mr Applegarth: We sold all the commercial, and it
was in three stages, but clearly the market
dislocation has meant we have not been able to sell
the unsecured or the commercial buy-to-let. As
markets return towards normal, so we should be
able to do that but that will take some time.
Q693 Ms Keeble: Can I just ask because you said
“the unsecured”. Does that mean your new package
is included in the riskier portfolio? Can you just
describe a bit about the buy-to-let and why that is
perceived to be riskier?
Mr Applegarth: Absolutely. There are two types of
unsecured lending. There is about £7.8 billion of it.
There is the unsecured lending that is bundled with it
to get the first-time buyer product and there is standalone unsecured lending. Our aim was to sell the
stand-alone unsecured because the unsecured would
together perform so well. Its three months plus
arrears are actually less than the industry average for
secured lending. So we looked to move oV the
balance sheet, sell, the stand-alone unsecured and
that accounts for 60% of that £7.8 billion. The risk
weighting under Basle II did not go up. It was just
the relative risk weighting versus mortgages which
came down. The same applies to the commercial
buy-to-let. The commercial buy-to-let did not
change its risk weighting, just relatively compared to
mortgages, which came down, made it look
therefore less capital eYcient. So it is good-quality
lending but it did not fit in a high-quality asset
balance sheet because we believed that high-quality
assets and transparency was the way to maintain
liquidity. Wrong!
Q694 Chairman: You mentioned special-purpose
vehicles. You have the Granite special purpose
vehicle. What is the purpose of that?
Mr Applegarth: Granite is our securitisation vehicle
and accounts for roughly 50% of our funding. The
way securitisation works is you borrow against a
pool of mortgages. The bond holders, the people
who are lending the money against it, they carry the
risk and therefore there can be no risk from those
loans to the PLC’s balance sheet, so even though it
is shown in our balance sheet, it has to be a separate
legal entity. The separate legal entity is a master
trust.
Q695 Chairman: Just one point there. In the
agreement with Northern Rock the Law Debenture
Corporation names a particular charity, Down’s
Syndrome North East, but this charity has come out
with a statement saying that they were not consulted.
Mr Applegarth: Indeed, and I regret that. We have
spoken to them and I have written to apologise. The
master trust—
Q696 Chairman: They say they had no knowledge of
Northern Rock at all. That is what they said. It
seems an extraordinary step that you took.
Mr Applegarth: That is not true. They had no
knowledge that they had been named a beneficiary
or potential beneficiary if there was a windfall from
the master trust at some time in the future. Clearly
they knew about us because the reason they were
picked is that in 2001 they were one of our three
corporate charities.
Q697 Chairman: You gave them £40,000.
Mr Applegarth: Yes, the staV raised £40,000.
Q698 Chairman: What they are saying is they were
not consulted about this.
Mr Applegarth: It is not usual to consult them but I
have to say we have spoken to them and I have
written to apologise.
Q699 Chairman: Some would say it is identity fraud
if you use a name and they do not know about it.
Mr Applegarth: I would not go so far as identity
fraud but I have written and apologised and they
have accepted my apology.
Q700 Peter Viggers: One of the aspects of this aVair
which has caused so much damage is the lack of a
clear, informed market for quite a long period, from
9 August, when you first knew of the liquidity
problems, through to 14 September, when you made
your announcement. Obviously, the FSA and the
Takeover Panel have some responsibility for
ensuring that there is no false market, that there is an
informed market, but the prime responsibility is
yours, and there must have been many times during
this turbulent period when you considered what
public announcements you should make. Can you
please talk us through the narrative of that?
Dr Ridley: Certainly. You must remember that on 9
August it was not as if there was a sudden change in
our profit forecast. This was the beginning of a
squeeze that, if it lasted only a short number of days,
would have no eVect at all. As it went on and it
became clear that there would be an impact on the
profit forecast, we were keeping in very close contact
with both the authorities that you mentioned and
also our own legal and other advisers, broking
advisers, about whether we needed to make an
announcement. The other thing we had to take into
account was that we were by then in talks with the
potential safe havens that have been mentioned. So
we simply took the best advice we could on when and
where we needed to make announcements and we
made exactly as many announcements as we were
advised we had to make.
Q701 Peter Viggers: Just for the record, can you
remind us of the share price performance during
this period?
Dr Ridley: There was a sharp decline in the markets
generally in the middle of August and some recovery
after that.
Q702 Peter Viggers: You took advice and made
announcements when you were advised to make
announcements?
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Dr Ridley: We were absolutely clear that we made
every announcement that we needed to make when
either we needed to announce a change of profits or
we needed to announce discussions with other
parties, and while the discussion of the facility with
the Bank of England was going on, that was also a
relevant factor that we were told we had to take
into account.
Q703 Peter Viggers: You maintained contact with
the relevant authorities throughout?
Dr Ridley: We maintained contact with the relevant
authorities throughout.
Q704 Chairman: Dr Ridley, did you think it was
appropriate to oVer a 14.2 pence dividend to
shareholders, almost £60 million in total, whilst the
bank was under Treasury protection?
Dr Ridley: We kept the position of the interim
dividend under continuous review from the time that
we announced it at the end of July until we took the
decision to not pay it. That was a decision that had
to be a careful balance of judgement between on the
one hand—
Sir Ian Gibson: We do not know.
Q711 Mr Dunne: You do not know what proportion
of your shares are held by your employees?
Sir Ian Gibson: No. We know that 75% of employees
hold shares. We will find out for you from the small
share register—
Q712 Mr Dunne: I am astonished to hear that no
member of the Board knows the proportion of
shares held by its staV, given the importance that you
place on employee ownership in the company. You
know 75% of your employees hold shares but you do
not know how many shares they hold. Do you know
how many shares are held by the foundation?
Dr Ridley: The foundation does not own ordinary
voting shares. What it owns is a stake that converts
into 15% of the company on takeover.
Q713 Mr Dunne: Does the foundation receive
dividends on those interests?
Dr Ridley: The foundation receives in lieu of a
dividend a covenant of 5% of pre-tax profits.
Q705 Chairman: Your announcement was Tuesday
25 September but a couple of days before it you were
still saying you were going to pay it out. There was
a bit of a brouhaha in the press that day. What
changed your mind about paying it out then?
Dr Ridley: We were taking continuous advice and
listening to all parties, including the FSA and others,
and we were having to balance the judgement
between, on the one hand, paying cash out of the
business and, on the other hand, our obligations to
shareholders.
Q714 Mr Dunne: So the foundation had no interest
in a dividend decision as such?
Dr Ridley: That is correct. The foundation has had
£175 million from us over 10 years.
Q706 Chairman: Do you think it was appropriate to
pay out £40 million to preference shareholders, even
though you had cancelled the payment to ordinary
shareholders?
Dr Ridley: That is simply a mistake that was made
in the press. It was not a dividend to preference
shareholders; it was interest on a debt.
Q716 Mr Dunne: Will the foundation, given its
contingent ownership position, have an ability on a
transaction with a third party to act as a blocking
shareholder in the event that a transaction
materialises?
Dr Ridley: My understanding is that its stake
converts automatically.
Q707 Mr Dunne: Following up on that, what
proportion of the shares of Northern Rock are held
by the Board?
Dr Ridley: I do not know the answer to that
question.
Q717 Mr Dunne: Into 15%?
Dr Ridley: Yes.
Q708 Mr Dunne: Approximately?
Dr Ridley: Can we write to you on that?14
Q709 Mr Dunne: Is it a significant proportion or it is
an insignificant proportion?
Dr Ridley: I should imagine it is a pretty
insignificant portion.
Q710 Mr Dunne: What proportion of the shares are
held by employees?
Dr Ridley: Seventy-five per cent. Sorry. It is the other
way round.
14
Ev 233
Q715 Mr Dunne: Indeed, which is very impressive
and distressing to the foundation that that is now
going to seemingly come to an end. Are any
members of the Board directors of the foundation?
Dr Ridley: No, currently no members of the Board
are directors of the foundation.
Q718 Mr Dunne: Therefore it could have a blocking
shareholding if the acquirer acquires 100%.
Dr Ridley: No, it converts once the acquirer has,
whatever the expression is, full control.
Mr Applegarth: It is not blocking. It is a dilution.
Q719 Mr Dunne: Picking up the Chairman’s
comment about the decision to reverse the dividend,
did you have any discussions with the Bank of
England which helped you change your mind?
Dr Ridley: No. The discussions about the dividend
we had were with the FSA and with other advisers.
Q720 Mr Dunne: Were there any discussions with
someone from the Treasury or the Chancellors
oYce?
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Sir Ian Gibson: On the day that the Board reached
the decision not to pay the dividend there were
discussions on a broad range of issues, including the
dividend, with the Tripartite group. The Treasury
was there, the FSA was there and the Bank
representative was there too.
Q721 Mr Dunne: So would it be fair to characterise
your decision that part of the contributory reasons
to changing your decision on the dividend was
because you had been leant on by the authorities
that were providing the bank facility?
Sir Ian Gibson: No, it would not be fair to
characterise it like that.
Q722 Mr Dunne: How would you characterise the
nature of those discussions with the Tripartite
members on the dividend?
Sir Ian Gibson: They wished to understand in detail
what the Board’s thinking was at the point at which
we were having those discussions with them, where
we stood on dividend, where we believed
shareholders’ expectations were, what we believed
the view of rating agencies might be in the case of pay
or not pay, and what we saw as any potential risk to
our regulatory capital. We explained our thinking to
them on those fronts and explained the process that
the Board was then going through in terms of its
review over whether or not to pay the dividend.
Q723 Mr Dunne: So the Board changed its view
rather than was persuaded to change its view?
Sir Ian Gibson: I think the chairman characterised it
well, which is that we must as a Board or as a subcommittee of the Board have discussed the dividend
payment almost daily—I do not have my notes with
me but very frequently during that period. I noticed
the Chairman of this Committee’s comments during
that period, for example. We looked at a whole
bunch of comments that were made. You said it was
a matter of public interest. There were lots of
comments that the Board talked about every day in
saying “What should we take account of here?”
Dr Ridley: On the point about what proportion of
our shares are held by employees, I do know that we
have a very large number of small shareholders in
comparison with the size of our staV and that is why
we know that it is a small number. The proportion
of shares held by employees will certainly be less
than 10% and almost certainly less than 5%.
Q724 Mr Love: On a related issue, I understand that
the company continued to urge employees to buy in
the share-save scheme that you operate up till the
end of August, when clearly there were some
diYculties. In retrospect, do you think that was a
sensible decision? As I understand it, it came to an
end at the end of August. For those that had signed
up, was it possible at that stage to cancel it on the
basis that those employees who had signed up might
lose significantly from the purchase of those shares?
Mr Applegarth: The Save As You Earn scheme, the
money that is invested they can withdraw back as
cash, so in terms of losing their money, no, that was
not the case.
Q725 Mr Love: They can do that at any time, or do
they have to do it before the closure?
Mr Applegarth: They have to do it at certain
specified dates.
Q726 Mr Mudie: I think there is general agreement
that if we had a market solution it would have been
better all round. Andy asked questions of the
Takeover Panel. Did your advisors indicate any
diYculty in the safe haven deal being dealt with in a
satisfactory timescale, in other words, not reaching
the Takeover Panel? We got the impression from
certainly the Bank of England that it was impossible
because of the Takeover Panel and the length of time
and market disclosures, etc.
Mr Applegarth: You certainly would not have been
able under the current legislation to actually
complete a transaction within a weekend but we
would have been able to have an oVer of a
transaction, and it is my belief that the oVer of a
transaction with a well-known bank would have
been enough to stop it.
Q727 Mr Mudie: You started discussions in midAugust and they came to a head in September. The
chairman rang the Bank of England on 16 August.
That was certainly a direct line then. Where were the
FSA in terms of liaising, speaking, working with you
throughout August into September?
Mr Applegarth: We formally had two calls a day
with the FSA but I have to say that the number of
informal contacts were greater than that. So we were
in very close and continuous contact with the FSA
and, of course, they are our lead contact for the
Tripartite and they garner information oVers for
others in the Tripartite and they pass
communication across. So the FSA were kept right
up-to-date with everything we were doing on
corporate activity.
Q728 Mr Mudie: How up-to-date and how
supportive were they of this safe haven?
Mr Applegarth: I think it can be generally
characterised that everybody could see that it would
be a potential—
Q729 Mr Mudie: When you say that, can you
confirm that “everybody”? It is certainly not the
evidence that the Bank of England could be included
in that “everyone”.
Mr Applegarth: That is a fair point. I am relying on
feedback from the FSA, who are our key contact of
the Tripartite. It may be either the chairman or the
senior independent in their direct contacts with the
Bank got a diVerent view.
Q730 Mr Mudie: So the FSA in eVect were the
liaison point between you and the Tripartite, and the
FSA therefore worked closely, I presume, on the safe
haven argument with you and regarded it as serious
enough to actually take to the Tripartite to ask them
to consider.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Mr Applegarth: Yes.
Q731 Mr Mudie: Did they give you any stronger
feeling than that? We failed to get Sir Callum, maybe
out of loyalty to the Tripartite, to say specifically
that he supported it. I am at a loss. If his
organisation took it to the Tripartite, they clearly
would not have wasted their time or wasted your
time in a pretty fraught situation by taking
something that was lame at that point in the game to
the Tripartite. Did you get the impression they were
supportive, that they thought it was a serious idea?
Mr Applegarth: I think the hard thing we have in
answering that question is clearly that we were not
party to the Tripartite discussions. We only know
the feedback from the FSA and they were
encouraging us to look at every opportunity to avoid
having to go to a lender of last resort.
Q732 Mr Mudie: Let me just ask you this, as a
layman. Certainly you, Dr Ridley. As an ordinary
bloke who hears disaster being faced, you work with
the FSA and you have another organisation willing
to take you over and save all the problems. The FSA
take it oV to the Tripartite and you get a decision no.
Did you just accept this with aplomb or did you pick
up the telephone and speak to anyone and say
“What the hell is going on?” I find it strange.
Dr Ridley: We were only going to be in a position to
take or not take a decision when we had an oVer. We
were doing everything we could behind the scenes,
both with the authorities and through our advisers
with other corporate parties to encourage an oVer to
come forward in the interests of our shareholders,
creditors and other stakeholders. Yes, we picked up
the phone to anyone and everyone.
Q733 Mr Mudie: No, I am not making myself clear.
At the stage where the FSA took the deal to the
Tripartite group—
Dr Ridley: I am not clear that is quite the right way
of characterising it. It is for them to answer about
that but there was not a deal that was taken by the
FSA to the Tripartite group, as I understand it.
There were continuous negotiations going on
between Northern Rock and the other party,
through advisers, and with the FSA talking to both
Northern Rock and the other party and the Bank of
England likewise. The eVorts being made were to
find a deal that was acceptable to the acquiring
party, that was likely to be acceptable to ourselves
and required various forms of support from the
Tripartite authorities.
Q734 Mr Mudie: Yes, that is the specific point, and
the Tripartite support was whether the facility that
was eventually oVered to you was going to be
transferable. Was that a condition of the deal from
the safe haven? I dislike calling Lloyds Bank a safe
haven because they will use that as a slogan for
years: “Lloyds, the safe haven bank.”
Dr Ridley: Because of the liquidity problems in the
market, in particular aVecting us, we understand
that the other company needed to have their comfort
and were negotiating towards that. We were not part
of that negotiation.
Q735 Mr Mudie: That was the thing that broke the
deal. Did you respond to the Bank of England in
terms of shock or anger or disappointment that the
deal had foundered because of their decision, or did
you just accept it?
Dr Ridley: No. As I say, we continued to speak to
anyone and everyone.
Q736 Mr Mudie: No, no. I am just asking. The
normal point would have been to pick up the
telephone and speak to the Governor of the Bank of
England and say, “What the hell are you doing? We
could avoid everything. This deal is on the table.
Why are you not taking this decision?” Moral
hazard, of course. Did you do that and if not, why
not?
Sir Ian Gibson: Could I comment?
Q737 Mr Mudie: No, let the chairman. I am just
asking for a specific point of view from the
chairman. The whole thing is in your hands, what
your company, your staV, your depositors are
facing. Did you pick up the telephone and play hell
with the Bank of England?
Dr Ridley: We spoke to the Bank of England about
all of this, yes, but—
Q738 Mr Mudie: I know you did but just answer the
question. When the decision came back “Sorry, they
can’t agree the facility,” I am just as a layman
thinking anybody in this room would have said, “I’d
better speak to the guy. He doesn’t understand how
serious this is.”
Dr Ridley: We were told that it was impossible for
them to provide the facility.
Q739 Mr Mudie: Okay, so you just accepted it. This
is not a judgemental comment. You just accepted it.
Dr Ridley: We did our best to put the position.
Q740 Mr Mudie: Sir Callum said, “I think it is
incorrect to regard the private sector solution as
being a firm, cut and dried oVer. It was still at an
exploratory stage.” It sounds to me that it was well
past an exploratory stage, and it would have to be to
give comfort to the depositors.
Dr Ridley: A degree of exploration had obviously
taken place, yes, but no, there was no firm oVer. We
never had an oVer on the table.
Q741 Mr Mudie: No, but you would have got an
oVer, you are strongly confident, if you had had that
guarantee.
Dr Ridley: We cannot be sure of that.
Q742 Mr Mudie: Your chief executive seemed to
indicate earlier that he would be content with that
and that would have saved the problem.
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Dr Matt Ridley, Mr Adam Applegarth, Sir Ian Gibson and Sir Derek Wanless
Dr Ridley: Had an oVer come forward within a day
or two on that basis then yes, we would have been in
a better position but of course, you cannot be
absolutely sure that an oVer is going to come
forward.
Q743 Chairman: Sir Ian, finally, do you think
relations between the Board and the shareholders of
Northern Rock were suYciently transparent?
Sir Ian Gibson: I think they were, yes. In fact, to pick
up a series of questions asked earlier, over the years
Northern Rock’s overall approach has been to be
extremely transparent about the simplicity and
straightforwardness of its model because that has
enabled it to disclose the quality of its book and
therefore attract reasonably priced credit. That has
continued too with its shareholders.
Q744 Chairman: The reason I am asking that is that
lawyers for the UK Shareholders Association are
now examining whether there is a potential class
action suit against Northern Rock for withholding
crucial information that could have prevented
shareholders from losing millions of pounds. That is
a press comment. Do you feel that Northern Rock
should have disclosed details of the risks to its
business model sooner? Why did the Board wait a
whole month before announcing crucial
information to shareholders?
Sir Ian Gibson: On the first point, the risk
information about its model was very clearly in the
market and has been for a very long time. It is a very
clear presentation of the company that is given in
our annual report. It is a very straightforward
business. It is essentially a UK mortgage-only
business, which some would see as a weakness,
others would see as a strength. It depends on your
point of view. The data surrounding that has been
transparent to all for a considerable period, not just
this year but year on year. As for a secondary
position, I think colleagues of yours, Chairman,
explored in great detail with the chairman and the
chief executive just now the whole process that took
place from, I guess, 14 August onwards, where we
consulted legal advisers, the UK Listing Authority,
the FSA, later the Tripartite, in terms of what was
appropriate to disclose at what point, either about
other party discussions or about discussions with the
Bank of England or about the trading circumstances
of the company, and we are fully satisfied that we did
follow the best advice and follow it to the letter.
Q745 Chairman: I am mindful that the Governor of
the Bank told the Treasury Select Committee that he
was alerted to an impending crisis on 14 August. The
shareholder group is saying they wanted to know
why an announcement was delayed until the rescue
package was finalised on September 14, exactly a
month later. What answer is there to that, Sir Ian?
Sir Ian Gibson: You have heard the answer, that first
of all, we were in a series of discussions with not just
the one party that has been focused on right now but
a number of potential acquisition partners, and
through that period, with the advice of the UKLA
and the FSA, as well as our lawyers, it was not
suitable to put information into the market. We
were, by the way, continuing to fund, as has been
pointed out, varying amounts diVerent days, but we
were always continuing to fund; we were always
liquid. The profits that we are now forecasting for
‘07 are in the market and profit warnings were issued
at the appropriate times in all cases. Once we were in
discussions with the Bank of England, our guidance
from all involved, including clearance with the
UKLA, was that those discussions be not made
public because there are circumstances, and we have
certainly seen the results of those circumstances, that
mean it is not appropriate in the view of the listing
authority or the FSA that certain of those
discussions are taken to the market, and they might
be for a diVerent business.
Q746 Chairman: Finally, can I ask you to give us a
message in terms of the future of Northern Rock
over the next six, nine months to reassure people.
Sir Ian Gibson: First of all, it is a bank that remains
in business, that is solvent, that is serving its
customers, that is paying its debts, that is paying its
employees, and it continues to wish to do that and
will strive in every degree to do that. Secondly, we
know we have the period essentially between now
and the end of this year in which to work out the
most appropriate strategy for the bank, for the
company, for its shareholders, for its creditors, for
its stakeholders and for its employees—we have all
those groups to consider, and we will—and to bring
that to the Tripartite group and obtain what
consents and appropriate support are necessary for
whichever of the range of solutions that we end up
choosing, and to do that in such a fashion that
people will say post that event . . . From my
viewpoint, I hope they say “They did the best that
anybody could,” because that is what I want them to
say and I hope that committees like this are able to
say, “In the light of quite unpredictable, unforeseen
circumstances, they made a decent fist of it in the
end.”
Chairman: We have a long way to go there because
we are looking at the Tripartite agreement and to
date not many people have taken responsibility, so
that is a conundrum for us which we want to
examine over the next few months. Can I thank you
for your attendance this morning.
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Thursday 25 October 2007
Members present
Rt Hon John McFall, in the Chair
Mr Graham Brady
Mr Colin Breed
Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr George Mudie
Mr Siôn Simon
John Thurso
Mr Mark Todd
Witnesses: Rt Hon Alistair Darling MP, Chancellor of the Exchequer, Mr Nicholas Macpherson, Permanent
Secretary to the Treasury, Mr Mark Neale, Managing Director, Budget, Tax and Welfare, Mr Richard
Hughes, Team Leader, Comprehensive Spending Review, Treasury, and Mr Clive Maxwell, Director,
Financial Services, Treasury, gave evidence.
Q747 Chairman: Chancellor, good morning and
welcome to the Committee. As you know, we are
taking this session in two parts, the first on the issue
of financial stability and transparency, which we
hope to spend the first three-quarters of an hour or
so on, and then on the issue of the PBR and the CSR.
On financial stability and transparency, we will be
hearing from you again in January, at the conclusion
of our inquiry, and it would be good if you could
confirm in advance of your final report on deposit
protection and other related banking issues that this
would fit in with your timetable.
Mr Darling: Yes, it would.
Q748 Chairman: Thank you. Could you please
introduce yourself and your colleagues.
Mr Darling: I can confirm I am the Chancellor. With
me there is Clive Maxwell, who is the Director of
Financial Services and, with your permission, after
we have finished the first part of the meeting, he will
withdraw since he is solely concerned with that area.
Nick Macpherson, the Permanent Secretary, you
know, as do you know Mark Neale, who is the
Managing Director for Tax and Welfare and
Richard Hughes, who is in charge of the
Comprehensive Spending Review.
Q749 Chairman: Thank you very much and
welcome. Considering that we have had the first
bank run in the United Kingdom for about 140
years, how successfully do you think the Tripartite
Authorities have handled this situation?
Mr Darling: There are certainly lessons to be
learned. My starting point is this, that what
happened in the second part of August and early
September was very dramatic. It started in the
United States; it rapidly spread from there to the rest
of the world and aVected us here in Britain. The
fundamental problem was that, whilst there was
plenty of capital available, the banks and other
financial institutions became very reluctant to lend
to each other and there was an acute shortage of
liquidity. That aVected Northern Rock in particular
because of its particular business model. It had
aggressively expanded its market share earlier this
year and was very dependent on being able to get
hold of wholesale funding on a very regular basis
and it became clear from the middle of August
onwards that it was finding it increasingly diYcult to
do so. When that became apparent to the authorities
in the middle of August, they did a number of things.
Firstly, the FSA worked intensively with the
Northern Rock bank to try and resolve its liquidity
problems by helping it get access to more money,
helping it with the securitisation that it had planned
and which it depended upon. It also had discussions
with, I think, two institutions which showed some
interest in acquiring either part or all of it but of
course, unfortunately, these did not materialise and,
as you know, Northern Rock found it progressively
more diYcult to get funds even at a price that it was
prepared to pay and eventually it had to come to the
Bank of England for specific support. Obviously, I
am happy to go into further details there as you want
but my view of this is that fundamentally the
structure we have in this country, where you have the
Financial Services Authority which is responsible
for the prudential supervision of individual
institutions, is right. We have the Bank of England
which is responsible for the stability of the financial
system. I would take a great deal of persuading that
you should merge these two. I think that would be
very problematic and certainly I do not think anyone
would argue we should go back to where we were ten
years ago when we had seven or eight diVerent
regulators. I think there are lessons to be learned in
relation to the interface between the Bank and the
FSA. Both of those institutions, the FSA when they
came to see you a couple of weeks ago, and the Bank
of England in its Financial Stability Report which it
published this morning, recognize that there are
lessons to be learned in the way that we dealt with
this in this country as well as there being
international lessons of course as well.
Q750 Chairman: We will be having both the Bank of
England and the FSA before us again before your
report, Chancellor. The Northern Rock run started
on 14 September but the announcement to the
changes in the depositor protection scheme for
Northern Rock customers was only announced on
17 September. Why was there a delay in recognizing
that additional action was required?
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Mr Clive Maxwell
Mr Darling: If we go back to the night of the 13th,
that is, the Thursday night before the announcement
was made, you will recall that I think it started to
appear in the early evening news bulletins on the
BBC that Northern Rock had sought facilities. Our
intention was to make a statement, in common with
market practice, at seven o’clock the next morning.
The reason for that is the directors of Northern
Rock had, understandably, decided they had to issue
a profits warning and that it would have been
disingenuous not to have mentioned that they were
going to the Bank of England for facilities but the
stories started to appear in the BBC and, of course,
the queues started to appear outside some Northern
Rock branches the next day. I frankly do not think
that the issue of a guarantee or the extent of the
cover under the depositors’ scheme was an issue on
Friday. It suddenly became an issue over the
weekend, which is why I decided that we would put
a guarantee in place on the Monday. Guarantees, as
you know, are by no means unproblematic and, as
you have seen with Northern Rock over the last few
weeks, the nature and extent of the guarantee is quite
a complicated thing. I think the issue of a guarantee
or people’s concern about whether or not they could
get all of their money out did not really become an
issue until over the weekend. Frankly, on the
Friday—and indeed, it has been the case ever since—
people could always get their money out of the bank,
as they can today if they want to do it, but I think
I was very clear by the weekend that, unless I went
further than what I had been saying from Friday
through to Sunday, and said, to put the matter
beyond all doubt, “We will guarantee the retail and
also the wholesale deposits”, their problem would
have continued but the guarantee itself was not an
issue on the Friday morning when those queues
started to build up.
Q751 Mr Fallon: Chancellor, when did you
personally first hear that Northern Rock might be
in trouble?
Mr Darling: On 15 August.
Q752 Mr Fallon: So four weeks before the bank run.
In this Tripartite system that you and Mr Brown
designed, of Governor, Financial Services Authority
and Chancellor, who was in overall charge?
Mr Darling: In terms of the Tripartite Committee?
Q753 Mr Fallon: Who was in overall charge?
Mr Darling: Ultimately it is the Chancellor. As I said
in the House of Commons a couple of weeks ago, I
am pretty clear about that. There are discrete
responsibilities. As I said, the FSA on prudential
supervision and the Bank in relation to financial
stability through its market interventions, but the
whole point of having a committee is to allow all
three institutions—because the Treasury is the
backstop, if you like, in all these things—to be
intimately involved. I said that I was first told
specifically of Northern Rock on 5 August; a great
deal of work was being done by the FSA and the
Bank between the 15th and the time that ultimately
Northern Rock had to come for specific lender of
last resort facilities.
Q754 Mr Fallon: But for a month the three of you
could not agree on the safe haven option, you could
not agree on a covert rescue operation, and when the
bank run started, you then took four days to put in
place proper saver protection.
Mr Darling: No, none of that is true. Firstly, in
relation to what happened during that month, as the
Governor told you when he appeared before the
Committee, whilst we were told there were concerns
about Northern Rock at the first Tripartite
Committee on the 14th and, as I said, the Treasury
and I were formally told on the 15th, at that stage it
was by no means certain that all was up with the
bank. Northern Rock was able to get finance; it was
finding it progressively more diYcult but initially it
was able to get access to finance. That is why the
FSA, as they have said in a memorandum to you,15
were working closely with the Northern Rock bank
to see whether or not they could help the
securitisation, they could help get additional funds.
On 29 August the Chairman of the Financial
Services Authority, Callum McCarthy, wrote to me
formally drawing my attention to the fact that he
thought Northern Rock then had quite real
problems. I think it was the following Monday that
the Tripartite Committee, the Governor, the
Chairman and myself, met. We agreed two things.
One is that, because of the systemic importance of
maintaining Northern Rock, we would have to
support that bank but, in addition, it was agreed that
where it might be appropriate, generalised support
to the whole market would be made, and indeed a
couple of days later, the Bank of England did put £4
billion into the system. I just want to emphasise to
you that during that four-week period there was a
great deal going on. The problem was that by the
beginning of September it was widely known in the
market that Northern Rock was very exposed and
they were willing to pay to get the facilities but they
were simply drying up. In relation to the covert
support, the safe haven point, by which I presume
you mean another company, there was one slight
expression of interest from an institution but that
never came to anything. There was one more specific
interest, although after two or three days that went
away as well, although they did reappear after the
bank had got facilities. In relation to covert support,
we were clear from the time it became pretty certain
that Northern Rock had severe problems that, if
necessary, it would be able to get lender of last resort
facilities. The problem was—and I said this in the
House last week—that that I was always very
sceptical whether or not you could do this covertly
simply because today’s market conditions are very
diVerent.
Q755 Mr Fallon: OK, but looking at the system as a
15
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whole that you put in place to protect us against this
kind of fiasco, the plain fact is that you were told on
14 August by Northern Rock that they were going
to run out of money.
Mr Darling: No, that is not true.
Q756 Mr Fallon: Through a triangle of indecision
and dithering, four weeks later they did run out of
money.
Mr Darling: Northern Rock did not say on 14
August “We are going to run out of money.” What
happened was the FSA said on 14 August it believed
that, because of Northern Rock’s particular
business model, because of its exposure, it was the
concerned about it in general. That problem began
to crystallise at the end of August, when it was clear
that this was not just a generalised worry or a
suspicion but that actually Northern Rock was
running into quite substantial problems. As I said to
you, during that period prior to the end of August
and after that until the middle of September,
extensive eVorts were made to try and resolve the
problem with Northern Rock. Remember, Northern
Rock is and remains the property of its shareholders
and it is run by its directors. We were trying to work
with them to try and resolve this position because as
time went on we became increasingly concerned
about that. In relation to the general problem that
we faced, I said right at the start that I think there are
lessons to be learned, both in terms of the regulation,
because if you look at Northern Rock, look at the
exposure it had and realise just how dependent it was
on being able to get funds on a daily basis, if that line
of funding dried up, as it did, what was its fallback
position? The answer in Northern Rock’s case is that
they did not have a fallback position. Other
institutions like Countrywide in the United States
did have standby credit lines to banks. Northern
Rock did not appear to have that sort of safeguard.
Work was being done but I am in no doubt that we
need to learn from this, firstly, I have mentioned I
think, better international surveillance. We have
international institutions which could be used far
more eVectively, and that is something that we
started work on when we met in Washington last
weekend. In relation to the position domestically,
the FSA have said, and it is right, that they do need
to look at their procedures and how they regulate
things. The Bank of England has said today that,
having regard to what happened over that period in
August and September, it too needs to ask itself how
it would intervene, whether in a general sense or a
particular sense, because it does worry me; I think
central banks do need to be able to intervene in ways
that sometimes, in the public interest, are not overt.
Q757 Mr Fallon: The FSA and the Bank have
admitted their responsibilities, their failures. Why
will you not admit yours? You are in charge of the
system. This is the first bank run for 150 years.
You failed.
Mr Darling: As I said to you right at the start of this
session, I accept responsibility for what happens at
the Tripartite Committee. The Chancellor
ultimately is responsible for these matters. I said the
same thing in the House of Commons last week. I am
very clear about that. What I want to do though is
to make sure that we learn from what has happened
here. I think there are changes that need to be made,
particularly in the interface between the Bank and
the FSA. There are changes too that we need to
make in relation to the deposit protection scheme,
which is perhaps the third point that you mentioned
in relation to the guarantee because much better
than a guarantee in future would be a system that
would allow us immediately, in the event of a bank
failing, to isolate the depositors’ funds and pay them
out as quickly as you reasonably can. Therefore
there would be absolutely no reason whatsoever for
a depositor with Northern Rock to be concerned
about whether or not their money was safe. As you
know, we are consulting on that now.
Chairman: That is one aspect we will be actively
looking at in our inquiry.
Q758 Mr Simon: When I asked Sir Callum
McCarthy do you think the Tripartite arrangements
work, which is hardly a trick question, he said, “I
think that they do work. Each of us has discharged
responsibilities.” He did not actually add
“admirably” but that was definitely his attitude.
Everybody who has been here has told us that the
Tripartite arrangements worked and it has all gone
fine, and yet we had a run on the bank. There is a
huge reality gap which is baZing us all.
Mr Darling: Firstly, I do not think, as you rightly
say, anyone has used the word “admirably” or
anything like that. My starting point, as I said to Mr
Fallon a short while ago, is that I think having the
FSA responsible for prudential supervision and the
Bank of England responsible for the general stability
of the market is the right model, and it is a model
that most countries in the world are moving
towards. The Tripartite Committee is simply a
mechanism for bringing those three things together
but when you ask was it able to stop Northern Rock
seeking funds, no, it was not, but I think it would be
wrong in your analysis to say that if only the
Tripartite Committee was diVerent or it had
functioned diVerently, this would not have
happened. The big problem was the fact that
liquidity dried up following the failure of the subprime market in the United States. That problem
aVected America, it aVected the Far East, it aVected
Europe, there were problems in Germany, some in
France, as well as a problem with a particular bank
here. In deciding what we do next, we have to be
clear about what the problem was in the first place
and I do not think it was the structure of the
committee that was the problem.
Q759 Mr Simon: Is it the problem that the structure
of the Committee was not suYciently able to
respond to the changing needs of a fast-moving
situation, was not suYciently dynamically
responsive to a crisis, and that a new structure needs
to be thought of which is more responsive to these
kinds of extreme pressures?
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Mr Darling: You can always improve structures and
you can always make changes but before you do,
you need to work out what the problem was in the
first place. The general problem was the fact that
liquidity dried up. The next problem was that you
were dealing with an institution, Northern Rock,
which was hopelessly exposed. Let us deal with those
two problems first of all. One is a generalised
problem. I think there needs to be better
international surveillance, there needs to be better
regulation to stop banks from hiding things oVbalance-sheet, and there needs to be questions asked
on the precise role of what credit rating agencies do.
There are all sorts of things you need to do there. The
second thing in relation to Northern Rock, I am
quite clear that regulators need to start looking far
more at liquidity and not just solvency. They tend to
be more concerned about solvency. Northern Rock
is and was solvent and it is unusual. Mr McFall was
asking about banks in the past. BCCI, for example,
was insolvent; Barings became insolvent. With this
bank that was not the problem; it was the fact that
you could not get ready cash. In relation to how the
bank and the FSA and ourselves react to those
things, yes, there are lessons to be learned. I think the
FSA needs to have more visibility of what the
consequences might be on an institution like
Northern Rock on the wider system and, as the
Governor himself has said in the report published by
the Bank of England this morning, the Bank of
England needs to focus more on what happens if a
particular institution gets into trouble on the wider
stability of the system.
Q760 Mr Simon: Exactly, which the Bank has done
this morning but the FSA certainly still has not
done. I understand that the best way to solve these
problems is to deal with the root causes and the core
conditions and make sure that they do not occur
again. The question still remains, if you find yourself
in a crisis like this, are the structures and the
institutions which consist of all the key actors able to
withstand and to respond to the pressure? We still
have Hector McCarthy telling us each of us has
discharged our responsibilities and the structures
worked. Plainly, they do not work.
Mr Darling: It is Hector Sants, I think, and Callum
McCarthy.
Q761 Mr Simon: They are as bad as each other.
Mr Darling: I know you have created a hybrid but I
think they might take exception to that.
Q762 Mr Simon: I took exception to them, I can
tell you.
Mr Darling: I am very clear. This is ultimately my
responsibility to make sure that the FSA firstly, is
properly equipped to do its job and secondly, it is
very clear what the extent of its job is and where the
boundaries are. Equally, it is my responsibility
ultimately to make sure the Bank also makes
improvements. I said this to the Commons the other
day: I have asked the FSA to let me have its
proposals by the beginning of the year and the Bank
of England is doing similar work at the moment.
Thereafter I intend to publish my proposals, fitting
in with your own timetable. I would find it useful to
get your observations on these things before I
publish the Government’s proposals, which I
understand, given the timetable that I think you are
working to, would be perfectly possible but the
answer to your comment, Mr Simon, is that I think
there is always room for improvement. It would be
nonsense to suggest that you could not improve the
present situation. I think we can but I think we need
to be very clear what problem it is we are trying to
fix.
Q763 Mr Dunne: Chancellor, just in response to Mr
Simon you said that the big problem was liquidity
and that it had been identified and alerted to you
that there was a liquidity problem in the markets
early in August, at the beginning of this process. As
you have accepted that you have responsibility as
lender of last resort, the Bank of England is not
independent in this context. What were you advising
the Bank of England to do in response to the obvious
liquidity problem?
Mr Darling: The position is that the Bank of
England would provide lender of last resort facilities
but you are right that I have to authorise it, because
ultimately the Treasury might have to guarantee
that or it might have to support the Bank in doing
so. The procedure is that the Governor and the
Chairman of the FSA would recommend, as they
did, that support to me. In relation to your other
point, as I said, I think in reply to Mr Fallon, when
at the beginning of September it was pretty clear that
whatever Northern Rock was trying to do, it did not
look like it was going to work, we discussed both
general support in the market and I think it was a
couple of days after that, probably the 4th or 5th,
that the Bank of England put about £4 billion into
the market but we also agreed right at the start that,
because of the importance to the stability of the
financial system, the systemic importance, we would
have to support Northern Rock as an institution.
Q764 Mr Dunne: Can I take you back to the £4
billion? You identified earlier that this problem was
a global problem and was aVecting markets in the
United States, in Europe and in the Far East. The
central banks in those jurisdictions were providing
liquidity into the markets in August, not on 4th or
5th September. You have not addressed my question
as to what advice you and the Treasury were giving
to the Bank of England to respond to this situation,
which was global.
Mr Darling: We discussed this on a number of
occasions and the Governor’s view was very firmly
that it would be very diYcult to get suYcient money
into the hands of Northern Rock without putting . . .
Bear in mind that, as of about a week ago, they told
the committee they have had to borrow about £13 or
£14 billion from the Bank. To get that sort of money
into the hands of one institution you would have to
put many more billions of pounds into the market
generally. Given that the problem was not lack of
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capital but was instead particular problems of
liquidity for Northern Rock, the Governor’s very
firm view was that that was not the right thing to do.
Notwithstanding that, as I say, on 4 August, in an
attempt to try and free things up and to encourage
banks to start lending to each other, the Bank of
England did provide that support.
Q765 Mr Dunne: I think that was 4 September.
Mr Darling: That is right.
Q766 Mr Dunne: You said 4 August, I think.
Mr Darling: I am sorry; I meant September.
Q767 Mr Dunne: Had the Bank acted in August in a
modest way and shown a signal that it was prepared
to provide liquidity to the system, we might not have
got into this problem.
Mr Darling: I think it is impossible to say whether or
not that would be the position.
Q768 Mr Dunne: This is what the ECB did and what
the Fed did and they have not had a run on a bank.
Mr Darling: Both in America and in Europe banks
have got into diYculties.
Q769 Mr Dunne: But they have been able to handle
it in a covert way, and we have not.
Mr Darling: It certainly was not covert, either what
the ECB did or what the Fed did.
Q770 Mr Dunne: But banks applying for facilities to
the Fed and the ECB have been able to do so without
it becoming public.
Mr Darling: I think the diVerence is that in the
United States they did make money available. It did
not stop three or four institutions from . . . I think in
fact three or four institutions have actually had to
close down in the United States and have been taken
over by other banks. In Europe some of the smaller
German banks got into diYculties. So it is not just a
problem for here. There are two things I would say
to you. One is we did have these discussions. Money
was put in, as I say, at the beginning of September.
Q771 Mr Dunne: Too late.
Mr Darling: No, I am not aware of any evidence that
we have that would demonstrate that had it been
done a week or two weeks earlier, that would have
sorted out Northern Rock’s problem. The problem
is Northern Rock would have had to have got this
money itself. The other banks, especially the larger
ones, were sitting on these things. The other thing I
would say is if you look now, two months later, it is
interesting that, although the Fed and the ECB and
the Bank of England here took diVerent positions,
the overnight interbank rates are pretty close to each
other, despite the fact that they took very diVerent
approaches.
Q772 Mr Dunne: Northern Rock top management
told us that had they thought about it early enough,
they could have used the ECB facility through their
Irish subsidiary. We have seen other UK banks now
taking out multi-billion-dollar facilities with the
Fed, or so it has been reported, in order to give
themselves back-up lines. If we had a diVerent
system applying in this country similar to either in
the US or in the ECB, surely this situation could
have been avoided?
Mr Darling: There is always going to be an argument
as to whether you should have general intervention
or specific intervention. One of the things that the
Bank of England has said in today’s report is that it
clearly needs to look at that as a result of what has
happened. You are asking me what discussions took
place. The Governor, whose primary responsibility
it is—one of the two core functions of the Bank is to
maintain the financial stability of the system—was
very firmly of the view, as he told you when he
appeared here two or three weeks ago, and on other
occasions too, was firmly of the view that he was not
convinced he would be able to get suYcient money
into the hands of Northern Rock, and it was into
those hands that money needed to go.
Q773 Mr Dunne: I have a specific question on the
timing of the Northern Rock situation, if I may. You
have told us that it became public knowledge, as we
know, on the evening of 13 September. Where were
you on 14 September?
Mr Darling: I was in London.
Q774 Mr Dunne: Were you not at the ECOFIN
meeting?
Mr Darling: That was later that day.
Q775 Mr Dunne: Do you think it was advisable to go
outside the country when we were in the midst of the
first run on a bank crisis we have had for 140 years?
Mr Darling: Two things. Firstly, I was in London in
the morning. I think I left about 10 o’clock. The
reason I went with the Governor was because at that
meeting I wanted to get European agreement to start
looking at some of the diYculties we had
internationally, to look at what we might do within
Europe itself, and subsequently there has been
agreement that we need to do more. Frankly,
Portugal is not the end of the world; it is possible to
receive information and issue instructions from
there, which I did, and I was back in London later
that evening.
Q776 Mr Dunne: Over that weekend you have just
told us you changed your view about whether there
should be a bank deposit guarantee.
Mr Darling: Yes.
Q777 Mr Dunne: When did you first start receiving
advice that this might be necessary?
Mr Darling: We discussed it on a number of
occasions. The first time that I think the Tripartite
Committee, the three of us, agreed it would have to
be done was on the Sunday morning when we met.
Q778 Mr Dunne: When was the Bank giving you
advice that it was something you ought to consider?
Did you have advice prior to the Sunday?
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Mr Darling: On the Sunday it was the Bank’s very
firm view that unless we did something on the
guarantee, the problems were going to subsist and it
is one that I agreed with. My recollection is that it
was raised with me in more general terms prior to
that but I would need to check to be absolutely
precise. As I said to Mr Fallon right at the start, I do
not think the absence of the type of guarantee that I
announced on the Monday was the problem on the
Friday morning. I think the problem on the Friday
morning was that, when you think about it, people
were sitting at home, they saw on their television that
a fairly well-known bank in this country was going
to the Bank of England for facilities and therefore a
fairly large number of people went down to
Northern Rock the next day to get their money out.
It was really over the weekend that especially a lot of
comment in the newspapers and on television about
just how much money is guaranteed that the
guarantee really came into play. As I say, guarantees
themselves are diYcult. As you can see just now, I
have given a guarantee which is giving Northern
Rock the breathing space that it needs but none of
these things are problematic. I was quite clear by
Monday that it was necessary to go further than
what had been said over the weekend and issue that
guarantee.
Q779 Mr Dunne: Did you get advice from Number
10 Downing Street on Sunday?
Mr Darling: No. I have said on many occasions in
the last ten years, I am in regular contact with the
Prime Minister for all sorts of reasons but no advice
was issued on that point.
Q780 Mr Breed: Chancellor, earlier on in the
meeting you said that you first became aware at the
beginning of August of the problems with Northern
Rock, yet we were told by the FSA that they were
concerned much earlier in the year, had issued a
warning about the business model, and indeed, had
even put them under close supervision. Are you
saying that the Tripartite authorities had not been
advised by the FSA of their concerns over Northern
Rock and that the first time they issued that to the
other parties was the beginning of August?
Mr Darling: I think 14 August was the first time that
the FSA formally said when looking at this
problem—and remember, I think the week before,
when problems had arisen in France, people started
focusing on these things. On the 14th, which I think
was a Tuesday, was the first time they said, “We
think Northern Rock might have a problem.” You
are right that the FSA and I suppose more generally
the Governor of the Bank of England have raised
concern about these things. The only observation I
would make is that, whilst there has been generalised
concern expressed about this aspect of the banking
system, I do not think anybody expected a complete
freezing of liquidity which, as far as I am aware, is
completely unprecedented in modern times.
Q781 Mr Breed: But two members of the Tripartite
Authority were concerned and they did not bother to
tell the third part.
Mr Darling: I think in the normal course of events
what the FSA and what the banks say is publicly
available. I do not think they were keeping it from
anybody. It was a more generalised concern. I think
what was unforeseeable when you think about it is
this: people start to default on their mortgages in one
or two American states; within days it spreads
throughout the United States and then across the
world. I do not think that had been foreseen before.
Q782 Mr Breed: Chancellor, you have been talking
about the problems of debt and the problems that
some banks may have for quite some time. This was
obviously in the context of a background where
there were concerns for a long time, yet apparently
the Tripartite authorities did not actually have a
formal note from everybody all together until some
months after the FSA and the Bank of England had
expressed concerns about the whole situation. How
could it be said that the Tripartite authorities are
actually working in any meaningful sense between
about May and August?
Mr Darling: Firstly, you mentioned debt. I am not
sure whether you mean corporate or personal debt.
Q783 Mr Breed: Both.
Mr Darling: That actually was not the problem
which confronted us in August. The problem that
confronted us was whilst the institutions right across
the world had lots of money, they simply stopped
lending to each other. That is what was unusual in
the present situation and that particular set of
circumstances was not specifically envisaged by the
FSA or anybody else this year. What the FSA were
saying is that in relation to one or two institutions—
and I think they had had discussions with Northern
Rock, as you might expect, about these things—they
had a more generalised concern. This is one of the
things, and as I said to you, questions do have to be
asked in relation to the regulator, the FSA, and all
of us. When you get a general concern, how quickly
do you move from dealing with that general concern
to actually saying, “Look, here are half a dozen
things you ought to be doing”?
Q784 Mr Breed: In hindsight, would you have
preferred that they had actually raised it with you
before 14 August?
Mr Darling: Hindsight is a wonderful thing.
Q785 Mr Breed: I agree with that. Would it have
been preferable for them to have alerted you before
14 August?
Mr Darling: In hindsight, it would have been much
better, would it not, if the FSA when first looking at
Northern Rock had said, “Hold on, what exactly is
your fallback position?” and when Northern Rock
said, “We haven’t got one” they did something
about it?
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Q786 Mr Breed: Do you think the Tripartite
Authorities should have all been aware of the
concerns of at least two of them on one particular
institution?
Mr Darling: They were not expressing concern
about one institution at the beginning of the year.
Q787 Mr Breed: You just said that they were both
expressing concerns about Northern Rock.
Mr Darling: The Bank of England expressed a
general concern. I think it was a speech the
Governor gave at the beginning of this year. The
FSA had been talking to Northern Rock and
suggesting it did some stress-testing of its systems.
When you think about it, at the moment the FSA
regulates hundreds of institutions. Some of those
concerns they will raise, they will deal with and they
will never come back and trouble anyone again.
They have to exercise a judgement as to whether or
not there is a particular concern that is so great, that
is not going to be resolved, that then leads to a
systemic problem.
Q788 Mr Breed: So their judgement was lacking in
this particular case. Can I just turn very quickly to
the possibility of the so-called safe harbour or safe
haven, the other bid? You seemed to indicate that in
fact there was not a substantial bid ever being able
to be considered by the bank or anything else?
Mr Darling: That is right.
Q789 Mr Breed: Mr Applegarth, the Chief Executive
of Northern Rock, said to us that had a facility been
granted to the bank, “I am led to believe that we
would have had a good to consider and I suspect
that, had an oVer been made with a big retail brand,
then the run would not have taken place.”
Mr Darling: I assume you are quoting from him
when he said “I am led to believe.” It sounds as if the
thing was rather contingent but my understanding of
what happened is this. There were actually two
institutions. One showed a slight interest but it never
really progressed further than a general inquiry.
There was a second interest which was raised with
the FSA and at one point they asked what would we
do if they asked for support—and it was very
substantial support; it could have been as much as
£30 billion—to be given at commercial rates by the
Bank of England. Our initial reaction was twofold.
One is that the Bank of England does not normally
provide, in eVect, investment help for a perfectly
viable bank. The second point is that there would
also be a state aid issue, I think. The third one is, if
we were going to do this, we would almost certainly
have to say to banks at large, “If we are making this
facility available, who else might be interested in
that?” However, in the event the matter was not
pursued.
Q790 Mr Breed: In that event, do you believe the
Tripartite Authority should be only reactive or do
you believe they should in these circumstances be
more proactive?
Mr Darling: No, I think they should be and they
were proactive. I said earlier on that the FSA,
discharging its duty, was looking to see who might
be willing to acquire part or all of this business, who
might be able to help Northern Rock out. It was not
for the want of trying. It was as this situation
developed. The market is a pretty small place; people
knew Northern Rock had problems and, whilst
there was an interest earlier on, as I have just been
talking about, the fact that that particular
institution, after I think it was two or three days said
“No thanks” perhaps indicates the problem that we
were up against. The ideal solution—and I was very
clear about this—right from the time that I first
became aware of this would be, if Northern Rock
could either be acquired, merged with or find
another institution, because that would have been by
far the best option. If that had come along and we
were able to help in respect of that, then of course we
would have done so. The diYculty was that, as the
days went by, it was increasingly obvious that people
just did not want to know. That was the problem.
Q791 Mr Todd: The stories the BBC ran led to the
queues forming outside Northern Rock and,
obviously, the bank was completely unprepared for
that event and had not prepared any communication
strategy to tell its customers. Have you conducted
any leak inquiry into where that leak may have
come from?
Mr Darling: No, and I suspect, having had some
experience of leak inquiries, it would be as successful
as every other leak inquiry that has ever been held.
It is of course open to you, if you wish, to summon
people to ask them how it might have happened.
Q792 Mr Todd: It clearly was not in Northern
Rock’s interest to disclose this information.
Mr Darling: I do not have the powers to summon
anyone that I might suspect and pin them against a
wall and demand they tell me but it was clearly very
unhelpful and whoever did it, he or she has not paid
the price but others have. In relation to the more
general point, again, in retrospect, I think Northern
Rock could have perhaps managed those queues
better than they did. The fact that there are only four
branches in London and the fact that they are used
to dealing with a very small number of people each
day means you do not have to have too many people
coming into the place before you get the queues out
of the front door.
Q793 Mr Todd: Indeed, one of their problems was
the rather small number of depositors they had.
Mr Darling: I think I am right in saying they have
about 70 branches in the whole of the country and
there are only four in London.
Q794 Mr Todd: Do you think that one of the
diYculties was that Northern Rock would have had
to have disclosed anyway that they were receiving
lender of last resort backing because this would have
led to a profit warning? Is there some merit in
looking at whether, in these very specific
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circumstances, some greater confidentiality might be
applied, or do we just have to live with the
transparency and accept the consequences?
Mr Darling: I think that is a very good point and it
is one that aVects not just the central bank here but
across the world. I was very clear from the beginning
of that week that, whatever happened, it would
almost certainly leak because that is the way of
things, not necessarily from someone doing it quite
maliciously but what was happening in the days
before that is that people were phoning up banks
saying “Have you been to the Bank of England?” Of
course, the people who had not, were anxious to say
“No, no, never in a month of Sundays” and
gradually . . . It is rather like, as MPs, we are well
aware of the journalists’ round robin on a Friday
afternoon: “Have you or do you know anyone who
ever has?” and the minute you do not say anything,
they finger you because you do not deny it. This is a
problem. On top of that, in relation to Northern
Rock, their legal advisers, as I understand, had told
them they would have to issue a profits warning, not
surprisingly, and they were also, I think, given
advice that, given the fact they had gone to the Bank
of England or were about to go to the Bank of
England, they would have to disclose that. The
choice is whether you try and do that in an orderly
manner, and the only thing I was wrong about the
leak was the timing of it, but it is a problem. As I said
to Mr Fallon, if central banks are to do their job,
there will be times when they need to do things
without people being aware of it for the greater
public interest.
Q795 Mr Todd: There is one other possible
framework, which is that the lender of last resort
facility could have been put in place rather more
rapidly than it was, giving less time for a leak to
occur. Northern Rock have claimed that it took
some time to put this in place; they had a plan to
communicate to their customers about it; that was
foreclosed by the leak that took place. Another
approach, as I said, would be to concertina that
negotiating process into a much narrower period.
Mr Darling: We actually did it quite quickly. As I
said before, it is the directors who are running the
bank and they did not actually come to the Bank of
England and say, “Look, we actually now need
facilities” until the week in question, and once they
had agreed to come, there was no problem
whatsoever. It was not like filling out a form for a
personal loan or anything like that. They were able
to get the facilities when they wanted them.
Q796 Mr Todd: They say they kicked oV on 10
September and they were intending to announce a
week later, which I must admit gives a huge
opportunity for a leak.
Mr Darling: My recollection is they did want a
longer period but I think two things went against
that. Firstly, it would have been astonishing if you
could have kept that quiet for a week. Secondly,
their own legal advisers—and directors have
fiduciary duties. This bank was trading. They had to
issue a profits warning because the last profits
forecast they had made had turned out to be wildly
optimistic and they have had to suspend payment of
a dividend in the meantime. The profits warning
requirement drove that as much as anything else but
my understanding is they would have had some
diYculty issuing a profit warning without
mentioning the fact that they were also seeking
facilities from the Bank. These are things we really
do need do need to look at. We cannot have a
situation where you can only provide support at
such a cost that nobody is actually going to take it.
That flies in the face of the whole concept of lender
of last resort.
Mr Macpherson: Further evidence of the diYculty of
keeping these things secret is provided by the general
standing liquidity facility which was available
through August. You will recall that one clearing
bank had access to it. It was supposed to be secret
but it was in the newspapers the next day with a
subsequent eVect on the share price. It is really,
really diYcult.
Mr Darling: Can I just say for the sake of clarity that
the reason that bank got the facility is not because it
was in trouble but simply it was squaring its books
at the end of the day. This is the point I was making,
that people did a phone round and only one person
said “I can’t comment.”
Chairman: In fact, the Chief Executive said it was
awash with cash.
Q797 Ms Keeble: Just to wrap up this last point, do
you not think there is a fair point that, if people have
their money in a bank and it is in diYculties of the
type that Northern Rock was in, actually people are
quite entitled to know what should happen about it
and what the prospects are for it having to go to the
Bank for a facility?
Mr Darling: I thought you were going to make a
separate point about the deposit protection scheme,
which I think we are probably agreed on. I can
understand the point that you make in relation to
that but I think there are times where if something
can be done to tide over a bank that might be in
diYculty, that maintains its position and,
importantly, the position of the whole banking
system, then that is justified. I would be reluctant to
get myself into a situation that if you had to make a
public announcement every time you did anything,
you might actually make a diYcult situation that
much worse. I certainly would not want to see
queues outside every bank as a matter of routine.
The banking system is hugely important to us and I
think it is probably far better that we can do things
. . . It depends on the circumstances butI think
sometimes covert operations can be very much in the
public interest.
Q798 Ms Keeble: Can we move on to the Tripartite
Authority and the Treasury’s role on it? You did say
previously that you had only known in August
about the problems with Northern Rock but both
the FSA and the Bank had both talked in general
about being aware of the general problems, which I
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am sure you were as well. I wondered if you had done
any scenario planning in the Treasury as to what the
implications might be of the fall-out of the subprime market problems in the US.
Mr Darling: There are two things. Firstly, you are
right that there was a generalised awareness of the
problem but certainly not about specific institutions
and certainly not about Northern Rock. I think the
existence of and the consequences of people lending
in the sub-prime market really only came to people’s
notice probably in about July. In relation to stress
testing, the Treasury has carried out exercises. If you
do not mind, I will ask Nick; it was before I came to
the Treasury. It did actually carry out a stress test
earlier this year but that was in relation to a slightly
diVerent scenario. It was more of a terrorist-based
one.
Q799 Ms Keeble: Could we have a note on it,
because I have some other questions.
Mr Darling: Yes, if you want to have a note on it, I
will happily do that.16
Q800 Ms Keeble: That would be helpful. Do you
have a named oYcial who takes the lead
responsibility in relation to the Tripartite Authority,
and who is that?
Mr Darling: Yes. Here he is.
Mr Maxwell: I take part in meetings of the Tripartite
Committee and Stephen Pickford, my Managing
Director, is also involved in doing that.
Q801 Ms Keeble: You have maintained that
consistently all through the crisis?
Mr Maxwell: We have cover. We ensure we have
senior staV cover involving us and Nick as well and
other senior staV whenever necessary.
Q803 Ms Keeble: What are your relations now with
the board? Do you have a Tripartite Authority
oYcial on the board of Northern Rock?
Mr Darling: No.
Q804 Ms Keeble: Were you consulted about the
appointment of the new chairman?
Mr Darling: In relation to your first question, no, we
most certainly do not. It is very clear that the
directors are accountable to the shareholders and
neither the Government nor the Bank of England
nor the FSA are on the board. In relation to the new
Chairman, Bryan Sanderson, yes, I knew about it
but that decision was taken by the board; in
particular the senior director, Ian Gibson, was
anxious that the board should be beefed up but that
was his decision. It really is most important, as I said
in the House the other day, the Government can help
but the Government does not own this company.
This company has to sort out its aVairs.
Q805 Ms Keeble: But you have put a large amount
of public money at its . . . You have given a large
amount of support to the institution.
Mr Darling: Yes, and therefore we are working
closely with the company but we do not have
somebody on the board. This company is owned by
its shareholders and it is the directors that are
responsible for it, not the institutions or the
Government.
Q806 Ms Keeble: You also said that there was going
to be action over the credit ratings agency. I just
wondered what progress you have made on that.
Mr Darling: This is something that has to be done
internationally, as well as in Europe and here as well.
I think the questions that really need to be asked are
firstly, what precisely people believe their role to be,
because a lot of institutions give the impression that
if the credit ratings agency says something is triple A,
that is fine and they do not make any further
inquiries. I am pretty clear that credit rating agencies
are there as simply one particular avenue of advice
and that first and foremost, the responsibility for
maintaining the financial security of an institution
must lie with its directors. I am very clear about that.
The way in which credit agencies operate is
something that I think we need to look at because it
has some bearing on what regulators require of
individual institution institutions when they take
advice and the way in which they satisfy themselves
as to whether or not they are doing the right thing.
Q802 Ms Keeble: One of the comments that you
made earlier, Chancellor, was that you heard about
one thing, I think it might have been the decision to
go for the facility, in the evening and you were told
formally the next day. I did wonder about the lines
of communication. Presumably, they are acted on
immediately and you do not wait for a formal
notification of something.
Mr Darling: No, and in the normal course of events,
as a Minister, and particularly as the senior
Minister, your oYcials keep you informed as and
when they hear things. I knew from what I was
picking up generally the week before; you could see
that there were problems but no-one mentioned any
specific company to me and certainly on the Tuesday
when the Tripartite committee met, they were aware
of it, and the Treasury was aware of this. What
happened was the FSA actually rang up—I cannot
remember whether it was you or Stephen Pickford—
the next day and actually said, “Look, there is a
problem here.”
Q807 Chairman: Chancellor, on the issue of
Treasury staYng for financial stability, following up
Sally’s question, I wonder if you could send us a note
on that because that is something of interest to us?
Mr Darling: On who it is or what?
Chairman: Treasury staYng of the financial stability
department. That would be of interest.17
16
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Q808 Mr Mudie: Chancellor, when the sub-prime
issue arose in the States, the Fed and the ECB took
policy decisions on putting liquidity into the market.
The Bank of England took the opposite stance. Who
took that decision? Was it solely the Bank of
England or did they consult you and did you have a
say in that policy decision?
Mr Darling: As I was saying to Mr Dunne—
Q809 Mr Mudie: No, he asked but I hope I am not
getting the same answer. I am asking you specifically
who took the policy decision not to put liquidity in
the market in early August.
Mr Darling: The decision was taken by the
Governor but having spoken to me about it. I
thought that is what I said to Mr Dunne.
Q810 Mr Mudie: When I asked you in the House you
said “I have many discussions.”
Mr Darling: I do, yes.
Q811 Mr Mudie: Of course you do. Were you asked,
consulted, or was he advising you of the decision?
We just need to know who took this decision?
Mr Darling: He discussed it with me and I said what
his belief was. We had a number of discussions about
it but that was his firm view. I can be very clear about
it: he took the decision but he consulted me and I will
back the Governor.
Q812 Mr Mudie: No, but he took the decision, and
you will loyally back him. That is fine.
Mr Darling: He is responsible for maintaining the
financial stability of the system but he does need to
talk to me, as he needs to talk to Callum McCarthy.
I have explained what his views were.
Q813 Mr Mudie: Your loyalty is heartening. Let us
take the one you do accept responsibility for, the
chairmanship of the Tripartite Committee. You
seemed to downplay the Lloyds TSB approach. You
see, Mr Applegarth told us that they were
negotiating until 10 September but he got a final
decision from the central bank that they would not
agree Lloyds’ terms, which were that the same
facility of £30 billion that was going to Northern
Rock be transferred to them, plus they did not like
the rate of interest. Are Northern Rock telling us
the truth?
Mr Darling: Mr Applegarth, if he is saying that we
reached . . . We were not at a stage where here was a
formal oVer with hundreds of conditions and the
only one that could not be sorted out was this. This
was a general enquiry from an institution who were
looking at possibly acquiring it. They did not come
to us and say, “Look, if we do this, we require a loan
of this and these terms and conditions.”
Q814 Mr Mudie: Loyally again, we could not get the
FSA, who seemed to be the conduit to the Tripartite
Committee—
Mr Darling: I think they raised it with them.
Q815 Mr Mudie: As Mr Maxwell was saying, who
handled from the Tripartite Committee, who was
the liaison point with Northern Rock over these very
sensitive negotiations that could have given a market
solution that would have saved all this problem?
Mr Maxwell: In most cases during that period the
contact with Northern Rock was carried out by the
FSA, its supervisor, and that is where the direct line
of responsibility is.
Q816 Mr Mudie: The FSA did say they took a
position, a request, to the Tripartite Committee.
Northern Rock say this was on the 10th and those
were the terms. I notice the Governor of the Bank of
England says it was not a facility; it was a subsidy. It
was the same facility that was awarded to Northern
Rock three days later.
Mr Darling: No, it was not at all.
Q817 Mr Mudie: You tell me. Plus interest rates.
Mr Darling: Can I deal with that, Mr Mudie? Firstly,
I noticed that Callum McCarthy said to your
Committee “I think it would be incorrect to regard
the solution as being a firm cut and dried oVer. It was
still at an exploratory stage and there were a number
of other issues which had to be dealt with,” which is
in terms what I was saying to Mr Dunne. What
happened, as I understand it—and Clive Maxwell
will add to this if he thinks it is appropriate—is that
the issue was raised with the FSA when, as you
would expect, they were looking round an
institution like this, they were looking at all sorts of
possibilities, they said, “What would happen if we
asked you for”—it was not a firm prospect—“up to
£30 billion from the Bank of England at commercial
rates, in other words, not penalty rates or anything
like that?” So in eVect, the Bank of England would
be providing the same sort of help as an investment
bank might do for maybe up to two years and for
quite a significant sum of money at prevailing
commercial rates.
Q818 Mr Mudie: What was the amount they were
asking for?
Mr Darling: I think it was up to £30 billion.
Q819 Mr Mudie: What was the amount you agreed
with Northern Rock?
Mr Darling: The lender of last resort.
Q820 Mr Mudie: When they got the facility that they
still have, and they have now borrowed up to £16
billion of it, what was the total amount?
Mr Darling: I will come on to that in just a moment
but there is a world of diVerence between providing
public funds at commercial rates to a bank that was
a going concern—
Q821 Mr Mudie: No, no, Chancellor. Rates we will
come to and I understand that but it is the facility.
Mr Darling: The facility that this possible bidder was
asking for was to a commercially viable going
concern. It was entirely diVerent to Northern Rock,
which by the time it asked for lender of last resort
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was in a much more diYcult position, and the lender
of last resort facilities, as Northern Rock have said,
they have drawn about £13 or £14 billion from
that, that—
Q822 Mr Mudie: What is the total you have agreed
with them?
Mr Darling: What we have agreed—and again, Clive
Maxwell will set this out in further detail—is that
they have that facility but it is secured against
collateral. We have also guaranteed various deposits
but of course, we fully expect to be able to get that
money back.
Q823 Mr Mudie: Why will you not tell us the facility?
Is it £30 billion?
Mr Darling: I can. I can tell you what it is. The terms
of the guarantee have been set out, I have written to
both the Chairman of this Committee, so you should
all have the terms and details of it, as well as the PAC
see in the normal way, so you can see what the terms
are.18 Because the money has not been drawn out of
the bank, it has not actually cost us anything yet and
I am confident it will not be because, apart from
anything else, we are taking collateral.
Q824 Mr Mudie: So it is £30 billion?
Mr Darling: No, it is not. Not at all. I will be very
clear about this, Mr Mudie, because you do need to
be clear about this. There is a world of diVerence
between a loan of £30 billion to a commercial going
concern and lender of last resort facilities, which are
actually less than that, and what the Government is
guaranteeing is the deposits. As the deposits are in
the bank physically at the moment, and as we have
collateral against which they are secured, it is not the
same thing as giving a bank £30 billion worth of
credit. Just for the sake of accuracy, have I got
that right?
Mr Maxwell: I think that is absolutely right.
Q825 Mr Mudie: You are sacked if you say no!
Mr Darling: It is me I am thinking about!
Mr Macpherson: The critical thing in the terms is the
rate and also, to use the term of art, the haircut, i.e.
how much collateral you have to put up in exchange
for the support.
Q826 Chairman: We all know what a haircut is but
just explain it for the public.
Mr Maxwell: A haircut is the amount of discount
you set against some collateral that somebody
provides against a loan, so if you are making a loan
to somebody and you take an asset which on the face
of it is worth £100, you might apply a haircut to that
so that you consider it as being worth £90 because
you do not know how much it might be worth in the
future. That is how a haircut works.
Chairman: A neat job!
18
Ev 243
Q827 Mr Love: In answer to a question earlier, you
said that you as the Chancellor were ultimately
responsible, and the Committee accepts that. Our
diYculty has been in finding out before you entered
the foray who was responsible amongst the
Tripartite Authorities. Was anyone responsible and,
more importantly, should someone be responsible in
the future?
Mr Darling: The answer to the question is I am
always responsible. Even if one of my oYcials attend
the Committee, I am responsible for the actions of
my oYcials. I am very clear about that. It is what
ministerial responsibility means.
Q828 Mr Love: You do not think prior to your
involvement someone should have been taking
responsibility in the Tripartite, or do you assume
that the Treasury takes responsibility?
Mr Darling: Maybe we are at crossed purposes here.
Whatever Treasury oYcials do on my behalf, I am
responsible for that. I carry the can. In relation to the
Tripartite Committee, obviously, as a matter of
routine, oYcials—deputies, as they are called—
attend it because, if you look at the ten years it has
been set up, there will be many meetings that are
fairly routine and you would not expect the
Chancellor to necessarily attend those but in relation
to when it became clear that there were problems,
sometimes the deputies attended, sometimes I
attended myself but, whatever happened, I would
have been told about it immediately so I knew
about it.
Q829 Mr Love: I am obviously not getting anywhere
with this. Can I take it from a diVerent angle? There
are many that say, because the Bank has
responsibility for providing liquidity into the market
and also has overall responsibility for stability of the
system, that it is pre-eminent in the Tripartite
arrangements. Would you agree with that?
Mr Darling: Its core responsibility to maintain the
stability of the financial system is set out in its
objectives and that is a position, a job, that the Bank
does day in, day out through its money market
interventions. I think I said in relation to Mr
Mudie’s point that is its responsibility, yes.
However, the whole point of a Tripartite committee
is because it recognizes that the FSA and ourselves,
the Treasury that is, have an interest in it and that is
why there is that committee. Ultimately, as I say,
whatever the Bank does, we stand behind it.
Q830 Mr Love: The Bank today published its
financial stability report and it has been widely
interpreted in the media as suggesting a
strengthening of its pre-eminence in the Tripartite
arrangements.
Would
you
support
that
strengthening?
Mr Darling: There are two things. One is, the way I
would interpret it, and rather more than that, the
way I understand it, is that the Bank is very clear that
it too has lessons to be learned, both in terms of how
it intervenes and also the extent of its interventions.
As I said right at the start of this, I think in answer
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to the Chairman’s point, I think there are questions
that we have to ask ourselves in relation to the
precise responsibilities, particularly at the interface
of where the FSA and the Bank operate. I am pretty
clear that firstly, I will not take anything away from
the fact that the Chancellor of the day is responsible
for whatever happens but I think what we do need to
do is to make sure that both the FSA and the Bank
have very clear responsibilities and that, if there is
any dubiety or any uncertainty as to who is doing
what, that we sort that out.
Q831 Mr Love: You have talked on a couple of
occasions, and in answer to this question you
mentioned the interface. One of the things that the
Bank has admitted to is perhaps poor
communications between the Tripartite parties. Do
you think that is solely responsible for the problems
that arose or is it more than just communication that
needs to be looked at?
Mr Darling: Communication can always be
improved. As I said in reply to an earlier question, I
am not sure it was the Committee itself or the
structure of the Committee that was the problem.
We have to ask ourselves at each and every stage
what are the problems that we need to try and fix?
The problem I identify in relation to the Tripartite
arrangements is that I think there does need to be
some clarification as between what the Bank does
and what the FSA does and the fact that there is
inevitably an overlap between the two. The Bank of
England is not responsible for the prudential
supervision of individual banks. However, when a
problem arises in any individual bank, it could have
wider systemic implications. That is one of the things
that we need to look at and obviously, the converse
of that applies so far as the FSA is concerned. It is
in that area, especially in relation to early warnings,
because obviously what we are trying to do here is to
stop this problem arising in the first place rather than
intervening, that we need to look at closely. I shall
not repeat it at length but the other problems too are
the international problems and also the fact that
every single director of every single financial
institution should really be asking themselves “What
is critical to my business and if it goes wrong what
do I do about it?” If the answer is “I don’t know,”
they should start thinking again very rapidly.
Q832 Mr Love: Finally, when Northern Rock came
before us they said the leak had made a big diVerence
to the way this had all panned out but they also
admitted that, even if there had not been a leak, they
think they would have been diYculties in explaining
this to the public. Can there be a role for just one
authority speaking to the public at any time in
relation to an issue like this? In other words, when
you trigger the Tripartite arrangements, only one
group should be speaking to them rather than all the
diVerent authorities?
Mr Darling: I think most people who deposit money
or do business with an institution want to hear from
that institution as to what it is doing. Remember, a
lot of the things that were happening lay within their
control, and I certainly think the communications
there could have been improved. Frankly, pushing a
leaflet through a letterbox to people standing outside
leaves an awful lot to be desired, and I certainly hope
this does not happen again anywhere but it needs to
be dealt with. I think also practical things like how
you deal with people who come along asking for
their money, other places in other parts of the world
actually dealt with it a lot better than it was dealt
with here. So communications are important. If
your question is should that be done by the Bank of
England, the FSA or the government, I will look at
all these things and, if you have recommendations to
make, I will certainly look at them but I think the
first port of call, because so much is controlled by the
actual bank—remember, this bank was solvent; it
was a going concern. It still is. It is the one that
primarily is responsible for communicating with
what, after all, are its customers. They are not the
Bank of England’s customers.
Q833 Mr Brady: It was clear that the Governor of
the Bank’s preference would have been to deal with
this through a covert intervention, and he was very
explicit when he came in front of the Committee that
he felt his freedom to do that was hamstrung by four
pieces of legislation. You on the other hand said that
you are sceptical that you could have done this
covertly, I think you said because of today’s market
conditions being very diVerent, so nothing to do
with the legislation. Can I take it you disagree with
the Governor’s assessment that it is legislation that
hamstrung him and prevented that action from
taking place?
Mr Darling: I will say again to you what I said, I
think, on the floor of the House, that I will look at
the four pieces of legislation he was concerned
about. One is the Market Abuse Directive, which is
the disclosure of inside information. The other was
the Takeover Code, which might, on one view,
preclude something happening over the weekend.
Then there is the insolvency legislation, which, I
readily agree with him, is something that we need to
look at, especially in relation to deposit protection.
The fourth thing is the compensation scheme, which
again, not only do I agree with him but we are
already trying to resolve that. What I did say, and I
said this on the floor of the House on 11 October,
was that the issue before us prior to 13/14 September
was not whether or not the Market Abuse Directive
said that we could not do something. The issue was
twofold. One is the directors were being advised that
they had to make a profit warning and also my
belief—and maybe because I am a politician I think
of these things first—that someone is going to leak
this and, as I say, sadly, I was right. I will look into
all these things and if there is a problem with the
Market Abuse Directive and it could be that there is
a problem, that is clearly something we need to
resolve but what I would say to you is, if there had
been a realistic chance of rescuing this bank over a
weekend, I would have done it and happily seen
whoever was challenging us in court but that did
not arise.
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Q834 Mr Brady: I recognise this is something you
are still looking at but if there is a problem with the
Market Abuse Directive, do you think that is more
likely to have arisen in terms of obligations placed
on the company in terms of disclosure, or on the
Bank in terms of what it was able to do?
Mr Darling: I think that Directive bites on both. It
is basically designed to stop people from doing
things and hiding the full extent of what they are
doing to people that have a legitimate interest, like
their shareholders but, like all these Directives, they
do not just bite on the company concerned; I think
they bite on other institutions and almost certainly
public institutions as well. If it is a problem, we
clearly need to deal with it. It is one of the things I
will cover when I publish my proposals at the
beginning of the year.
Q835 Mr Brady: Finally, there is, I think, an
exemption in the Market Abuse Directive that seeks
to give greater freedom of movement to central
banks. Do you believe that is adequate?
Mr Darling: That is one of the things I have to look
at but, as I said to you and I have said before, I do
not think that was the fundamental problem that
was facing us in the second week of September.
Q836 John Thurso: Chancellor, the support given to
Northern Rock gives the impression that no bank
with retail depositors can be allowed to fail. Is that
actually the case?
Mr Darling: The position is as I set out in my
statement of 11 October, which is that judgement
has to be exercised as to whether or not the failure of
an institution, no matter what sort of financial
institution it is, would result in systemic damage to
the financial system. It does not mean that we would
intervene in every case. For example, the Bank did
not intervene in relation to Barings in 1994.
Q837 John Thurso: I do not think Barings had retail
depositors.
Mr Darling: No, it did not but a view had to be
taken—obviously, I was not there at the time—as to
whether or not the failure of that bank would have
an adverse eVect on the financial stability of the
system.
Q838 John Thurso: So the fact that the Northern
Rock depositors are being protected on this
occasion is because not protecting them would have
rocked the system?
Mr Darling: It is the system that we were concerned
about. Mr Macpherson has just reminded me of
course that BCCI did have retail depositors but the
judgement was taken there that it would not cause
the systemic problems that I believe would be caused
this time.
Q839 John Thurso: So, to be absolutely clear, the
fact that it has happened on this occasion is not a
precedent that any other institution should feel able
to rely on?
Mr Darling: Each case will be assessed on its merits.
Q840 John Thurso: Earlier on in your comments to
one of my colleagues you described Northern Rock
as being hopelessly exposed and their business
model as being extreme, which I think everybody
here would actually agree with today. A year ago
Northern Rock was seen by the City as being a
highly successful business with an excellent profit
record and well worth investing in. What is the
lesson for the City to take out of this? Do we actually
have a problem with our understanding of risk
generally?
Mr Darling: I think in general terms I agree with a
lot of what the Governor said in his speech in Belfast
a few days ago, and that is that he believes that all
institutions ought to carefully evaluate the risk to
which they are exposed. I have said before that
regulators should concern themselves not just with
institutions that do not appear to be doing terribly
well but also with institutions that do appear to be
doing terribly well because, if they are out of line, it
may be they are doing a very good job but they ought
to just be sure that that is the case. What is going on
in the world at the moment is that people are repricing the risk and that is what is causing the
diYculty. As the Bank says in its report today, and it
is very evident from discussions I had with my fellow
finance ministers in Washington at the weekend, this
process is still going on all over the world and people
do need to be far clearer about what risks they are
exposed to and what they have done to lay oV that
risk by reducing it.
Q841 John Thurso: Just following up on that last
question, if I may, on lessons learned, I felt when the
board of Northern Rock came before us that the
evidence given by the Chairman of their Risk and
Audit Committee indicated that really, the bank
itself had not looked at this risk and had not really
properly worked out what they would do, which is,
I think, very much what you are suggesting should
happen. How do we get this through to companies,
that risk and audit committees need to do more than
tick boxes; they actually have to undertake the spirit
of what that corporate governance is meant to be
about rather than just the letter?
Mr Darling: I think in relation to financial
institutions that must be the job for the FSA because
it has to be a requirement on directors that they
understand the risks to which they are exposed, and
in this particular case there is nothing inherently
wrong with having a risk as long as you have that
risk covered oV in some way or you can mitigate that
risk. Nothing is risk-free. For example, other
institutions that used this model and used to borrow
on the wholesale market either also had banks with
an investment arm so they had some other cover or
they had standby credit facilities. Countrywide is a
case in point. Northern Rock did not have that, and
earlier this year they quite aggressively pursued the
mortgage market, it was very dependent on getting
a securitisation away at the beginning of September,
which in the event they could not because, just at the
time they needed to raise the money, the funds
dried up.
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Q842 Jim Cousins: Chancellor, the guarantee going
to depositors was rapidly eVective in calming the
situation. Is there a time limit on that guarantee?
Mr Darling: We have asked the Northern Rock
bank to come back to us with its proposals by the
beginning of February and obviously, I am willing to
review the situation at that time. We do have a state
aid issue in that, as you know, there comes a point
where the Commission will say this is going on for
too long. I am not sure that is an immediate problem
but I really want to get across to the bank that they
have a breathing space, if you like; they need to
consider their options; they have a new chairman
now and they need to consider what the best course
of action is for the bank. That is their decision, they
are the directors, they own the company but we have
given them that breathing space and we have said to
them “Look, you need to come back by the
beginning of February.”
Q843 Mr Cousins: Of course the very phrase
“breathing space” which I do understand does imply
a time limit, but you have given the Committee this
morning, I think, a very clear assurance that if the
time has to run further than the beginning of
February that would not necessarily be an obstacle.
Mr Darling: No, we are not saying it is a drop dead
date. To take it to the extreme, if they said, “Look,
we will come back to you in 10 years’ time” I think
there might be a problem.
Q844 Mr Cousins: Sure.
Mr Darling: I am reasonably confident they will
come back to us rather sooner than that. We have to
get state aid clearance for this sort of support and the
state aid rules are quite clear, you can do this sort of
thing to provide support in times of diYculty like
Northern Rock but you cannot do it in perpetuity. I
said, when I did the statement in the House a couple
of weeks ago, I want to be as helpful as possible but
I am afraid the bank needs to play its part too now.
I am encouraged by the fact that perhaps with a new
Chairman he will put a degree of not just expertise
but a degree of vigour into trying to sort things out
for them.
Q845 Mr Cousins: Have the European Commission
advised you of any timescale in which they think the
state aid restrictions would kick in?
Mr Maxwell: No they have not is the short answer,
but there are diVerent ways in which you can apply
for state aid approval and some of those approvals
have certain time limits on them.
Q846 Mr Cousins: And they are?
Mr Maxwell: Restructuring Rescue aid, for
example, usually has initial limits around six
months.
Mr Darling: Usually—
Mr Maxwell: Usually it is very much as has been
discussed.
Q847 Mr Cousins: There has been no specific
instruction or advice from the European
Commission that there is a clock ticking and an
end date?
Mr Darling: No.
Q848 Mr Cousins: Have the Tripartite Authorities
considered what they would do in the event of the
bankruptcy of Northern Rock?
Mr Darling: No because at the moment that is not
an issue. My concern would always be, in the event
of the bank being unable to find some way out, that
we protect the depositors. The opportunity is now
there to make sure that suitable arrangements can be
made. I very much hope the directors will use this
opportunity to try and find a way to enable the bank
to carry on in one shape or form but that has to be
a matter for them at the end of the day.
Q849 Mr Cousins: Chancellor, just to sum up. There
is no drop dead date—to use your own phrase.
Mr Darling: Correct.
Q850 Mr Cousins: The Tripartite Committee has not
considered what action it would take in the event of
Northern Rock’s bankruptcy?
Mr Darling: Because that issue has not arisen. The
FSA have always said, and continue to say, that the
bank is solvent. What you said in relation to the drop
dead rate is absolutely correct, however, since I dare
say the bank will follow these proceedings with great
interest, that does not mean that I do not regard it as
being a matter of urgency and I think a matter of
weeks and months is what we are talking about.
They need to come forward with a proposal because
self-evidently they need to find a long-term solution
for the problems they have got.
Mr Cousins: People in the North East, Chancellor,
will be grateful to you for what you have said this
morning.
Q851 Chairman: Finally on the Northern Rock
issue, when the Governor was here before us he told
us that he had sent you a letter on 13 September
which gave advice on further borrowing of Northern
Rock and he would be happy for that to be made
public. I have written to you on that, could you give
us your comments on that, please?
Mr Darling: Yes. I have got your letter and I have
considered it carefully. I have looked again at what
the Governor said to me and what the Chairman of
the FSA said. For the record, they wrote
recommending that I authorise the provision of
lender of last resort facilities. I do not believe that it
would be in the public interest to release these letters
at the moment. In particular the Chairman of the
FSA is quite clear that he wrote to me on a
confidential basis and has made it very clear that he
would have concerns for the future if he thought
letters that he sent to me with his best advice were to
be made public, at least in the immediate vicinity of
problems arising and also having regard to the fact
that the Northern Rock position is not yet clarified.
I do not believe that I can release these letters. I am
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25 October 2007 Rt Hon Alistair Darling MP, Mr Nicholas Macpherson, Mr Mark Neale, Mr Richard Hughes and
Mr Clive Maxwell
not saying that I cannot do so at some point in the
future but my judgment—and it has to be my
judgment on this—is that I do not think it would be
in the public interest to release these letters at the
moment.
Q852 Chairman: So it is relating to the immediate
environment, maybe at a later date you will.
Mr Darling: I am happy to revisit the position but I
will have regard to two things. One is the situation at
the time a request is made but I also want to make
sure that in future, whether it is me or any other
chancellors in the future, that both the Governor
and the Chairman of the FSA can write to me in
terms which are more than a formality, that can
actually be proper advice. Therefore, as in all these
things, of course they need to be looked at on their
merits, but that is the position, regrettably, that I
find myself in at the moment.
Chairman: Chancellor, can I thank you for the first
half of this session so we can release Mr Maxwell but
it is not goodbye, we will see you some time later.
Thank you very much.
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Tuesday 13 November 2007
Members present
John McFall, in the Chair
Nick Ainger
Mr Graham Brady
Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr Siôn Simon
Mr Mark Todd
Peter Viggers
Witnesses: Professor Willem Buiter, LSE; and Professor GeoVrey Wood, CASS Business School, City
University, gave evidence.
Q853 Chairman: Good morning and welcome to our
Committee inquiry into financial stability. Professor
Richard Portes, who was to appear with you this
morning, has indicated that he is ill so he has given
his apologies. Can I ask you to identify yourselves
for the shorthand writer please.
Professor Buiter: Willem Buiter.
Professor Wood: GeoVrey Wood.
Q854 Chairman: Thank you very much for agreeing
to come and give us your insight into the situation
which was triggered by the Northern Rock Bank and
the drying up of liquidity. We have witnessed the
first bank run in 140 years as a result of that. With
which, if any, decisions of the Tripartite Authorities
do you disagree most strongly?
Professor Buiter: Well, there are quite a few. The
very structure of the tripartite agreement was flawed
so I disagreed with the tripartite agreement before
they even started doing anything. The notion that
the institution that has the knowledge of the
individual banks that may or may not be in trouble
would be a diVerent institution from the one that has
the money, the resources, to act upon the
observation that a particular bank needs lender of
last resort support is risky. It is possible, if you are
lucky, to manage it, but it is an invitation to disaster,
to delay, and to wrong decisions. The key
implication of that is that the same institution—it
could be the FSA or it could be the Bank of
England—should have both the individual, specific
information and the money to do something about
it. Given that, the decision to provide the support to
Northern Rock—which was a joint decision and had
to be authorised of course by the Treasury—was not
backed up at that point by a joint statement by all
the parties involved to tell the public that their
money was safe. As I put in my note,19 they should
have had the Chancellor and the previous
Chancellor and the Governor and the Head of the
FSA and its Chief Executive all standing up saying,
“Your money is safe”. If they were not quite
convinced that the public would believe them—and
in these days you cannot be sure of that—then the
immediate creation of a deposit insurance scheme
that actually works and is credible would have been
desirable. To wait three days was again an
unnecessary delay. The FSA throughout all this
19
Ev 310
seems to have been asleep on the job, not having
noticed that the funding policy of Northern Rock
was high risk and also not expressing stronger
concerns about the breakneck rate of expansion,
especially in the last half year. I like healthy growth
but it is hard to believe that the quality of the asset
portfolio and the ability to vet the credit-worthiness
of your borrowers does not suVer when you take
20% of the net increase and 40% to 50% of the gross
increase in activity in this half year period, so I think
they were an organisation that was clearly engaged
in high-risk behaviour, and the fact that the FSA did
not call them back or felt they did not have the
authority or the information (I do not know) is
worrying. Then of course I think the Bank of
England made policy errors, even given the existing
framework, in its management of liquidity. Its
demands for collateral were too strict—stricter than
any other central bank that matters, much stricter
than those of the ECB and stricter than those of the
Fed—and its demands for collateral at its discount
window, the so-called standing lending facility, were
also way too strict. Basically they would discount
only stuV that is already liquid: UK government
securities; European Economic Area government
securities; a few international organisations’ debt
like the World Bank; and then, under special
circumstances, US Treasury bonds. All that stuV is
liquid already so all the Bank oVered at its discount
window was maturity transformation, not liquidity
transformation, and that was absolutely no good.
When they created the Liquidity Support Facility
for Northern Rock they created what the Bank’s
discount window should have been all along—
something that lends against illiquid collateral and
also lends for longer periods, because the Bank
discount window is only for overnight lending. The
Bank has since retreated from its policy on collateral
and they have also declared themselves willing to
intervene more aggressively at longer maturities. At
least, they oVered to do so; when they did nobody
came, partly because their promised interventions at
three-month maturities were at a penalty rate rather
than at market rates. They are not quite there yet but
I think they have learnt and they are moving in the
right direction. There was a whole slew of errors
from the Treasury, the current and previous
incumbent, from the Bank of England and from the
FSA, and nobody comes out of it smelling of roses.
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Q855 Chairman: That was comprehensive.
Professor Wood?
Professor Wood: I think I can be fairly brief,
Chairman. First of all, let me start by saying where
I agree completely with Willem. I agree that the
structure was fundamentally flawed. It is simply a
mistake to have responsibility lie away from
someone who can do something about it. I do not
think it would be possible to put the responsibility
onto the FSA because the FSA is not a bank and it
cannot provide liquidity. The FSA, as Willem put it,
was asleep on the job; that is manifestly right. A very
clear signal of a bank running a big risk is rapid
expansion. Northern Rock was giving that signal
quite clearly; it really is remarkable that they missed
it. With regard to the support operation and the
provision of liquidity, again as Willem said, there
should have been announcements that your money
was safe. We might come back to that later in the
context of deposit insurance. Walter Bagehot
criticised the Bank of England’s behaviour in 1866
for its lending, as he put it, “hesitatingly, reluctantly
and with misgiving”. This prolonged the crisis and I
think the same thing happened this time there was a
certain manifest hesitation and that made people
nervous. A couple of issues where I do disagree with
Willem just a little bit. I think the Bank is right to
take collateral. I think it should charge higher rates
on less good collateral, first of all to ensure that
banks do not run risks confident that the Bank of
England will bail them out and, secondly, of course,
to protect the taxpayer if some of this less good
collateral does not eventually pay up. That the Bank
was engaging in maturity transformation and not
liquidity transformation is fine. I think it was the
right thing to do at that time. By and large, the
problems were in the structure, the division of
responsibility and the lending hesitantly, reluctantly
and with misgiving.
Q856 Chairman: Both the Bank of England and the
Financial Services Authority have claimed that they
warned financial institutions about the risk of
markets becoming illiquid. I think the FSA sent their
paper out in January and the Bank of England sent
their paper out in April 2007. I note from an
interview that the Governor of the Bank of England
had with the BBC last week that he said more could
be done in this area to ensure that financial
institutions listened to the Bank and the FSA
regarding their warnings and take action. What is
your advice in that area?
Professor Wood: The best way to make them listen
is to penalise them if they do not. It seems to me
therefore that the Bank of England’s behaviour in
being very reluctant to take securities that they
would not normally take, except when the crisis got
really bad, from Northern Rock and refusing to
accept them from other institutions for some
considerable time was exactly the right thing to do.
The casual lending on almost anything that the
Federal Reserve and the ECB did almost
immediately seems to me to have been an error of
judgment and is likely to bring problems in the
future.
Professor Buiter: The private banks have a lot to
learn as well. They were foaming at the mouth right
up to the moment that the crisis hit. The now
departed Chair of CitiGroup, the American bank,
said in July that they were still dancing in the assetbacked securities market, so they believed the party
would never end and they acted recklessly on both
sides of their balance sheets, unlike Northern Rock
which seems to have acted recklessly only on one
side of the balance sheet. The banks did act
recklessly. How do you make them listen? What
GeoVrey proposes might help but I doubt it.
Financial markets and financial institutions go
through these bouts of euphoria where they really
believe that they know better than the authorities
and that this time it is diVerent and we have new
institutions and instruments that will make the risk
go away. That fallacy takes hold every so often and
there is very little you can do about it.
Q857 Chairman: So therefore we have just got to
dance to the tune of the banks and when they get into
trouble we forget about moral hazard and we bail
them out because the whole financial system is at risk
and therefore we are in hock to them?
Professor Buiter: Not at all.
Q858 Chairman: So what do we do?
Professor Buiter: First of all when they do get into
trouble, when I said that the Bank of England
should have accepted a wider range of collateral, I
did not mean to suggest—in fact I explicitly do not—
that they accept illiquid collateral at face value. They
should be priced at a heavy discount and even when
you think you have arrived at a fair price you apply
further haircuts, further discounts to it, so it
becomes penalty collateral provision, overcollaterising significantly if necessary. That can be
enough of a penalty. Secondly, I think that once
deposit insurance was in place there was no reason
to allow the institution in question, Northern Rock,
to be supported. The contagion eVect was contained
by creating universal coverage of not just retail
deposits but also wholesale deposits and in fact all
unsecured credit except subordinated debt, so all the
deposits were safe, and at that point the support for
Northern Rock could have been withdrawn. The
option there would have been to either let it go into
insolvency or to take it into public ownership. That
would have been a very good discouragement of
future bad behaviour.
Q859 Peter Viggers: There was a clear warning
about liquidity not least in April from the Bank of
England, and when we asked Northern Rock what
notice they took of that they told us that they
fulfilled all the stress tests which were agreed with the
FSA. Nevertheless, the situation went badly wrong.
Where would you allocate responsibility for this, on
the directors of Northern Rock?
Professor Wood: Ultimately Northern Rock’s
failure has to lie with them, but the FSA was
charged, perhaps not terribly sensibly, with ensuring
that the directors did things correctly. As I
understand it, most stress tests in most banking
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Professor Willem Buiter and Professor Geoffrey Wood
systems focuses on capital adequacy. Bankers
generally have thought too little (central bankers
included) about liquidity for some time, and I think
attention should shift back to that. There is the basic
problem. Again we come back to the issue that
Northern Rock was expanding so fast that it was
manifestly a danger signal. Even if you satisfy all the
tests in good times you should think what is going to
happen if times become not quite so good.
Q860 Peter Viggers: Bearing in mind the Bank’s
warning about liquidity, was it surprising that the
stress tests were not constructed to include liquidity?
Professor Wood: That is terribly diYcult because the
availability of liquidity changes from circumstance
to circumstance. The stress tests have to deal with a
wide range of conditions and conjecture and that
will be diYcult to do. I think one should simply
adopt a more conservative banking model rather
than seek technical solutions that do not always
work well. There are statistical problems—I am sure
Willem will confirm—in these markets because the
distribution of outcomes is not in a form that is
readily handled by statisticians.
Professor Buiter: One could have expected that they
would have looked at the consequences of some of
the markets in which Northern Rock was funding
itself simply closing. What happened of course in the
case of Northern Rock is that all of the markets in
which it funded itself closed, something which had
never happened before, so you would have had to
have an ultra stress test to capture that. However,
they seem to have done not even the kind of liquidity
stress-testing that I would have expected them to do,
partly because the FSA is an institution that thinks
more about capital adequacy and solvency issues
than about liquidity issues. That is the natural
province of the Bank.
Q861 Peter Viggers: Does it surprise you that the
board of Northern Rock, with the exception of the
Chairman, are still in control of the company’s
destiny, bearing in mind that some £30 billion of
public money is now invested through what is a
discredited board?
Professor Wood: It is not clear to me the extent to
which they are actually in control. The company has
to have directors but can they actually take decisions
without the Treasury or the Bank of England’s
agreement? I really do not know. The company has
to have directors.
Q862 Peter Viggers: Are you close enough to the
situation to know the extent to which the Bank of
England and the FSA are now eVectively controlling
decisions?
Professor Wood: No. You must ask them that.
Q863 Peter Viggers: Very well. To what extent do
you think the crisis of Northern Rock can be
characterised as a failure of the FSA to regulate
properly?
Professor Wood: Again we come back to the fact
that it is basically a failure of the regulatory system
as it was designed; it is a deficient system. Beyond
that the FSA does not seem to have carried out its
job with the skill and diligence that one might have
expected, but then again the Northern Rock board
was not doing a wonderful job either.
Q864 Peter Viggers: Are there immediately any
further powers that any of the Tripartite Authorities
need or do you think the system itself needs to be
reviewed?
Professor Buiter: They need the power to put banks
into administration eVectively without the deposits
being frozen, as is the current situation, which is of
course a terrible situation. They have to be able to
ring-fence the deposits of banks that go into
administration. If anything they have to have FDICtype powers of taking deeply troubled banks, where
you do not know necessarily where there are
liquidity and insolvency issues, into public
ownership at no notice and to manage them as a
going concern, with existing obligations, existing
exposures and no new business until things settle
down, and in the longer term a future for the
institution can be found. The kind of open-ended
breastfeeding of a private institution that goes on at
the moment is the worst of all possible worlds.
Professor Wood: That is exactly right. The
Comptroller of the Currency in the US coined the
term “too big to fail” of Continental Illinois Bank
when it failed. If you have proper bankruptcy laws
such as Willem has outlined then no bank becomes
too big to fail and they can bear the consequences of
their actions.
Q865 Peter Viggers: We have had a forceful
memorandum from the British Bankers’
Association pointing out that liquidity regulation is
the only remaining area of banking supervision that
is host rather than home state regulated. The British
Bankers’ Association has urged us to await decisions
by the Basle Committee of Banking Supervision
because banking liquidity and banking supervision
is essentially an international matter. Do you think
we should await international developments or do
you think there are steps we can take domestically?
Professor Wood: I have to say I have not read the
British Bankers’ Association memorandum but it
seems to me from how you summarise it to embody
a certain lack of clarity of thought. The home
country and only the home country can supply
liquidity. If a British bank is short of sterling the
Bundesbank cannot supply sterling; it has to be
home country provision of liquidity. The only case
when that is not the situation is in the euro zone
where of course you have several countries using the
same currency.
Professor Buiter: I must say I do not understand the
statement that you have just quoted at all. The bank
could be foreign owned but if it is registered in
Britain then it is a British bank and it will have to be
supported by the Bank of England. That is how it
works. It is not true for branches but it is true for
UK-registered banks and that is the only way to do
it so, no, we do not have to wait at all for liquidity.
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Professor Willem Buiter and Professor Geoffrey Wood
Liquidity is provided at the level of the currency
area, be it the dollar area, the sterling area or the
euro area, so it sounds like this is confused babble.
Q866 Mr Fallon: Just to be very clear then, you think
that responsibility for both general and individual
liquidity should transfer back to the Bank; is that
right?
Professor Buiter: That is one solution. The other
solution would be to transfer provision for
institution-specific liquidity provision lender of last
resort to the FSA by giving it an uncapped and openended credit line with the Bank of England
guaranteed by the Treasury so it can just do the
lender of last resort bit. The market support will
always have to be done by the Bank of England, and
you may therefore wish to put the individual
institution support there as well. I think there are
tensions there with central bank independence
because especially individual institution-specific
support operations are always deeply and inherently
political (with a very small “p”) because property
rights are at stake and it is diYcult to have that done
by the same institution that is meant to be nonpolitical. If you were to give banking supervision
and regulation, including the lender of last resort
knowledge therefore, back to the Bank of England,
then you might want to take the MPC out of the
Bank of England.
Q867 Mr Fallon: Because we have learnt over the last
few months, have we not, that the Bank is not quite
as independent as we originally thought. Even the
decision not to put liquidity into the market in
August was referred to the Chancellor.
Professor Buiter: Independence, as I interpret it,
applies only to interest rate decisions and that is why
I think it might be a good idea to take the MPC
(which all it does is set the Bank rate) out of the Bank
of England which can then do everything else,
including liquidity provision, at any maturity longer
than overnight, foreign exchange market
intervention, whatever.
Professor Wood: I do not think it is necessarily
correct that we should want to give liquidity support
to an individual institution if the rest of the market
is in good order. That suggests that individual
institution is fundamentally deficient and should be
closed. The lender of last resort operation should go
to the market as a whole when the market is short of
liquidity. If an individual institution needs it, and the
rest of the market is fine, there is something wrong
with that institution. On the question of the
Treasury being involved in this decision, there is a
long history of course of the Treasury being involved
in these decisions simply because the Bank of
England, even in the 19th Century, was a very small
bank and did not have much capital to lose. In the
19th century it got other banks to help out. In the 20th
century it has to go to its owner, the Treasury, to
ensure that the owner would provide more risk
capital if necessary.
Q868 Mr Fallon: It follows from that that after
saying the deposits should have been guaranteed you
think that Northern Rock should simply have been
allowed to fail?
Professor Buiter: Yes.
Professor Wood: The word “fail” is a dangerous
term.
Professor Buiter: Sink or swim.
Professor Wood: Sink or swim, put into liquidation,
in that sense fail, but not simply collapse; that would
be foolish.
Q869 Mr Fallon: What about the rescue operation
itself; was the Treasury right to refuse the tentative
oVer from Lloyds TSB to carry out a takeover?
Professor Buiter: I do not know the details of the
oVer but if it is true that they wanted up to 30 billion
UK, as they would say in America, £30 billion, in
continued financial support to finance a takeover,
then I think the Treasury and the Bank—this was a
joint decision—were absolutely right to refuse it.
This would be the socialisation of banking, and that
might be a good idea but I do not think that is what
this was about.
Q870 Mr Fallon: So it would never be right for
government to lend on commercial terms in order to
protect financial stability?
Professor Buiter: They were not protecting financial
stability. They would be protecting the shareholders
of the company wishing to take over Northern
Rock.
Q871 Mr Fallon: But would it ever be right for the
Government to lend on commercial terms if they
thought there was a serious risk of financial
instability?
Professor Buiter: Yes.
Professor Wood: I think I would resist the feasibility
of that situation. If you have got proper lender of last
resort facilities in place, if you have an adequate
bankruptcy procedure for banks, the question
would not arise.
Q872 Mr Brady: Should the Bank of England have
injected term liquidity into the financial system
before the run on Northern Rock?
Professor Wood: I think not. If commercial bankers,
as was the situation, could not price these securities,
if they did not know what they were worth—I
observed and Willem pointed out to me this morning
that Morgan Stanley has written these things down
to zero, for example—if that is what they think they
are worth, it seems to me no more than an
impertinence to go to the Bank of England and say,
“Use taxpayers’ money to buy these things from us.”
Professor Buiter: I disagree. There are times when it
is clear that, say, the spread of the three-month
premium of the inter-bank rate, LIBOR, over the
expected three-month policy rate, bank rate, is not
just a default risk spread but includes a liquidity risk
spread, and when that goes together with a seizing
up of inter-bank markets, the Bank should
aggressively expand credit at that maturity or at
those maturities where there is, in their best
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Professor Willem Buiter and Professor Geoffrey Wood
judgment, such a term structure of liquidity spreads
as well as term structure of regular interest rates.
You cannot in general as a bank fix multiple interest
rates if markets are orderly but if markets are
disorderly you can indeed intervene at multiple
maturities, and the Bank should have done so
against the kind of collateral that the markets found
hard to price and then price it punitively, and in that
way prevent moral hazard, yes, so they should have
done so.
Professor Wood: Maybe I could follow that up and
say I just do not see what problem that was causing.
The banks could, after all, get the liquidity they
needed for their day-to-day business. The fact that
they could not trade at longer maturities is not usual
but it was not causing any significant diYculties at
the time.
Q873 Mr Brady: We also had divergent views from
the FSA and from the Bank on this, with the FSA
saying that if liquidity in smaller amounts had been
made available to Northern Rock earlier it is quite
possible that it would not subsequently have needed
to apply for lender of last resort facility, whereas the
Governor of the Bank made the point that because
of the sheer volume of support that Northern Rock
needed—close to £25 billion—it was not possible to
see how you would achieve that level of liquidity for
Northern Rock simply by injecting it generally into
the market. Would you comment on those two
views?
Professor Buiter: There are two problems. The fact
that Northern Rock needed £20 billion plus does not
mean that it could not have been provided at the
regular discount window. That is, after all, demand
determined, subject to the availability of collateral;
collateral is the constraint there. If the problem was
just that Northern Rock could not borrow, I would
not have done so, but since the inter-bank markets as
a whole, and indeed the wholesale markets and the
commercial paper markets were also seizing up,
there might have been a case for intervening, but that
is the same as the last question really, whether you
could by restoring liquidity to the markets have
prevented Northern Rock from going to the wall.
That would take an enormous amount of money
injections. We know for instance that despite all the
money that the Fed and especially the ECB have put
into these longer terms markets, the actual spreads
of three months LIBOR and the euro equivalent and
the dollar equivalent over the expected policy rate is
no smaller in euro land today than it is here, so it
really may take a large injection of liquidity to get an
appreciable result if the market is really fearful.
Professor Wood: I would simply add that I do not see
how giving a small amount of liquidity earlier to
Northern Rock would have been much help since
the problem, as we have seen, has been the shortage
of a large amount of liquidity, and so I think the
FSA’s point is not valid.
Q874 Mr Brady: Finally, just to be very explicit, you
both tend to agree with the view that was put by the
Governor of the Bank, and I quote his example, that
looking at what the European Central Bank lent to
banks through the auctions they conducted relative
to the size of the banking system they lent an average
of £230 million per bank whereas Northern Rock
needed close to £25 billion. You tend to agree with
the basis of that perception?
Professor Buiter: Yes, that is correct, but you could
have done it at the Bank’s regular discount rate for
Northern Rock. You could have done £20 billion
there.
Professor Wood: Calling it emergency lending was I
suppose asking for trouble.
Q875 Mr Dunne: Can I just pick up one of the
responses you made to Mr Brady. During August
was it not the case that the credit spread was
considerably higher in the UK than on the
Continent and in the US?
Professor Wood: When?
Q876 Mr Dunne: You are saying that has now
narrowed?
Professor Buiter: They are the same. They are about
half a per cent in all three areas.
Q877 Mr Dunne: But the time of the crisis was
August.
Professor Buiter: It was higher in the UK, yes.
Q878 Mr Dunne: Indeed and was that not partly
because the central bank here was not providing any
liquidity?
Professor Buiter: That was my interpretation, yes.
Q879 Mr Dunne: Indeed. How can you therefore
make the statement that had it provided liquidity it
would not have had some beneficial impact on
liquidity throughout the system, irrespective of
Northern Rock?
Professor Buiter: It would have had a beneficial
impact on the system but I doubt whether it would
have been enough to save Northern Rock. Northern
Rock needed individual attention.
Q880 Mr Dunne: There were many other issues
which you identified at the beginning which caused
the problem?
Professor Buiter: Yes, but banks generally were not
lending to each other, and that is never a good idea
because that also means they are not lending to
households and to non-financial corporations.
Q881 Mr Dunne: We were told by the management
of Northern Rock that they had an Irish subsidiary
and had they been able to have a facility in place with
the ECB through their Irish subsidiary in time, they
might have been able to secure some liquidity
through that.
Professor Buiter: Correct.
Q882 Mr Dunne: Do you think that would have been
an appropriate thing to have done?
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Professor Buiter: Sure.
Professor Wood: For Northern Rock, yes.
Q883 Mr Dunne: I think you said earlier that the
currency for lender of last resort is critical but in this
case had the liquidity operations been managed by
the Bank of England in the same way as the ECB the
pure currency risk was something presumably that
could have been priced into the facilities?
Professor Wood: You mean if they borrowed from
their Irish subsidiary? Sure, they would have had to
switch into sterling and if they were a well-run bank
they would have hedged that risk.
Q884 Mr Dunne: Indeed. So would it be prudent
then for British banks today to ensure that they have
facilities with other central banks in order to
maximise their prospects for liquidity if they need it?
Professor Wood: I suppose if you are saying that
other central banks give out liquidity too generously
(which I think they did) it would be prudent from the
point of view of individual British banks, yes. I do
not think it would be prudent from the point of view
of the British banking system. But in any event, if all
banks borrow abroad and switch into sterling, they
can only get that sterling from the Bank of England.
So any one bank could protect itself by borrowing
abroad, but the system could not.
Professor Buiter: I think they should all do so, if they
can, and of course not just in the Euro zone but in
the United States as well because at the US discount
window you can discount anything, including cats
and dogs, in principle.
Q885 Mr Dunne: Indeed, and two of the major
British banks have taken out very substantial
facilities with the Fed, have they not.
Professor Buiter: Yes.
Q886 Mr Dunne: Does this not raise questions of
credibility about the regulation of the British
financial services and banking industry?
Professor Buiter: We have a financially integrated
global system and that means that liquidity can be
purchased abroad as long as sterling is convertible.
I hope it will remain that way.
Q887 Mr Dunne: Do you see damage being done to
the British banking industry in particular or do you
think this is not a peculiarly British problem?
Professor Buiter: To me it was the way in which
inappropriately restrictive British liquidity policy
could be mitigated by some banks, the ones who
were lucky enough to have subsidiaries abroad in the
euro zone or the United States that they could use.
Q888 Mr Dunne: In addition to the points that you
made at the very beginning, what other lessons do
you think the regulatory authorities here need to
learn to ensure that these liquidity problems do not
recur in the UK?
Professor Wood: The regulatory authorities in a
sense did ensure that it did not occur in the UK once
they dealt with the Northern Rock issue. What they
should certainly do is to make clear again—it has
been made clear in the past—that in times of
diYculty they will accept a wider range of collateral
than usual, but they should also give the warning
that they charge much higher rates of discount for it.
Q889 Mr Dunne: The issue of providing a lender of
last resort facility on a covert basis, which appears to
have happened in the US and on the Continent, does
not appear to be capable of happening in this
country; can you explain why?
Professor Buiter: I think that particular statement of
the Governor is not correct. There is nothing in the
appropriately titled “MAD”—Market Abuse
Directive—to prevent covert support to banks in
trouble. On the day he said it, the statement was
contradicted by a spokesman for the Commission,
and every lawyer I have talked to since then says that
they have no idea where that interpretation came
from. If it is true then the Directive really is
appropriately named. We think we know, for
instance, that the ECB, which is a EU central bank,
has engaged in covert discounted borrowing which
really falls into that category and has gone beyond
that, quite likely. Because it is covert we have the
issue of absence of evidence and evidence of absence.
But a) I think it is not true and b) if it were there
should be an enormous outcry against it, but it was
not an issue, they could have done that.
Q890 Mr Dunne: So you think the powers exist at the
moment and they have just misinterpreted it and got
it wrong?
Professor Buiter: Yes.
Q891 Chairman: The Governor made that point in
this Committee, Professor Buiter, and he said it was
four pieces of legislation acting together.
Professor Buiter: The other pieces were by and large
correct. The deposit insurance scheme is a shambles.
You cannot do under-the-table mergers or
takeovers—and that is absolutely correct, but that is
why you should be able to take banks into public
ownership. That would be a solution for that
particular thing on a short-term basis. And whatever
the third one was—
Q892 Chairman: Insolvency.
Professor Buiter: Deposits get frozen, yes, that is
also correct. Of the four things he said I only
disagree factually with one which is the MAD.
Q893 Mr Simon: All the people that we have had so
far—the Bank, the FSA, the Chancellor and
Northern Rock—have all explained to us that the
Tripartite arrangements work, whereas to most of us
that seems a bit counter-intuitive because they do
not seem to have worked very well. You are the
adjudicator in this: do the Tripartite arrangements
work?
Professor Buiter: I think we have already said that in
provision of liquidity they worked but did not
work well.
Q894 Mr Simon: How do you think they could
work better?
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Professor Wood: Again Willem has made two
suggestions. One is that the Bank of England take
over the supervision for liquidity purposes of
individual banks. That would be a perfectly sensible
idea. The other is to turn the FSA into a bank. I
think that would be maybe sensible but certainly
diYcult.
Q895 Mr Simon: Do you think there should be a
diVerent set of arrangements when a certain point of
crisis is reached or passed?
Professor Wood: No, I think that would be
misguided. It would be like having two pilots on the
plane and saying this other one is going to take over
when things get diYcult. When do they get diYcult
enough? We should have sensible arrangements
from the start.
Professor Buiter: The Tripartite agreement needs to
be changed along the lines that GeoVrey just restated
here. It did not work well and the reason it did not
work well was not an accident, it was simply a
design fault.
Q896 Mr Simon: And you reckon with your two
modifications or some version—
Professor Buiter: Either of them—not both please,
just one.
Q897 Mr Simon: Obviously not both. One of which
is greatly more unlikely it seems to me than the
other. You reckon that would have solved this
problem and this would not happen?
Professor Wood: All I can say is in previous episodes
in the past in this country and elsewhere it did.
Q898 Mr Simon: What do you think are the chances
of them doing something like that?
Professor Wood: You should ask the Government
that, not me.
Q899 Mr Simon: Obviously we did ask the
Chancellor last week and he did not give us a very
full and accurate reply.
Professor Wood: Well, you can tell him from me that
I think it is a good idea.
Professor Buiter: We hope that after mature
reflection he will decide that change is the better part
of valour.
Q900 Mr Simon: You are talking to all these people
all the time. You must have a sense of whether there
is movement likely.
Professor Buiter: They may simply limit themselves
to informal arrangements. I do not think you are
going to see new legislation but the memorandum of
understanding is just that; it is just a bit of paper, as
somebody else once famously said. They may just
have some clarifications in a footnote that says the
Bank of England will henceforth start looking at the
liquidity positions of UK registered banks and
deposit institutions again.
Professor Wood: That would be a change because at
the moment the Bank does not have the resources to
do that.
Professor Buiter: Nor does it have the people.
Professor Wood: In addition I think it should be
done soon simply because it is important to have
these institutions run in before the next problem hits.
An example is in the United States where
arrangements were changed and also some key
people had died just before the financial crash of
1929-31 and it was largely because of the absence of
experience that that turned into such a disaster.
Q901 Mr Simon: Any more?
Professor Buiter: No.
Mr Simon: Thank you.
Q902 Chairman: Professor Wood, can I take it from
your comments that the Tripartite system worked
but failed?
Professor Wood: That would be going too far,
Chairman; it worked but not too well.
Q903 Mr Love: Professor Buiter, you threw away a
line earlier on suggesting that the Monetary Policy
Committee should be taken out of the Bank and that
eVectively the functions of the FSA ought to be
merged with the remainder of the Bank. I think that
was the suggestion you were making. I just wonder
how Professor Wood would respond to that.
Professor Buiter: Only the FSA’s liquidity
supervision function.
Q904 Mr Love: I understand. I wonder if you would
respond to that because you have been suggesting
that we could do one of two things. I would like to
press you on which of the two; do you think the
Bank should be the major institution or should it be
the FSA?
Professor Wood: Quite clearly the Bank should be
the major institution in the provision of liquidity.
Unlike Willem, I do not think we need to take the
MPC out of the Bank for that purpose. The MPC is
for all practical purposes out of the Bank anyway. It
is involved in only one set of decisions; it plays no
part in others. I think it is convenient
administratively to have it in the Bank; and there is
from time to time some connection between
monetary policy and financial stability policy, and
under such circumstances it is convenient to have
them together.
Professor Buiter: One quick footnote to that. The
problem at the moment is that the MPC only sets the
bank rate, but that is meant to be the target for the
overnight inter-bank rate, and in fact the overnight
inter-bank rate moves violently around. If you are
going to have this clearer separation, then the Bank
of England should change its policy in the overnight
market and actually peg the rate, at least the rate at
which it repos, does its sale and repurchase
operations, and it should always stand ready to repo
at its target rate at any amount all of the time, as
opposed to its current practice of trying to target
both price and quantity a little bit. They really have
to change their operating procedures otherwise the
liquidity management policy inextricably gets tied
up with interest rate setting. You have to be fair to
the MPC. If they set the Bank Rate then they should,
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except for a little default spread for the inter-bank
rate over the policy rate, peg the overnight rate. That
requires a change in operating procedures at the
Bank.
Q905 Mr Todd: Can we turn to depositor protection.
There is an argument for saying that depositor
protection introduces a moral hazard by
transferring risk but not straightaway. How do we
set appropriate depositor protection to ensure that
that does not happen?
Professor Wood: You cannot do that; deposit
insurance inevitably creates some moral hazard. The
starting point has to be to think why do we want
deposit insurance. It was introduced in 1933, if I
recollect, in the United States in very special
circumstances. The Federal Reserve had failed to act
as lender of last resort. The US had many small
banks financed entirely by retail depositors and
deposit insurance works in such a circumstance. It
was a substitute for a lender of last resort. Nowadays
what we might call flighty liquidity—banks’
liquidity that disappears quickly—is in wholesale
markets, and deposit insurance, therefore, cannot
prevent the important wholesale runs. It seems to me
we should therefore think of deposit insurance as a
social provision, to protect what used to be called in
the banking industry the widow and the orphan, and
it should therefore be accessible immediately if a
bank closes, and it should be set at a fairly low level.
If it were set at a low level this would have the
incidental benefit that first of all large depositors,
other banks, might pay closer attention to those they
lent to. Secondly, if it were set at a lower level it could
again continue to be financed by a mutual scheme
and thus the taxpayer would have less interest in
propping up banks.
Q906 Mr Todd: You are agreeing with that by the
sound of things; is that right, Professor Buiter?
Professor Buiter: Yes, but I would make a specific
point that it should only extend to retail deposits,
that is deposits by natural persons, not wholesale
deposits or business deposits, unlike what we have
now.
Q907 Mr Todd: So it has no purpose as a financial
stability tool?
Professor Buiter: No.
Q908 Mr Todd: It is purely, as you have said,
social policy?
Professor Buiter: Yes.
Q909 Mr Todd: Okay, if that is the case, what sort of
rate should it be set at? Is the current rate
reasonable? There have been suggestions of raising
it to £50,000, or is that just simply a political decision
to be made, you draw a line somewhere which seems
fair at the time?
Professor Wood: Basically it is a political decision. It
is linked to vulnerable persons’ deposits. In the
United States you can insure as much as you like
simply by opening enough deposits; it has to be
individuals.
Q910 Mr Todd: Do you think consumers are well
enough aware—and I think the evidence was in this
crisis that they were not—where the current limit
actually lay? I think most people thought that
deposits either were not guaranteed at all or they
were guaranteed almost infinitely, and to hear there
was a particular limit set on it was news to most
people, so is there associated with this an important
function of public education so that people
understand clearly?
Professor Buiter: Absolutely. Every bank should
have large signs when you walk in “Your deposits
are guaranteed up to . . . ”
Q911 Mr Todd: “Do not deposit more than
£35,000 here”.
Professor Buiter: Or “do so at your peril”!
Q912 Mr Todd: Right, so the eVect of that would be
presumably to persuade consumers to spread risk so
if they have large amounts of money to deposit they
would deposit it in a number of institutions?
Professor Buiter: Yes, that would be right.
Q913 Chairman: If I could come back to you on that.
There have been figures starting oV at £100,000
down to what the level is in the United States at
50,000, and the British Bankers’ Association have
come in and said that £35,000 is an appropriate level
because 90% of the population would be covered by
that. Could you give us an indication of where your
sympathies lie in terms of the level? Would it be
100% of that level protected?
Professor Wood: If we are protecting the widow and
the orphan it has to be 100% since we cannot expect
that such people would have the time or the
knowledge to police their banks. In terms of the level
it seems to me the British Bankers’ Association point
(which I had not heard before) was quite a good way
of thinking about the question.
Professor Buiter: A second reason for having 100%
is if you have anything less it is still an invitation to
run. Unfortunately while co-insurance is a good idea
for most insurance—you cannot have a run on your
life insurance company but you can have a run on
the bank—I really would not recommend anything
less than 100% and probably between £35,000 to
£50,000. Certainly £100,000 would be way in excess
of the widows and orphans criterion.
Q914 Jim Cousins: The Chancellor, when he spoke
to us on this issue, said that the 100% guarantee that
was given by the Treasury was a case-by-case
guarantee and each case would be assessed on its
merits, but the Governor in his very interesting radio
broadcast last week said something rather diVerent.
He said that the existing system of deposit insurance
we have trapped retail depositors—the word
“trapped” was his and “that’s why we could not
allow Northern Rock just to fail.” Do you think that
the Governor in saying that has undermined the
Chancellor’s promise to us that this guarantee to
depositors was only a case-by-case one?
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Professor Wood: I am not quite clear what the
Governor meant by saying it trapped depositors. If
he meant that when the institution failed the
depositors were then trapped because they could not
get their cash out right away, that is right, but that
has no bearing at all on what the Chancellor said.
Q915 Jim Cousins: I am inviting you, Professor
Wood, to see the implications of the Governor’s
remarks. He described retail depositors as being
trapped by the present system of deposit insurance.
Professor Wood: That statement is to me only
meaningful if the Governor is saying after their bank
has closed they are trapped in the sense they cannot
get their money immediately.
Professor Buiter: I have no idea, I cannot make sense
of the statement.
Professor Wood: Apart from that, I cannot see what
he means.
Q916 Jim Cousins: You cannot make sense of the
Governor’s statement?
Professor Buiter: Of the statement you are quoting.
I did not hear the interview, I just read excerpts from
it and that was not part of it. I find it hard to see what
it could refer to.
Q917 Jim Cousins: What the Governor said was this:
“We need a system in this country in which we can
prevent the retail depositors from being trapped.”
Professor Wood: That becomes much clearer. What
he plainly meant was that retail depositors should
get their money out immediately if the bank fails
rather than being locked in for some months, which
is part of the present system, and a very bad part.
Professor Buiter: In the United States they get paid
within two working days so that was what he was
referring to obviously.
Q918 Jim Cousins: The point I am putting to you
both is that the Chancellor said the guarantee he
gave to depositors in Northern Rock would not be
extended anywhere else, it was a case-by-case
system. The Governor’s doubts about the overall
system seem to indicate that it must be more general.
Professor Buiter: The Governor is talking about the
long-term reform—but hopefully it will be done very
swiftly—of the deposit insurance system which
should be one that allows you to get your money out
immediately. It did not refer to this one-oV or ad hoc
(if there is more than one bank) series of individual
bank deposit guarantees that the Chancellor created
for the purpose of this specific crisis. They are two
diVerent things; there is no contradiction.
Q919 Jim Cousins: Professor Buiter, while such a
system, whatever it might be, is being put into place,
which is not the case now, do you think it is credible
that we could say in the event of another diYculty in
another bank that the 100% guarantee to depositors
could not be extended if retail depositors are, as the
Governor says, trapped?
Professor Buiter: I do not understand the question.
I was surprised by the Chancellor’s statement
because as I understood his original announcement
it said that any bank that found itself in similar
circumstances to Northern Rock would get
Northern Rock treatment, both on the funding side
and on the deposits side. There might well be
individual fine-tuning if the banks have very
diVerent funding policies or very diVerent
compositions of deposits but, as I understood it,
eVectively the deposit risk for the entire British
banking system has been socialised.
Q920 Jim Cousins: I think that is a very important
statement to make and I will just play it back to you
so that we have understood its significance. You
have said that whether or not the Chancellor so
intended, the entire deposit risk of the British
banking system was socialised, as you put it, when he
gave his deposit guarantee to Northern Rock?
Professor Wood: It is my understanding, as it is
Willem’s, that he said it would apply to any bank
that got into diYculties, so in that sense, yes, he was
underwriting all the risk of the British banking
system. I think he did back away from that
subsequently, much to my relief; it seemed rather a
lot of money to guarantee.
Q921 Jim Cousins: But is there not a real diYculty
here that you are saying on the one hand that a
deposit guarantee was given in a form that socialised
banking risk for retail depositors and then you are
saying the Chancellor backed away from it, so where
does that leave us all?
Professor Wood: It leaves us all with the Chancellor
having backed away from a 100% guarantee, and
thank goodness for that!
Q922 Jim Cousins: Professor Buiter?
Professor Buiter: It leaves us, if indeed the
Chancellor has backed away decisively from this—
Q923 Jim Cousins: You are not so clear that he has
backed away?
Professor Buiter: I am not clear at all because I think
the statements, both the original ones and
subsequent ones, are suYciently ambiguous that
they are compatible with almost any course of
action.
Professor Wood: If I could take up that point—it
takes us back to the Chairman’s opening questions
on why were things badly handled at the start—one
of the ways in which it was badly handled were these
confused statements.
Q924 Jim Cousins: Professor Buiter, in your
evidence to the Committee—and I am following it
up directly because it is a right old shambles if you
are right—you said that national financial regulators
in the European Union should go the way of the
dodo?
Professor Buiter: Yes.
Q925 Jim Cousins: The evidence you have given to
the Committee this morning rather bears that out,
does it not?
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Professor Buiter: Well, one example does not prove
the case. It is not really a matter of individual
competence so much as the fact that we have this
regulatory race to the bottom when we at least could
neutralise the European element if we had a single
European regulator. Capital is global and
unfortunately governance is not and regulation is
not, but where we can operate in a larger area,
especially if it includes a significant number of
serious financial centres, we should do so, yes; it just
simplifies the task of preventing the further spread of
light-touch regulation.
Q926 Ms Keeble: I wanted to ask a bit about the
assessment of risk and the role of the credit ratings
agencies. To what extent do you think the
complexity of the financial instruments has made it
very diYcult for investors to assess the true risk of
the assets in which they are investing? Linked to that,
what do you think of the due diligence which they
undertake?
Professor Wood: The instruments have got a bit
more complex but the basic problem, as I
understand it, was quite a simple one—loans secured
on property were bundled up and these loans were of
various qualities of borrowing. They were bundled
up and people did not look inside these bundles.
That may have been bad ratings agency work but it
was also bad banking not to know to whom you
were lending money.
Professor Buiter: It is inherent in the process of
securitisation, which by the time you get to the
ultimate investor, who is six transactions or more
away from the originator of the loan, neither the
buyer nor the seller has any idea as to the underlying
risk characteristics of the security they are buying.
That gets worse when the securitised mortgage loans
get packaged with credit card receivables, the square
root of car loans, and whatever else. The structure
they have put together became so complex they
probably were not even understood by their
designers. Due diligence does not mean anything if
you cannot understand what you are dealing with,
and the rating agencies are in no better position to
know what the true value is, they did not go and
check individual addresses as to what the mortgages
were worth.
Q927 Ms Keeble: There are two sides to that and I
want to come back on to the credit ratings agencies.
I could understand that a casual investor might not
look into the bundle to see what is there, but some of
these investors are substantial and sophisticated and
one would have expected a degree of due diligence or
that they would have required a greater
transparency in the products.
Professor Wood: One would hope that but there
actually is a diYculty because when you are putting
these products together you are bundling together
various categories of asset which had behaved
diVerently in the past, and you estimate what the risk
characteristics of the bundle is based on the
experience of these diVerent assets in the past. The
trouble in the present situation was the past had been
rather an unusual period, a period of remarkable
stability, so I think there was probably very little
evidence, even if they had done the work, on which
they could say what would happen if we suddenly
moved from stable to unstable times.
Q928 Ms Keeble: So people took risks they might
not have done firstly because there had been a period
of stability and was it also not secondly because it
was oV balance sheet?
Professor Wood: Probably the first is more
important but again—
Professor Buiter: The level of transparency of the
whole process is low. Many of the institutions have
ended up holding them and dealing in them through
oV balance sheet vehicles whose reporting
obligations are minimal, and so it became harder not
just to understand the individual instrument, as
GeoVrey just described, and how to price them but
also it became hard to figure out who held them, so
the knowledge on who owns what is still fairly
patchy.
Q929 Ms Keeble: I just want to come on to the credit
ratings agencies. I think it was Professor Wood who
said that the concept of due diligence in this area was
pretty meaningless. Would you agree with that,
Professor Buiter?
Professor Buiter: Yes, you cannot be duly diligent
for things that you really cannot understand. I think
the regulators and the Bank can help create
incentives for simplicity, for instance by the Bank of
England, in this particular case, announcing that
they would take certain kinds of structures as
collateral in repo operations at the discount window
but not other more complex ones. That is one way of
making simplicity attractive.
Q930 Ms Keeble: You have said that you think that
it would help if there were clearer reporting
requirements. Do you think that it would also be
appropriate to look more carefully at the role of the
credit ratings agencies and in particular their
propensity for being able to advise on the structure
of investments and then also do the ratings of them
as well?
Professor Buiter: I have argued that they should
become ‘monolines’, basically agencies just doing
one activity, just doing ratings. You cannot manage
the potential conflict of interest involved in advising
a client on how to design a structured financial
product to get the best possible credit rating and
then rate that same product. That is going to create
a conflict of interest so it should just not be possible
to do that; you rate and that is it.
Q931 Ms Keeble: Professor Wood, would you agree
with that?
Professor Wood: Absolutely. It slightly surprises me
that the agencies have not grasped that for
themselves and set up separate ratings agencies
because these would attract customers.
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Q932 Ms Keeble: Professor Buiter, you have made
comments about Basle II and the Credit Ratings
Agency. I wonder if you would just like expand on
some of the comments you have made?
Professor Buiter: The credit rating agencies and their
ratings play a central role in the first pillar of Basle
II, the capital adequacy parts, and the other element
of Basle II that I think deserves some scrutiny is the
use of internal models for marking to model the
things that we cannot mark to market because there
is no market for them, and that goes for most overthe-counter products, eVectively, not just for the
ones that have temporarily become illiquid. So you
have two key pillars on Basle II: mark to model—
turns out to be mark to myth in disorderly times—
and the rating agencies, which are deeply and
inherently conflicted, and we are giving these rating
agencies a semi-regulatory task through the Basle
Agreement. We cannot ask for the private provision
of public goods like that. I think Basle II has to go
back to the drawing board before it is even out of the
stable. This is a mixed metaphor.
Q933 Ms Keeble: Can I ask one further point? Really
the credit ratings agency should be capable of at least
guiding people as to where the risk lies in the system.
Why have they failed and what assessment do you
have of exactly where the risk is, because there is
quite a problem: the same investments are there, the
same risk assessments, the same ratings are being
undertaken, nothing has changed essentially, and
there is a lot of people’s money tied up in institutions
which hold these investments.
Professor Buiter: But the agencies did reasonably
well when they rated sovereign debt and
corporations, large corporations. Remember, they
only rate default risk and expected loss conditional
on a default occurring; they do not rate market risk,
liquidity risk and everything else; so in some ways
they would have been completely useless for the
current crisis in any case because there was a
liquidity crisis, by and large, rather than an
insolvency crisis and we should not ask of them
things that they do not promise to sell. But even in
the area where they are evaluating things, they
invented this new activity, rating fancy, structured
complex products, but it is just very diYcult and
basically impossible.
Q934 Chairman: Can I ask both of you in terms of
the rating agencies, you both believe that they are
inherently and deeply conflicting?
Professor Wood: Yes.
Professor Buiter: Yes.
Q935 Chairman: Secondly, in terms of Basle II, John
Plender of the Financial Times was writing and he
made comments that were along the same lines as
yourself, Professor Buiter, but he is talking about
Basle II, saying that it relies on the modelling
techniques that led to the sub-prime disaster and the
new rule book also depends heavily on the credit
rating agencies in whom investors have lost
confidence.
Professor Buiter: Exactly the same point.
Professor Wood: The same point.
Q936 Chairman: So we need a fundamental look at
Basle II then?
Professor Buiter: Yes, back to Basle one and a half!
Q937 Mr Love: We will invite you back when we are
looking at Basle II. You both agreed earlier on that
the Northern Rock crisis did not have any
implication for the stability of the financial system.
Do you believe that any of the losses suVered by the
much larger banks, such as Citibank, have any
implication for financial stability?
Professor Wood: They obviously make the
institutions which have lost capital more fragile than
they were before they lost capital, but one would
hope it also makes them more cautious in the future,
which makes them less fragile. So, in the short term,
yes, they are more fragile, in the longer term
perhaps not.
Professor Buiter: In the short term, by impairing
their capital or at least reducing the margins, it will
make them more reluctant to lend, and that means
that the cost and availability of loans for the real
economy is going to be more restricted in times to
come, so a net contraction on demand is imposed.
Q938 Mr Love: Quite a number of the US banks
have come forward with estimates of their losses. We
have not seen that so much in terms of UK banks.
Should UK banks be more transparent about what
is happening to the balance sheets? One of the
reasons they have given for that is the diYculty in
quantifying what those losses are. Is that a
reasonable excuse to give?
Professor Buiter: The reason most of the big ones
have not reported yet is that they are on a sixmonthly reporting cycle, not on a quarterly one; so
that is a straightforward reason. If you started
bringing in suddenly higher frequency reports, that
would really put the wind up your sails. You have to
have a very good reason for doing that. I think as
long as they stick to the regular cycle, that is fine, but
they are going to have the same problem as their
American counterparts, in that they have on their
books, or are exposed to, stuV that is really illiquid,
has not been traded in deep, transparent markets for
months now, some of them never, and therefore it is
very hard to establish a price. Yes, it is very hard,
and it means also that there is non-uniformity in the
treatment of the same claims by diVerent banks. My
view is that we really have no idea about what most
of these banks have on their books. Some of them,
like maybe Morgan Stanley, apparently evaluate a
fair amount of the stuV they have as if it was worth
nothing; that certainly puts a clear floor under what
could happen, but very few other banks have been
willing to do that.
Professor Wood: There is a big diVerence between
some of the British and some of the US institutions.
Some of the US institutions are not strictly speaking
banks. Banks have the option of carrying these loans
on their banking book rather than their trading
book. They are not, therefore, required to mark to
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Professor Willem Buiter and Professor Geoffrey Wood
market. Whether that is a good thing or not, banks
are allowed to treat these things very much like
overdrafts. You do not mark overdrafts to market
because there is no market. So there is an accounting
diVerence, which can produce diVerent reports and
results.
Q939 Mr Love: You mentioned Morgan Stanley
suggesting that quite a lot of their paper is worthless,
but we understand that quite a lot of them are still
valuing at 90 cents in the dollar. If it all turns out to
be worthless, as perhaps Morgan Stanley are already
admitting, would that shake their financial stability?
Professor Wood: First of all, it would be a surprise
if it were all worthless, and I say that very seriously.
When Continental Illinois Bank failed in the United
States, it eventually paid out, I think, 93 cents in the
dollar, or perhaps a little bit more, (but it took some
time). So it would be a surprise if these securities
turned out to be worthless this time.. Secondly, if
every bank in the system took this big hit at once, it
would indeed impose a severe contraction ratio on
the economy. If they spread it out, sure, it would be
more diVused. Whether that is good or bad I cannot
immediately answer; I would have to think about it.
Q940 Mr Love: What is the implication of holding
quite a lot of this stuV oV balance sheet? Is there any
implication directly and, if they took it all back onto
their balance sheet, would there be problems that
would arise from that?
Professor Buiter: It depends on whether they are
required, either through legal obligations to do so,
say through a credit-line or some other legal
commitment, also reputational considerations. If
they are exposed, substantively exposed, then having
them oV balance sheet is simply a smokescreen, it is
a way of hiding things. It is done generally for
regulatory arbitrage purposes to reduce the capital
you need to carry this stuV. Basically many of these
vehicles are banks without capital or without
reporting requirements and without governance,
and so that is a lot easier to manage, but, of course,
therefore also riskier. I think you have to think of
most of these vehicles as ultimately ending up on
bank balance sheets.
Q941 Mr Love: Lack of transparency is a word used
quite regularly both for oV balance sheet but also for
perhaps a lack of adequate reporting of all of this,
and of course that leads to continued lack of
confidence in the market place. Should we be doing
much more? Should there be more robust
regulation, regulatory requirements, relating to both
transparency and in a sense, therefore, to stability?
Professor Wood: It was, of course, in a sense,
regulatory requirements that led banks to put these
things oV balance sheet. Because the requirements
were formal and in place, they knew that if they were
not on the balance sheet they did not have to count
against capital. So you have to think very carefully
about the kind of regulation you have so as not to
encourage that kind of behaviour. All regulation is
not good regulation; all regulation does not produce
improvement.
Professor Buiter: There is a real problem about
trying to prevent accountancy and auditing tricks or
mitigating them by regulation that can be easily
avoided. You really have to have principle-based
bank regulation that basically says it looks like a
bank, it lends like a bank, even though it may not
take too many deposits, we will treat it as a bank for
regulatory purposes. So you make an institution
pass the duck test when you decide to regulate it, but
that is more easily said that done because the
principle still has to be translated into actual
operational rules. The principle versus rules debate
is a false dichotomy; both have always been
necessary. It is not easy, and you can do better than
we are now, but most of the activity that caused the
trouble took place out of the view of the regulators.
Q942 Chairman: Can I thank you very much for
your evidence this morning. It has been hugely
helpful to us.
Professor Buiter: Thank you very much. It has been
a pleasure.
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Ev 105
Witnesses: Mr Paul Taylor, Group Managing Director and Global Head of Sovereign, Public Finance,
Corporate and Financial Institution Ratings, and Mr Charles Prescott, Group Managing Director,
Financial Institutions, Fitch, Mr Michel Madelain, Executive Vice President, and Mr Frédéric Drevon,
Senior Managing Director, Moody’s, and Mr Ian Bell, Managing Director and Head of European
Structured Finance and Mr Barry Hancock, Managing Director and Head of European Corporate and
Government Services, Standard and Poor’s, gave evidence.
Q943 Chairman: Good morning and welcome to the
Committee’s inquiry into financial stability and
transparency. Can you introduce yourselves for the
shorthand writer, please, starting at this end?
Mr Prescott: Charles Prescott, Financial
Institutions, Fitch Ratings.
Mr Taylor: Paul Taylor, Fitch Ratings.
Mr Madelain: Michel Madelain, Executive Vice
President of Moody’s. I am responsible for bank
ratings.
Mr Drevon: Frédéric Drevon, I am Moody’s for
Europe. I am also co-head for securitisation
business. I am London-based.
Mr Bell: Ian Bell, I head the securitisation business
of Standard and Poor’s in Europe.
Mr Hancock: Barry Hancock, Head of European
Corporate Ratings for S&P in Europe.
Q944 Chairman: Maybe I can start by asking a
simple question. What do rating agencies do and
what do your ratings mean? All your ratings mean
diVerent things in diVerent companies. Is that
correct? Maybe you can tell us, starting with Fitch,
what your ratings mean, and Moody’s, what your
ratings mean and then yourselves?
Mr Prescott: Our ratings are measuring the
likelihood of interest and capital being repaid in
terms of the conditions of the issue.
Mr Madelain: Our ratings speak to the risk of
default and recovery on securities issued in the
capital markets.
Mr Bell: Similarly to Fitch, our ratings are opinions
as to the likely default, either on interest or principle
in a timely basis.
Q945 Chairman: So really your ratings reflect credit
risks—that is the ability or willingness of a party to
repay a debt—but they do not imply anything in
terms of liquidity, potential for appreciation or
volatility. Is that correct?
Mr Bell: That is correct.
Q946 Chairman: So they do not do that for liquidity.
Therefore, an investment decision based only on
ratings can be misguided.
Mr Bell: We have always been very clear that no
investor should base a decision to invest or not invest
in any debt solely on the rating; this is one
component of all the risks that that investor should
take into account.
Q947 Chairman: So the decision could be
misguided?
Mr Bell: If based only on a rating, almost
certainly, yes.
Q948 Chairman: At the end of the day, you have
diVerent quantitative models to rate the credit risk,
but you usually almost always agree in terms of the
rating, triple-A or whatever else. Some of you use
triple-A, some of you use lower case “a”, but you
always usually agree. How do you agree at the end
of the day when you start oV with a diVerent base?
Mr Taylor: Actually we do not always agree; quite
the contrary in fact. There are two levels to this. One
level is what you do not see in the public markets. So
each of the agencies has situations where they do not
rate something because they disagree with the risk
assessment that appears in the public market, but we
also have diVerences in the ratings themselves. If you
look at the specific ratings assigned to diVerent
issuers, diVerent transactions, diVerent companies,
banks, there are diVerences between the levels
assigned. There is a lot of similarity as well simply
because of the fact—
Q949 Chairman: I am pointing out that Arturo
Cifuentes, who is the Managing Director of RW
Pressprich says, “In practice, however, the degree of
agreement category by category is extraordinarily
high. This degree of agreement seems strange.”
Mr Taylor: I am not sure it is extraordinarily high.
First of all, it is based on facts. The facts we all get
are the same. How we interpret those facts is down
to our individual decisions and analysis. The facts
are the same. So you would not expect massive
diVerences on a frequent basis, but there are
diVerences.
Mr Drevon: I should also add in the specific context
of securitisation, arrangers who create these
transactions have a goal to achieve a higher rating,
typically a triple-A rating, so they will structure a
transaction in a way that achieves the highest rating
possible; so it is not unlikely that diVerent rating
agencies rating the same instrument will achieve the
same highest rating.
Mr Bell: In addition, in structured finance you also
have the fact that, even if there are diVerences in our
analysis of a particular transaction because the
people structuring the transaction wish to have the
highest rating, they will simply take the most
conservative position of the two or three agencies, so
enabling each agency to give a triple-A.
Q950 Chairman: Do you agree with Mr Cifuentes
that the rating agencies enjoy a power that goes
beyond what regulators probably intended and,
maybe even worse, understand?
Mr Madelain: I think that is an understatement. I
think we are a provider of opinions on credit risk.
There are many other providers, many diVerent
ways to form opinions, and we are one of such
providers.
Q951 Chairman: I will go on with what he is saying.
He says whether a bond gets an investment grade
rating or not is critical—in some cases it prevents
certain investors from buying the bond, in others it
forces the holders of the bond to sell it—but what is
frightening, he says, is not only that the agencies
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determine whether the bond meets the BBA
standard or not is the fact that you define that
standard. Is that not frightening?
Mr Madelain: There are two things. There are
certain situations where ratings are embedded in
regulations. This is clearly the case in the United
States; much less so in Europe. Second, we have
rating criteria that, indeed, lead to assigning certain
rating levels, but those are fully transparent and
available to every user of ratings and actually may
default from one agency to the other.
Q952 Chairman: In terms of the practice of the
rating agencies, the appraiser in the rating process is
paid by the seller rather than the buyer. Is that
correct?
Mr Madelain: That is correct.
Q953 Chairman: The rating agencies provide
technical assistance and advice on how to design
structures that could attract the best possible
rating—
Mr Drevon: That is incorrect.
Q954 Chairman: —to the very issuers whose
structures they will subsequently rate?
Mr Bell: That is absolutely incorrect.
Q955 Chairman: So, you agree completely with
Professor Buiter?
Mr Drevon: No, we disagree completely.
Q956 Chairman: You disagree with Professor
Buiter?
Mr Bell: Yes, absolutely.
Q957 Chairman: Okay; that is fine. The rating
agencies provide other financial services and
products than ratings or ratings advice?
Mr Madelain: We do not provide advice, as we
have said.
Q958 Chairman: Other financial services that you
provide.
Mr Drevon: We can speak for Moody’s. We do
provide some additional tools to the market but
those are done separately, they will be done
separately from the rating agency.
Q959 Chairman: But you provide those services.
Mr Hancock: Exactly the same at Standard and
Poor’s.
Q960 Chairman: Standard and Poor’s provide those
services as well. Do Fitch provide those services?
Mr Taylor: Actually, no. We are representing Fitch
Ratings. We do not provide those services. We have
a sister company, which is a completely diVerent
company, a diVerent management structure.
Q961 Chairman: There are Chinese walls between
you.
Mr Taylor: It is a diVerent company, who do provide
those services.
Q962 Chairman: So you provide those services.
Okay.
Mr Madelain: What is important is that those
services are unrelated to ratings.
Q963 Chairman: You agree with two of the three
points that Professor Buiter is making and, as a
result, he came to the conclusion, as Professor Wood
did, that you are inherently and deeply conflicted.
Mr Madelain: The issue of pay model, which is what
you have just described, is eVectively creating a
potential conflict. What we do believe is that we do
manage that conflict eVectively, as has been
demonstrated by our track record in this area and
also I think, as we have stated many times, by the
importance of our reputation for the viability of the
services we provide.
Q964 Chairman: Why is your reputation under such
scrutiny at the moment? Why are you getting
investigated on Capitol Hill and you are considered
right at the centre of the sub-prime market? You
seem to be the architects of the rating of this and the
fact that there are problems, in fact global problems,
associated with it. You are perfectly decent guys.
Why did you get yourselves centre stage here?
Mr Drevon: You know, we have been in the market
for many years rating diVerent instruments and so
we are used to be being under scrutiny for the simple
reason that we provide a very public opinion about
credit risk. It is very easy to point a finger at a rating
agency because that public opinion is available in the
market place, and so we are used to having to defend
our opinions and we do that on the basis of our track
record, which we publish, which clearly shows that
our ratings have a very predictive power in terms of
diVerentiating credit risk. In terms of your specific
comment, which was in relation to our role in the
sub-prime market—
Q965 Chairman: I ask questions; I do not make
comments.
Mr Drevon: I am sorry. In terms of your specific
question in terms of our role in the US sub-prime
market, I think we have been quite clear also, and I
think we included that in our submission.20 We did
not design the securities, we did not originate the
underlying mortgages, we are not investors; we
provided one specific role, which was the credit
opinion about credit risk.
Q966 Mr Fallon: Nevertheless, you are selling
services to the people you are supposed to be
regulating. That is the position, is it not?
Mr Bell: Undoubtedly there is a potential conflict of
interest. It is well known to the market.
Q967 Mr Fallon: You are selling services to the
people you are supposed to be regulating.
Mr Bell: We do not regulate; we merely express
opinions as to the credit risk.
20
Ev 280
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Q968 Mr Fallon: You are part of the regulatory
system and you are selling services?
Mr Madelain: I think we need to be clear on that
point. I am not sure what you mean by “selling
services”.
Mr Prescott: No, it is obviously not because they
were paying us. We look at every issue in its own
right and we will decide what actions to take
depending on the circumstances and the information
that is available to us.
Q969 Mr Fallon: You take fees.
Mr Madelain: The business model we have is that the
fees are paid by the issuers of securities, yes.
Q980 Mr Fallon: But you did not take any action.
You have written us a long submission here pointing
out how Northern Rock was over-reliant on
wholesale markets, its funding mix was historically
very skewed, and so on, but you did not change your
rating of Northern Rock before the interim results,
nor between the interim results and the final crash on
14 September?
Mr Prescott: That is correct.
Mr Hancock: I would add that at S&P we have over
2000 clients who are rated within Europe and the fee
from one of them is not going to influence a decision
that we would make on their credit standing. We
would be driven entirely by our belief on the likely
probability of default.
Q970 Mr Fallon: Let us just be clear about this. Did
any of you take fees from Northern Rock?
Mr Hancock: Yes.
Mr Taylor: Yes.
Q971 Mr Fallon: You took fees from Northern
Rock?
Mr Taylor: There has never been any denial of a
conflict of interest in the issuer pays models. There is
nothing secret, there is nothing surprising, about
that.
Q972 Mr Fallon: Then you will tell me Mr Taylor,
how much fee you took from Northern Rock, if it is
not a secret.
Mr Taylor: I do not know the number.
Q973 Mr Fallon: Roughly?
Mr Taylor: I do not know the number.
Q974 Mr Fallon: How much a year do you charge
Northern Rock?
Mr Taylor: I do not know the number.
Q975 Mr Fallon: Does anybody else know what they
charge Northern Rock?
Mr Hancock: I could not tell you, no.
Q976 Chairman: Is it a substantial sum?
Mr Taylor: In the context of our overall business,
almost certainly not. I do not actually know the
number.
Q977 Chairman: Could you write to us with that and
give us a number so that it is a matter of public
record.21
Mr Taylor: It is commercially sensitive. I am sure we
could let you have—
Q978 Mr Fallon: You told me it was all open and
above board.
Mr Taylor: No, we do not disclose the fees paid by
individual issuers to us.
Q979 Mr Fallon: The reason I am asking you this,
Mr Taylor, is that the submissions you have all made
to us make it very clear that, apart from the
downgrade the day the interim results came out,
there was no change in your opinion of Northern
Rock from 2006 until after 14 September. Why was
that? Was it because they were paying you?
21
See Ev 264, 276, 285
Q981 Mr Fallon: But you are taking fees from all of
them, Mr Hancock, that is the point. You are the
traYc-lights being fixed by the speeding motorist,
are you not?
Mr Hancock: We are driven entirely by our
reputation. If we lost our reputation, if anybody
doubted that we were driven by the fees we received
from any individual client, that would be the end of
our business model.
Q982 Mr Fallon: Can you explain to me then why
you did not flash any kind of warning up about
Northern Rock between July and the middle of
September?
Mr Hancock: I think if you looked at the history of
the rating of Northern Rock, we had indicated that
in the 13 years that we have been rating them they
were rated somewhat lower than many other
financial institutions within the UK. We certainly
highlighted their increased, or higher, reliance on
wholesale funding. Certainly we did not expect the
repercussions of the US sub-prime market to have
the impact and repercussions on funding of all UK
banks, but we have certainly highlighted the extra
risks that were involved in their reliance on
wholesale funding.
Q983 Mr Fallon: I do not think you quite see this
from the way we are seeing it. This is the first bank
run for 140 years. You are the people who are
supposed to be flashing up the warnings about the
likelihood of banks getting into trouble and then you
come here and tell us you are being paid by the very
same banks and you did not give the warning.
Mr Bell: I think it is worth drawing attention to two
pieces of research or two investigations that have
taken place. As the potential conflict of interest is
well-known, we would like to draw attention to the
fact that it has been researched in the United States.
A few years ago the Federal Reserve Board asked a
bunch of academics to investigate whether or not the
conflict of interest did aVect the way the rating
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agencies assigned their ratings. That academic
research clearly came to the conclusion that they did
not and that our reputational integrity was more
important to us than the fees. In the same way, after
2003 there was a quite legitimate investigation of the
rating agencies by the Committee of European
Securities Regulators as well as the European
Parliament that was quite extensive, and they also
reached the conclusion that our conflicts of interest
did not impact on the ratings we gave. So, although
we absolutely accept that these are legitimate
questions that should be asked, as there is a potential
conflict we would like to draw attention to all the
evidence that is accumulated in the case that that
conflict does not impact on the rating process.
Q984 Mr Fallon: Let us focus on the evidence on
Northern Rock. Why was it that none of you flagged
up after July the real danger facing Northern Rock
from the closure of the financial markets?
Mr Bell: I think the fact that needs to be borne in
mind is that the crisis that unfolded in the
international capital markets in August was of a very
novel kind, one never seen before, and it took the
entire market by surprise, it took the regulators by
surprise, it took the Fed, the Bank of England, the
ECB, by surprise, it certainly took the investment
bankers by surprise and it took us by surprise. Our
business is to express opinions. We do so based on
our best understanding of how events are likely to
unfold. Undoubtedly, if your business is, as our
business is, to predict the future and try to see into
the future, there are times and there will be things
that you do not see. We did not see the way in which
the sub-prime crisis would ripple through the capital
markets of the world and impact an English bank,
like Northern Rock.
Q985 Mr Fallon: You all failed.
Mr Madelain: I would like to give you my
perspective on this situation. As has been provided
to you in various submissions, I think we made an
assessment of the liquidity situation and the risk
situation, the funding strategy of Northern Rock. I
think we felt that this risk was manageable. We had
identified—. I think what is important to realise is
that when you assign a rating you assign a rating to
a scenario which you think is the most plausible
scenario for that institution. You do not assign a
rating to an extreme case. So, that is just to explain
what was the background for our rating. Moving
into the specifics, I think that we had obviously very
early on measured the situation on liquidity that was
aVecting the market, and our view was that
Northern Rock was obviously exposed. We did
engage with the bank on that situation and we
moved the rating when we were informed,
eVectively, of the decision of Northern Rock to seek
assistance from the Bank of England.
Mr Taylor: To answer your question directly, the
rating did not change by much, the situation
changed by a bit. Going back to your first question,
which what is the rating actually doing, the rating is
addressing—. If you hold a security from Northern
Rock, what is the likelihood of you getting your
money back? So, because of the strength of support
that came in there, we did not have to change the
rating, the rationale of the rating changed and was
described by research issues by us, but the risk of the
piece of debt did not change by that much if you were
a bond holder.
Q986 Peter Viggers: When you were asked whether
each of you drew fees from Northern Rock, Fitch
and Standard and Poor’s said, yes; Moody’s was
slightly less forthcoming. Can I assume that
Moody’s also receive fees from Northern Rock?
Mr Drevon: We do.
Q987 Peter Viggers: In assessing these fees (and we
would like you to let us know what the fees were) can
you, please, also tell us whether these fees were
proportionate compared with other institutions
comparable to Northern Rock? In other words, were
you remunerated in a manner which was perhaps in
excess of that which one would normally see from
such an institution? I would you like to put that
question to you, please, and I hope you will be able
to respond. You have been criticised for the speed
with which ratings adjusted to the sub-prime crisis.
Previously you were criticised for the speed with
which you adjusted to problems with Enron. Were
you satisfied with the speed that you responded and
what plans have you to improve the speed with
which you intend to respond?
Mr Madelain: I think actually we feel we did
eVectively respond to the situation in a timely
manner. I would like to make two comments. The
first comment relates to what we have done. All over
the summer we had very intense activity around the
assessment of the situation and the communication
to the investors of the impact of the situation on the
bank we rated. We had weekly conference calls for
global investors, we published more than 25 research
reports through the summer on that very topic, so I
think that the level of response and the expectation
of the investors at that stage were eVectively met. I
guess the other question that one would have is what
eVectively we were able to communicate. I think it is
very important that you understand that the
opinions we produce are based on the public
information that is available to us in the form of
financial reporting as well as information that is
made available by the banks that we rate; and there
is obviously a limit in what we can do and that limit
is aVected by the amount of information that is
available.
Q988 Peter Viggers: But you are experts, otherwise
it is just rubbish in, rubbish out.
Mr Madelain: But the expert is forming an opinion
using information that is made available to you. We
cannot create information that is not available to us.
Q989 Peter Viggers: Switching to another point, to
Fitch, Fimalac claim that you warned investors
about the dangers of a sub-prime mortgage market
in 2005. Is that correct?
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Mr Taylor: It is correct, yes.
Q990 Peter Viggers: What did you do about it?
Mr Taylor: What did we do about it? One of the
challenges we have had as an industry over the last
couple of years is when the markets have been so
buoyant, as we have put out comments about maybe
credit deterioration or concerns in increasing
leverage, for example, in transactions, many, many
players in the investor community simply were not
viewing credit perhaps at the forefront of their
investing decision. So, even though we can draw
attention to commentaries about deteriorating
credit risk, it was not being reflected in investor
behaviour. A good way of describing that is the
average ratings we have been applying, for example,
in leveraged corporate transactions in Europe have
been coming down on average for the last two years.
Until recently the price was coming down as well.
The increase in risk as we reviewed it has not been
reflected in market pricing; so there was an
imbalance between what we were saying, the
direction of credit and the way the market was
responding to deals being placed.
Q991 Peter Viggers: Were you content that the
information you were putting out reflected the
reality that investors would probably want?
Mr Taylor: It is very diYcult to say that, because
what actually happened in the US sub-prime market
was very much unprecedented. We had not seen
anything like it before. You can argue about the
magnitude of what happened versus the magnitude
of what we were talking about, but I think the
direction was clear, but it was not just us, many
commentators in the market were saying similar
things.
Q992 Peter Viggers: Do you at Standard and Poor’s
and Moody’s accept that Fitch was ahead of you in
warning of the dangers of sub-prime?
Mr Bell: I am not exactly sure when their warning
came out. We had warnings at roughly the same
time. They may well have been ahead. I think one
has to remember two things. First of all, we did, as
did the other agencies, warn investors about the
deterioration in sub-prime, but also one has to bear
in mind how you rate structured finance
transactions, which is that the criteria require a
credit cushion. In order to have a triple-A you have
to have a credit cushion so the pool of mortgages can
absorb a certain amount of losses before there are
any losses at the triple-A level. These cushions were
very substantial in the case of sub-prime. They
reflect our analysis of past data. Those cushions are
not simply reflective of what happened in the past.
For triple-A ratings we simply do not say: “we
assume the future will be the same as the past; what
we do is we stress the past”. We look at how bad
things got in the past and we say: “we will multiply
that level of rates to create a cushion that should
survive not just credit problems in the past but a
much worse credit scenario”. What happened in the
case of US sub-prime, however, is that the future was
much worse than even our worst case assumptions—
the deterioration in credit, the deterioration in
underwriting, the deterioration on the fraud side, the
amount of fraud involved, and also a series of very
unusual and completely novel patterns of behaviour
by sub-prime borrowers, things that had never been
seen before in any other market. All of these
combined to create a situation that was worse than
our worst case assumptions and also completely
novel, not just to us but to the entire markets. As a
result, with hindsight, if we had known exactly what
was going to unfold, we would have rated these
transactions diVerently. However, we maintain that
we rated them with all our knowledge and all our
skill to the best of our ability.
Q993 Peter Viggers: But you are experts and
presumably well paid. Did you study the initial subprime market, notice the way they were
collateralised and then draw conclusions to enable
you to warn people?
Mr Bell: Absolutely. I think also one needs to
remember that we have been rating sub-prime
transactions since the early 1990s. This was not a
new market for us. In 2001 there was a crisis in the
then sub-prime markets, so we drew all the lessons
that we could from this. What happened is that the
crisis in 2007 was of a speed and amplitude much
greater, not just than in the past, but much greater
than anything we had seen as a worst case scenario
in the future.
Q994 Peter Viggers: Can I turn to Moody’s. Brian
Clarkson from Moody’s said in the Financial Times
on 18 September, “A more uniform method of
valuation is essential for eYcient and rational price
discovery and to address future liquidity issues.”
Could you expand on that statement?
Mr Drevon: I think it appears right now that one of
the main reasons why we are in these very troubled
times is not necessarily linked to the credit risk we
are seeing but more to liquidity-related issues and
liquidity-related issues due to the fall in values we are
seeing on a number of securities. Why are we are
seeing this level of falls? First of all, it is very clear
that these instruments are complex and require
significant amounts of time to fully understand and,
therefore, to try to find a tool for valuation. There is
no standardised solution to that. DiVerent banks
will come up with diVerent solutions to value these
securities and, by definition, this will result in
diVerent methodologies across diVerent institutions
across diVerent markets. This creates generally
concerns that institutions may have more risk than
they have been disclosing because they are using
diVerent methodologies. So there certainly is, I
think, a clear understanding in the market place that
there needs to be more done in terms of agreeing on
solutions to have a more standardised approach for
valuations. From Moody’s point of view, this is not
an area that we are involved in at this stage. We
provide credit ratings, but we think it is an area
which may benefit in the market in the future. We
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
plan on developing tools to provide fundamental
valuations to help investors with valuing these
securities.
Q995 Peter Viggers: You have a unique status under
US security laws. You profit from your privileged
status and it was Mr Bell, I think, who referred to
your reputational integrity. Do you think you
deserve this unique status in the US?
Mr Drevon: Moody’s has generally been in a
position to say that we are not in favour of using
ratings for regulations. We have been very clear
about that in all our observations. We think that
ratings are used for many things already, including
by investors, by issuers. They are used by investors
who buy whole issues, investors who trade, by
investors who will short sell. We think that adding
regulations to that as an instrument that will be
using ratings is not something that we recommend,
in fact.
Mr Bell: I would go further to say that, although
undoubtedly we do commercially benefit from that
status, we have always, at S&P, as well as Moody’s,
been opposed to being part of regulation. We did not
ask for this status, we did not lobby for this status,
we disagreed with the SEC when they created this
status and we have said ever since that it is a bad
idea. We welcome the changes in the law that
provide more clarity about how this status is going
to be provided in the future.
Q996 Chairman: If I can go back to another
question, roughly speaking you all rated Northern
Rock the same.
Mr Hancock: Not dissimilar. There were minor
diVerences.
Chairman: Not dissimilar, and you all had business
with Northern Rock. I will be writing to you
formally on that regarding your relationship with
Northern Rock and the income you have, and if you
decide to write back to me and say it is confidential,
then it is going to be a matter of public record, but
you will be getting a letter from me on that.22 Sally.
Q997 Ms Keeble: I must say what it reminds me of
is the children’s game, pass the parcel. You have got
some risk bundled up, it gets passed from pillar to
post and, when the music stops, people open it and
find that there is nothing there, or next to nothing
there. It makes me wonder how hard you actually
looked at the securities that you were supposed to be
rating: because once the information had come out
about the sub-prime market, it is hard to imagine
how anyone could have regarded them as sound
investments at all. I just wondered, if you listen to
what the professors said as well, how far you look
and scrutinised what you were rating?
Mr Bell: We have 30 years of experience of rating
structured finance and the first structured finance
transactions, both in Europe and in the United
States, were residential mortgages. The advantage of
residential mortgages is that because the pools are
22
See Ev 258, 272, 280
quite large, thousands and thousands of mortgages,
they do respond fairly well traditionally to statistical
analysis. We have used that statistical type of
analysis, taken quite a lot of information from the
pools, and we do a lot of due diligence in that sense,
over the 30 years. Our record shows that actually it
has been extremely successful in predicting the
probabilities going forward.
Q998 Ms Keeble: In this particular case it is not just
that we had the first run on the bank and all that; a
lot of people, a lot of my constituents, could have
lost a lot of money, all their money, so it is
desperately serious. How far down through the
structure did you actually prod to test how viable
these loans were and what this was built on? Not just
general mortgages, specifically these risky loans,
obviously risky because they are sub-prime, and it is
very clear that there was basically pretty much
nothing there?
Mr Bell: I think that is not actually correct. What
you are seeing is a large number of down grades.
Right now we do not know what the ultimate default
will be, but right now the defaults on these pools are
very, very small; they are less than 1% of actual
defaults. Those will almost certainly rise, but to say
of something that was rated triple-A, for example,
was downgraded to double-A or double-A minus
that there is nothing there, in all likelihood those
bonds will be paid out in full.
Q999 Ms Keeble: If you bundle things up and pass
them on and keep on doing that, it is just like pass
the parcel: it keeps on going until somebody blows
the whistle and it stops. What I want to know is how
far down did you go, not just saying they have not
defaulted, the record is good, we have got 30 years
experience. What analysis did you actually do of
what these securities were actually based on?
Mr Drevon: Again, our analysis is really statistically
based because we are looking at very large pools, in
the case of US sub-prime we are looking it more than
40 diVerent pieces of data on each loan to come to a
conclusion, and that helped us to understand the
level of risk in each individual loan and then, based
on that data, make assumptions about the credit risk
of those pools. It is a very serious amount of work,
extremely detailed, and we make available to the
market place the models we use to analyse that type
of risk. We are very transparent about the process.
Q1000 Ms Keeble: When it is peeled oV now, it is
quite clear that there was gross mis-selling, or what
would be deemed to be mis-selling—people could
not repay, they did not have the income, all kinds of
things—so how reliable can your statistical tools
have been? I could understand that if you applied
them to middle income mortgages they might be
very reliable, but sub-prime is diVerent, is it not?
Mr Bell: It is, and that is why our rules for sub-prime
and the way in which we stress them is very diVerent.
We do not stress them at all the way we stress prime
mortgages. Clearly there are lessons that we are
going to have to learn about the US sub-prime.
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Clearly we are looking at what went wrong and how
we could possibly learn from this and how we can
change our criteria, change our tools of analysis. Are
there any items we should be looking at that we did
not look at before? Such crises are always an
opportunity for us to learn.
Q1001 Ms Keeble: I want to ask you in a minute
about the lessons you have learned, but you have
also said repeatedly that your advice functions are
diVerent from your ratings functions and that you
have got diVerent structures, diVerent agencies. You
say that, but everybody else who is coming here (and
obviously we all talk to people informally too) says
there are conflicts of interest: that you advise and
that you rate on the same products. How is
everybody else so mistaken about what you are
doing?
Mr Bell: I cannot answer that. What I can say is that
we have a potential conflict of interest which is
known and managed. We simply do not provide
advice. It is very diYcult for me to say anything more
than that. We do not have advisory functions, we do
not have a consultancy function for structured
finance, our analysts are hired and our company is
hired to rate transactions. We do not have any
advisory contracts.
Q1002 Ms Keeble: Okay. You have sat here, Mr Bell,
and you have talked about the cushion that is
needed, this and that and the other, to get a triple-A
rating. That comes perilously close to saying, if you
do this so we can tick these boxes, you can get a
triple-A rating. You have sat there and said it, and
we will see it when the transcript comes out. How do
you actually make sure that other people do not
listen to you, say “Oh, well, to get the triple-A, I have
to do X, Y and Z and then I will get it, and that is
the model and that is all I need to do”? How do you
safeguard against that?
Mr Bell: All our ratings are done by a committee; all
of our rated transactions and structured finance are
analysed. Because our criteria are transparent and
available to the market and available to investors so
that they can understand how we rate, we are very
conscious that there will be a tendency by investment
bankers and market participants to game our ratings
and, therefore, the rating process is never a
mechanical one. We always look at each transaction
and try to understand and try to see whether or not
anybody has tried to game our criteria.
Q1003 Ms Keeble: Can you say whether, as a result
of this, you have actually tightened up things? Do
you actually sit on doing the final assessment or do
you have a completely arms-length group of people
who get all the data, a bit like the MPC, I suppose,
and look at it all and then think, “Right”?
Mr Bell: DiVerent from whom? Because we do not
have an advisory function.
Q1004 Ms Keeble: You have sat here and described
how we could go about—. You have described
briefly some of the things that are needed to get a
triple-A rating. Do you actually take decisions on
the ratings that people get or do you have some
people who will assess a product, do all the reports
and then a separate group of people who take the
decisions on what ratings they should get?
Mr Bell: The latter. Maybe it is easier if I just explain
the way in which we operate. Our criteria are public
so that market participants know how we apply the
rules. They have provisions so that we can have
diVerent criteria if we feel someone is gaming them,
but basically our criteria is public. The client will
approach us; an analyst will be assigned to a
particular transaction—that is the primary analyst.
Sometimes on big transactions, complex
transactions, there may be two analysts. They will
gather the information; they will ask the questions
that they believe they should have obtain answers to
in order to achieve the rating. They will then, once
they have done this, go to a committee and they will
present the conclusions of their work to the
committee. The committee will vote on the rating.
That is how we operate.
Q1005 Ms Keeble: Do the assessors get information
from separate sources or just from the client?
Mr Bell: They will get assessment, they will get
information from all the sources they deem relevant,
so they will get it from the client, they may get it from
the press, they will get it from other market
participants if need be.
Q1006 Ms Keeble: What happens if the client says,
“If I tweak it here or there, will I get a triple-A”?
What do you do then?
Mr Bell: We basically answer the issue of our
criteria. So if a client says, “I thought I had followed
your criteria. I thought I would get a triple-A. I have
not got a triple-A. What is wrong? Why did I not get
a triple-A?” We will give them an answer and say the
criteria had not been followed.
Q1007 Ms Keeble: But before hand, I mean, when
you are doing the assessment?
Mr Bell: This is what I am talking about. When we
are doing the assessment the client will sometimes
come to us and say, “I do not understand; I thought
I had met the criteria”, and we will explain, “No, we
do not believe the criteria has been met”, and then
they will decide whether they want to go ahead with
the transaction or maybe they want to change the
transaction.
Q1008 Ms Keeble: How about the others? How does
what you have described compare with the other
agencies?
Mr Drevon: I think the committee process is
probably somewhat similar. One thing to note which
I think is important is that the reason why we have
transparent methodology being made available to
the market is because we think it is good practice.
We were being accused a few years ago of being
black boxes: a client, an arranger comes to us and
asks us to rate a transaction, we give the rating but
we do not explain the rationale for that rating. We
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
have taken many steps over the last few years, in
fact, to become much more transparent and make
available our criteria to the market place. From a
policy point of view, I think this was the right track
to take.
Q1009 Mr Simon: Going back to the extent to which
you agree or not and why, you started oV by saying
that the ratings that you issue measure diVerent
things, they are not all the same; so S&P measures
default probability, Moody’s measures expected
loss. Then, the next thing you said is that it is not true
that there is an extraordinarily high degree of
agreement between the things that you rate. So far
that would make sense. If you are all measuring
diVerent things it is not surprising that there is not an
extraordinary high degree of agreement, although it
is surprising that there are people in the market
saying that there is an extraordinary high degree of
agreement. Then Mr Taylor told us that the reason
there is an extraordinary high degree of agreement is
that the facts are the same, at which point I am
starting to lose it. The facts are the same, so there is
an extraordinary high degree of agreement, but you
are all measuring diVerent things, so it is not
surprising that there is not an extraordinary high
degree of agreement. If there is an extraordinary
high degree of agreement, what is the point of having
three of you in a normal market where the product
is the same and the price is roughly the same? What
would be the point of having three providers if you
are not in any competition, if you agree about
everything, even though you are measuring
diVerent things?
Mr Madelain: Let me answer the first point, which is
that we are measuring diVerent things. When you
talk about investment rate security, the diVerence
between measuring expected loss and default
probability tends to be very small. The reason it is
very small is because the diVerence is made up by the
expected recovery, eVectively.
Q1010 Mr Simon: What are you adding to the
market by measuring these things diVerently? What
is the point? Why do you not measure the same
thing?
Mr Madelain: Obviously Fitch can comment on
their own practices, but we feel that what is
important for the investor is to actually know the
ultimate recovery, pay-out, eVectively, that he can
expect from the investment he is making.
Q1011 Mr Simon: So you think that is the best way.
You need to measure the loss, not just the
probability of default?
Mr Madelain: That is correct.
Q1012 Mr Simon: And you are Moody’s?
Mr Madelain: Yes.
Q1013 Mr Simon: S&P, you think that is wrong.
You think that you only need to measure the
probability of default?
Mr Taylor: No, I am Fitch. I do not think it is wrong
actually. A lot of this is nuanced, to be honest. For
an investment grade security the impact of recovery
assessment is very limited, because if you are taking
a healthy, strong investment company and saying,
“Let us predict what it is going to look like as it is
about to go down the pan”, there is hardly any
purpose for doing that, there is no value we can add.
We actually do this for our ratings at the lower end
of non-investment grade; we build in the assumption
of recovery. So we are actually doing the same thing,
but we are saying, as you start getting down to the
much riskier levels of assessment, we think it
therefore adds value to talk about recovery
prospects as the risk becomes greater.
Q1014 Mr Simon: So you are only measuring very
slightly diVerent things?
Mr Taylor: In practice, yes.
Q1015 Mr Simon: The facts are the same, and you
are all talking to the same people and using similar
procedures to establish the facts, so it is not
surprising that you all come up with the same
answers all the time, which you obviously do even
though you do not like admitting it. In which case,
going back to the fees that you charge and receive,
if I am a typical participant in this market would I
normally be attempting to have a relationship with
all of you: I pay you all and you all rate me.
Mr Madelain: It depends.
Q1016 Mr Simon: I know that sometimes you
decline to rate. I know that you do not all rate
everybody every time.
Mr Madelain: Exactly, yes.
Q1017 Mr Simon: If I want to make a good
impression, would I not want to be rated by all three
of you?
Mr Hancock: There will be a number of clients who
are rated by all three, there will be a number who are
rated by two and there will be some who are just
rated by one. There is diVerent market practice in
diVerent countries and sectors of the market that we
operate in.
Q1018 Mr Simon: Roughly how would that break
down? Would two be the most common, would
you say?
Mr Hancock: Yes, probably.
Q1019 Mr Simon: Why is that? Speculate a little
from a very informal position as to what I as a
punter gain by being rated by two of you when you
almost never disagree with each other and you are
measuring the same things and the same facts?
Mr Madelain: The point is we can disagree.
Q1020 Mr Simon: I know it is possible.
Mr Madelain: And we can disagree sometimes on
things that are very important—the cut oV point
between investment grade and non-investment
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
grade, for example, or special situations where we
may take a view and other raters may take a very
diVerent view.
Q1021 Mr Simon: We have been hanging this
around the Northern Rock situation. Give us an
example in the Northern Rock situation of such a
nuanced disagreement and the positive impact that
it had?
Mr Madelain: At the moment, I understand—
Q1022 Mr Simon: No, no, I am talking about the run
up to the run on this bank, which none of you sussed
out in advance. To be fair, nobody else noticed it
either and it is obviously not your fault—I am not
saying it is your fault—but give us an example of
how this might have worked in this particular
instance where you rated it in some nuanced
diVerent way and thereby sent a subtle signal to
the market?
Mr Madelain: We had a higher rating for Northern
Rock than Fitch and S&P. We had a double issue
rating on Northern Rock, and the reason we had a
higher rating was because in our rating methodology
we do assign a higher weight to systemic support to
bank ratings.
Q1023 Mr Simon: But that does not really make any
diVerence, does it? It is a diVerent methodology,
everybody knows that, everybody knows what the
methodology is, so unless you are actually going to
be making decisions in a diVerent way, unless you
are going to be forming views diVerently—
Mr Madelain: We formed a view, which was that
eVectively we are rating the bank higher.
Q1024 Mr Simon: That is because you always rate
those higher banks higher than they do, and
everybody knows that, so what is anybody learning
from this?
Mr Hancock: It comes back to the users of ratings
value a variety of opinions. In this case Moody’s
took a diVerent slant on the likelihood of state
intervention in the case of Northern Rock. These are
opinions, there is no right or wrong, and clearly our
users value having a variety of opinions.
Q1025 Mr Simon: Very briefly, Mr Bell, two
hypotheticals. If one of the three of you did not exist,
would it be a big problem for the market? Secondly,
if none of you existed, would it throw the markets
into crisis?
Mr Bell: If one of us did not exist, it would narrow
and reduce the number of opinions that investors
can turn to.
Q1026 Mr Simon: That is called a truism.
Mr Bell: Yes.
Q1027 Mr Simon: If one of you did not exist, there
would be one fewer of you than there are now. I
understand that. I would like a little bit of
interpretation, which is what you do for a living
after all.
Mr Bell: I think the more educated, informed
opinions there are, the more—
Q1028 Mr Simon: So it would be better if there were
ten of you?
Mr Bell: Absolutely.
Q1029 Mr Simon: Good.
Mr Bell: If none of us existed, it depends which
markets you are looking at, but in markets which are
structured finance, which are global markets with
fairly complex instruments, it is diYcult to see how
such markets could meaningfully exist without a
series of independent opinions that looked directly
at the transactions.
Q1030 Mr Simon: Why cannot we just have a
computer model? Everybody knows what these
criteria are. Why can we not just have a programme
and everybody runs it through at their desk?
Mr Madelain: They are available today.
Q1031 Mr Simon: Why do we need you then? Why
do we need to pay you to do that?
Mr Bell: Because the thing about computer models
is they are very inflexible and, therefore, they are
subject to gaming. There are a lot of very highly paid
people in banks whose job it is to try to figure out a
better mouse trap, and if you have an inflexible
model with no human element to actually see how
the model is being gamed, you will get yourself into
a lot of trouble fairly quickly.
Q1032 Mr Simon: I am sorry if I am going on a little
bit, but when I ask, “How come you all agree or you
do not quite agree?”, nobody says, “We disagree
because we have added a little bit of human element
into this, because we made a slightly diVerent
judgment.” The only reason you disagree is, “Oh, we
have got a slightly diVerent criteria”?
Mr Madelain: It is not. It is human judgment. That
is exactly what it is.
Q1033 Mr Simon: You could write that into your
model?
Mr Madelain: No, it is not a model, it is actually a
view we form over time for bank ratings. We assign
a higher element.
Q1034 Mr Simon: In all cases; in every instance?
Mr Madelain: No.
Q1035 Mr Simon: “In these cases we assign this
rating”—that is not a warm, human, touchy
judgment. You could write it as an algorithm.
Mr Madelain: Well, eventually you can, but how you
came to that conclusion is exactly the image, and
that is what you diVerentiate as.
Q1036 Mr Simon: That is another truism. These are
all human judgments because the algorithms are
written by humans.
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Ev 114 Treasury Committee: Evidence
13 November 2007
Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Mr Bell: Let me give you an example outside of
Northern Rock which I think is useful. Both
Moody’s and us rate structured finance transactions
in emerging markets, including Russia. They are
not, you will be glad to know, rated triple-A.
However, we have formed quite diVerent views
about the nature of the risk of sovereign interference
in Russia on various asset classes and Moody’s view
of their analysts based in Russia, knowing the
market and knowing the Government, about what is
more likely, an interference with a mortgage
transaction or an interference with a consumer loan
transaction, is the exact opposite of ours. We have
our view; they have their view. As a result we rate
those transactions diVerently and we explain why we
rate them diVerently. That is a classic example of the
human subjective element based on our staV in
Russia and their understanding of what is
happening. Moody’s staV in Russia have a diVerent
understanding. I am not saying I believe ours is
better because I am S&P, but I think it is of value to
investors to be able to see those diVerent ratings, to
understand why they are diVerently assigned, to
understand the subjective element behind them and
then, as an investor, to make their own view as to
whether they feel Moody’s is right or whether we
are right.
Q1037 Chairman: You mentioned about value to
investors to see the diVerent ratings. Would you take
it then that some investors can mistake a good credit
rating for a green light to invest?
Mr Bell: My experience of investors over the 20
years that I have been in the structured financial
market is that the spectrum of investors in structured
finance is huge. At one end it is composed of
extremely sophisticated funds that have their own—
Q1038 Chairman: My question is a very simple one,
Mr Bell: do you think that some investors can
mistake a group credit rating for a green light to
invest?
Mr Bell: I think some investors may well have done
that, yes.
Q1039 Chairman: You would all agree on that?
Mr Bell: Yes.
Q1040 Chairman: So the fact that you have all given
roughly a good credit rating to Northern Rock to
investors and they invested on that basis, you would
come back to them and say, “Oh, it is nothing to do
with us because it is only about creditworthiness”?
Mr Madelain: We are very clear in our
communications in what the meaning of the rating
is.
Q1041 Chairman: Back to my point earlier that some
investors would invest and use that as a green light.
As one commentator has said of your defence on
that, whilst some can have sympathy with it, it
reminds him of what the gun manufacturers say after
each mass shooting in the United States, “There is
blood on the floor but it really is not anything to do
with us.”
Mr Hancock: We are certainly aware of these
concerns and issues and we go to great lengths in
trying to educate investors and others on how to
use ratings.
Q1042 Chairman: You have not done very well so
far?
Mr Hancock: By way of example, we have an event
every working day of the year somewhere in Europe,
and part of the eVorts of those events is to get clarity
on these issues. We are investing a huge of amount of
time in trying to invest in the market more generally.
Q1043 Chairman: But after the Northern Rock
situation it does not seem as if there has been much
success here for all three you.
Mr Madelain: I am not sure what is the link, what is
the statement that you made.
Q1044 Chairman: Some investors use your debt
ratings as a green light to invest. They have invested
in Northern Rock and at the end of the day, as Mr
Fallon said, you did not downgrade your ratings
until September, so some people are going to find
themselves on their backside as a result of that and
you are then going to turn round and say, “It is
nothing to do with us, mate”, because this is all to do
with credit risk. But we are here as the interface
between Parliament and the City and the community
and trying to get some handle on the situation, as Mr
Fallon has tried and Mr Siôn has tried, but it is no
use you then turning round to us and saying, “It is
nothing to do with us.” You have got to do
something as a result of this now.
Mr Drevon: On the question of are ratings misused
in a certain way? Again, I think we have done a lot
to try to communicate on that and maybe that is not
enough. We have in fact been looking at providing
more information to investors on other risks. We
have been looking at terms of—
Chairman: I think this Committee, from the evidence
you have given us this morning, would think that
you have really failed hopelessly on that situation
Philip.
Q1045 Mr Dunne: I would like to take us a bit above
the Northern Rock situation to look at the impact of
particularly the new financial structured products
and your relationship with the explosion of issuance.
Could you start by telling us, somebody, a volunteer,
how many triple-A rated sovereign credits there are?
Mr Taylor: It would vary by agency.
Q1046 Mr Dunne: In order of magnitude: one dozen,
one hundred?
Mr Taylor: Thirty maybe, 30, 40.
Q1047 Mr Dunne: How many corporates globally
triple-A rating?
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
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Mr Hancock: A handful.
Q1048 Mr Dunne: Banks?
Mr Hancock: A handful.
Q1049 Mr Dunne: Any?
Mr Hancock: There is the Rabobank in the
Netherlands which remains triple-A rated. It is the
only one in Europe without public support.
Q1050 Mr Dunne: How many structured financial
products are triple-A rated?
Mr Taylor: Thousands.
Q1051 Mr Dunne: Can you give us some idea of the
volume of issuance which is rated by you. I think one
of you, I think Standard and Poor’s, provided us
with a figure of 34 trillion dollars of debt obligations
which are currently rated. Can you give us some idea
of what proportion of that is triple-A rated?
Mr Bell: Totally or just structured finance?
Q1052 Mr Dunne: That you look after, that you rate.
What proportion is triple-A?
Mr Bell: I genuinely do not have that number. I
would say 50 to 60%.
Mr Hancock: We can certainly revert to you with
that.
Q1053 Mr Dunne: It would be very helpful if we
could have an analysis, Chairman, by rating
category, by type of issuer, the volumes and the
number of issuers?
Mr Hancock: Certainly.23
Q1054 Mr Dunne: That would be very helpful. How
long has each agency been rating the diVerent types
of structured financial products? I think you
mentioned 30 years.
Mr Bell: About 1976, I think.
Q1055 Mr Dunne: And is that the same for Moody’s
and Fitch?
Mr Drevon: Yes, approximately. It should be the
same thing.
Q1056 Mr Dunne: But that is just for mortgage bank
securities. Mr Bell, as you were saying earlier, there
are some very ingenious minds generating new
products all the time, so can you give us some sense
for the longevity of the historic track record that you
look at when you come to approach a new
instrument and explain how you do that. Perhaps
Moody’s. If somebody comes up with a new
instrument, how do you go about assessing where it
sits within the rating structure?
Mr Drevon: It is in fact very simple. The more
information there is, the more track record there is,
the clearer we have a view of what could be future
performance and we can evolve models around that.
To the extent that there is a new instrument that
23
See Ev
Ev 115
comes in which has virtually no track record, it
would be very diYcult for us to come to a
conclusion.
Q1057 Mr Dunne: Does that mean you do not oVer
rating or you do oVer rating?
Mr Drevon: No, we may decide there is not enough
information or enough data made available to assign
a rating. That is quite possible. It is certainly the case
in some emerging markets, it may be the case for a
new type of asset class, but typically, again, if you
look at some of the large asset classes which have
been discussed, and mortgages, in most markets
there is suYcient data being made available now and
some of the new asset classes, like collateralised debt
obligations, have been around for approximately ten
years now.
Q1058 Mr Dunne: After what point do you start to
issue ratings?
Mr Drevon: There is no specified point in terms of—
Q1059 Mr Dunne: Let us take collateralised debt
obligations, which have been going for ten years.
How long did it take before you started to provide
ratings?
Mr Drevon: Collateralised debt obligations, they
started with the repackaging of corporate debt, so
we had a lot of information on the underlying risk,
which is a corporate debt. So, we could have
assigned these instruments very rapidly, again, on
the basis of the underlying data. I think we have to
look at what also goes in the structured fund’s
instrument.
Q1060 Mr Dunne: That is a good line. How carefully
do you look at what is going into the individual
products as they are evaluated? Let us look at a
complicated one. How about a first default basket?
How closely do you get into what comprises the first
default basket?
Mr Drevon: The analysis would be on each
individual instrument that goes into that
transaction, and we would take a view on what is the
likelihood of default of that specific instrument,
what is the correlation between those diVerent
instruments, model that and come to a conclusion.
Q1061 Mr Dunne: If we take something else, a CDO
square, which is new expression to me, that
essentially is a CDO vehicle investing in pools and
tranches of other CDO instruments?
Mr Drevon: That is correct.
Q1062 Mr Dunne: Do you go down to the
underlying individual asset across a pool?
Mr Drevon: That is correct, yes. We do what we call
a “look-through”, so we go, in fact, not at the first
level, but we go for the underlying assets, which is
the corporate risk.
Q1063 Mr Dunne: Is the issuer able to provide access
to the underlying data in every case?
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Mr Drevon: In most cases the underlying corporate
names are rated; so we use the rating information.
Q1064 Mr Dunne: Let us suppose we are not dealing
with corporate names, we are dealing with packages
of securities which do not have to issue accounts and
do not have to issue public statements.
Mr Drevon: Typically those instruments would be
rated by us and we would use the rating as an input.
Q1065 Mr Dunne: So you rely on your own rating of
an underlying instrument.
Mr Drevon: That is correct, yes.
Q1066 Mr Dunne: Without necessarily going in to
look at whether that rating is correct or not?
Mr Drevon: No, we believe that our ratings are
correct as a policy for our rating system.
Q1067 Mr Dunne: How frequently do you reassess
ratings of individual instruments? Particularly I am
interested in the financial products rather than the
corporates, which have a natural publication cycle.
Mr Drevon: It is on-going work at Moody’s. The day
we assign the first rating is also the first day we start
monitoring the rating; so there is no specific day in
the year we decide we are going to review the ratings,
it is an on-going review.
Q1068 Mr Dunne: Once a year, once every two years,
once every three years?
Mr Drevon: It really is instrument specific. In some
instruments we will review them every week because
there are very specific events surrounding that
instrument. In some other instruments, take a high
quality sovereign risk, we know that the likelihood
of that changing is going to be lesser, and so the
monitoring is going to be on an annual basis.
Q1069 Mr Dunne: Who monitors the monitors? Is
there any independent assessment of any of your
methodologies? Perhaps I will ask somebody else.
Mr Bell, you are nodding.
Mr Bell: The independent assessment is basically
conducted by the investors. Our criteria are public.
Therefore, it can be conducted by anyone who
wishes: the regulators, CESR, the investors.
Q1070 Mr Dunne: Do any investors in your
experience ever analyse your methodology, other
than in relation to questioning your decision? Do
they go back to first principles? Do they ask for all
of your data to cross-check with their own models—
Mr Bell: Yes.
Q1071 Mr Dunne: —in relation to that instrument.
Mr Bell: Certainly in Europe I have come across a
number of investors. Also we do do exactly that. If
the information that we have received suggests that
we should change our criteria, we will often request
a comment from the investors. We sometimes get
quite vociferous comments for or against any
proposed change, so is there an on-going debate with
the investor community.
Mr Hancock: I would just add, it is exactly the same
on the corporate and government side. We have an
enormous number of phone calls from investors and
other interested parties questioning our opinions
every day and, as a matter of policy, we put the
names and phone numbers of the analysts on each
piece to encourage that.
Q1072 Mr Dunne: Do you publish your
methodology in relation to individual instruments
and your model? Can somebody actually come in
and look at your model?
Mr Bell: Yes. In CDOs, for example, our model is
available for free on the website. I believe that is the
case for the other agencies.
Q1073 Mr Dunne: Do any regulators overlook your
methodologies or models? Do you have discussions
with them at all?
Mr Bell: We have had discussions with regulators
where they have asked questions about our
methodologies.
Q1074 Mr Dunne: Any question of whether it is
valid, or was it more to do with the conclusions that
you have come to for a particular instrument that
they are interested in?
Mr Drevon: I believe the regulators have been
looking more at the conclusion than the
methodology itself.
Mr Taylor: The experience that I have had is just
that they are trying to understand how we look at
things, how the process works.
Q1075 Mr Dunne: So they are looking ultimately at
how you arrive at the outcome, but they are not
seeking to question whether the methodology itself
is correct or appropriate?
Mr Taylor: Correct.
Q1076 Mr Dunne: Can you explain why it is that
diVerent credits with the same rating have such
widely diVerent spreads in the market place? To give
you an example which was given to me the other day,
if you take an emerging market, Peru 2016, which is
trading this spring at 96 basis points above the
relevant US treasury and you compare that with a
US corporate dollar bond, say General Motors,
2031, which had a 250 basis point spread over
Treasury, whereas a foreign corporate dollar bond,
KazCommerce Bank 2013 had a 263 basis point
spread, that is a significant diVerence, all of which
have got a double-B plus rating, I think it was from
Moody’s in that case, so perhaps Moody’s can
answer. Why is it that the spread is so significant if
the rating is the same?
Mr Madelain: I think the spread speaks to more than
just credit risk but also to the liquidity of the
instruments, and there may be also some diversions
of view between our perspective on the credit risk as
a suitable security and the general consensus of the
market.
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Q1077 Mr Dunne: So the credit rating is not a guide
to an investor as to the performance of the
underlying instrument, it is merely a guide as to
whether it is going to repay at the end of its maturity.
Mr Madelain: If you define performance as return,
that is correct.
Q1078 Mr Dunne: What about the default rate of
diVerent types of instruments? What has the
experience been of that?
Mr Drevon: We published a very significant amount
of statistics looking at the performance of our
ratings, and if you look over long periods of time,
particularly 15 years or more, the performance of
structured finance ratings, in fact, are in line with the
performance of other bonds, such as corporate
bonds.
Q1079 Mr Dunne: That is interesting, because there
was an article in the FT in August that suggested
that actually the performance of CDOs was ten
times riskier than corporate bonds, and that was
from a Moody’s study?
Mr Drevon: I think you always have the possibility
to drill down and say, if we look for a period of six
months at a specific asset category and specific rating
level, there will be diVerences—that is absolutely
normal—but the work we do is based on long-term
statistical data and when we look over the long-term
horizons, there is a high degree of convergence in
terms of the performance of the ratings on the
structured final side and the corporate side.
Q1080 Mr Dunne: If I can quote to you from this
article, it comes from a Bloomberg’s market report
in July which said that corporate bonds rated BAA,
the lowest Moody’s investment grade rating, had
now reached 2.2% default rate over five-year periods
from 1983 to 2005, according to Moody’s, but from
1993 to 2005 CDOs, which have only been going that
long, with the same BAA grade, suVered five-year
default rates of 24%. Are you going to suggest that
that CDOs have much higher default rate with the
same rating than corporate bonds over their life?
Mr Drevon: No, it does that in general. It does it in
specific rating levels, and I think you commented on
one rating level for a specific horizon, but even
within the CDO categories there are a number of
diVerent types which will have diVerent
performances.
Q1081 Mr Dunne: Can we turn for a moment then to
how you decide at a certain point that credit is
deteriorating? We have touched on what happened
in Northern Rock, where you did not decide it was
deteriorating until the Bank of England had stepped
in. Is it the case that you tend to reduce grades of
debt that you see heading towards default shortly
before the final default in order to improve these
performance statistics that we have just been
talking about?
Mr Hancock: Certainly not. Indeed, the way the
statistics are actually published, you can look
through that, so the investor is quite able to look at
what the rating was one year, two years, five years
before the default, so there is absolutely zero
incentive to do that, and it will be seen through by
the users, who have access to all of this information.
Mr Madelain: I think what is important to note is the
performance of the rating. There is a very high
degree of transparency about that. I think all
agencies publish a huge volume of statistics, either at
the aggregate level or at the asset class level, actually
tracking the performance of our ratings. So, it is
certainly an area where transparency is very high.
Q1082 Mr Dunne: Have you read Peter Warburton’s
report? This is language which you may disagree
with, I expect. It says, “The final trick that rating
agencies pull is to post-validate their assignment of
a rating by making sure that very few bonds actually
default from a high rating. Hence, by heavily
downgrading a nearly bust bond a few weeks before
its final demise, the agencies can claim that it
defaulted as a C-rated bond rather than a DD-rated
bond which it was when the bad news hit?
Mr Hancock: Can I just reinforce that the user of all
our ratings has all of the data available to identify if
that behaviour is prominent.
Mr Bell: I would also say, if you look, for example,
at the table that we include in our submission of the
default rates in the US RMBS, they are from initial
rating not from final rating.
Q1083 Mr Dunne: I think your best defence to that
charge actually is what happened with Northern
Rock, because you failed to downgrade them and
perhaps you should have seen the warning signs a bit
earlier. A couple more questions, if I may,
Chairman. One is in relation to the information that
is available to you as a rating agency in the US
compared to Europe. You routinely receive
information not generally available to the public
markets from issuers, but in the US information on
underlying collateral is generally available to
investors, whereas it is not in Europe, and a charge
has been made that during the summer crisis prices
of securities began to show investors perceiving risk
well ahead of the rating agencies in the US. That did
not happen in Europe because the information was
not available. Would anybody like to comment on
that?
Mr Taylor: I do not think we have any problem at
all with greater transparency in the markets. We
have no problem whatsoever with the market seeing
absolutely what data we get.
Q1084 Mr Dunne: You would be quite happy to see
information made available to investors in Europe
in the same way as it is in the US? That does not
happen at the moment.
Mr Bell: Yes, absolutely, in fact we welcome it and
we have been, in some cases, urging, particularly in
this crisis, our clients to make that information
available, because we think it is good for the market
that it should be available.
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Q1085 Mr Dunne: Do you see any parallels with
what is happening in the US banking sector: losses
being generated by investors, particularly in these
CDOs, between other market failures such as the
Lloyd’s insurance market? If you take the example
of the Piper Alpha loss of one billion dollars,
because the way the reinsurance arrangements
worked, that translated into a 16 billion dollar
Lloyd’s reinsurance loss. Do you see investment in
CDOs by CDO funds as creating a spiral in a similar
way to that, or potential risk of a spiral?
Mr Bell: I think you need to distinguish between a
credit loss and a mark to market loss. The credit risk
never disappears, but neither is it necessarily
magnified by being repackaged, it is just moved
around. In terms of credit losses, the credit losses
suVered so far in the global market as a result of the
events of the summer have been actually very small.
The losses you are looking at which are being
announced by all the banks are mark to market
losses. Undoubtedly, if you have many transactions,
including in this synthetic area, then you have much
greater value of issues out there, and on a mark to
market basis you clearly have a greater chance that
the losses will be magnified. In terms of credit losses,
there is no magnification because the loss does not
get magnified as it gets moved around.
Q1086 Mr Dunne: Until somebody defaults, and
then it does get magnified.
Mr Bell: Sure, but there is no magnification. The
ultimate default, the borrower in the sub-prime who
borrowed 25,000 or 100,000 dollars, can only default
to the 100,000 dollar tune even if that loss has been
repackaged in an RMBS or a CDO. It has been
moved around, but he cannot default more than
100,000 dollars. The losses that you are now
witnessing in the system are mark to market losses as
these securities’ values have been marked down, and
I think this is one thing that is worth bearing in mind.
In terms of the magnitude of those mark-downs, we,
for example, looked at one triple-A prime UK
RMBS bond that traded at 80 cents in the dollar or
80 pence in the pound. That loss, taking into account
the credit enhancement already in the bond,
assumed that the person who sold it at 80 pence in
the pound was selling it on the assumption that in a
UK prime residential mortgage backed security 80%
of the pool would default and the price of properties
in the UK would fall by 40%. I do not think that on
any valuation theory, other than Armageddon,
anybody believes that eight out of ten UK borrowers
are going to default on their mortgage and the price
of houses in the UK is going to fall by half. What you
are seeing in the market today, all those enormous
mark to market losses, does not reflect credit
deterioration, they also reflect a clear element of
panic.
Q1087 Mr Dunne: Are any of you considering
liquidity and introducing a measure of liquidity as
part of your rating methodology?
Mr Prescott: We are setting up a working party to
look at liquidity in financial institutions.
Mr Hancock: It is certainly something we will be
looking at.
Q1088 Chairman: Why do you need a working party
in the light of Northern Rock? Why do you not just
go ahead and ensure that you assess liquidity? For
God’s sake, you have all given Northern Rock a
really good rating, the disaster happened and now
you are saying, “We are going to set up a working
party because we never assessed liquidity.” Why do
you not just say here and now you are going to assess
liquidity?
Mr Hancock: Certainly within the rating of
Northern Rock we did assess liquidity. Now clearly
our assessment of liquidity did not withstand the
repercussions—
Q1089 Chairman: So they failed.
Mr Hancock: I think what Philip was referring to—
tell me if I am wrong—was some sort of separate
indicator for liquidity in addition to the probability
of loss indicators.
Q1090 Mr Dunne: My question is how do you do
that if you are not participating in the market?
Mr Taylor: We are looking at it. We are
investigating it because market participants are
asking if we can provide that kind of service. We will
investigate and do the best we can to look into it and
see if we can put something together. Maybe we need
to buy in new expertise, new tools and new data.
There is no guarantee we can come up with that kind
of product, but it is work in progress.
Mr Bell: The decision to do such a process is fairly
easy to take; the creation of such a scale is actually
quite complex.
Chairman: Okay.
Q1091 Jim Cousins: Looking at the events of this
summer and, indeed, the autumn as well, would you
expect a bank approaching the Bank of England’s
credit facility to inform you?
Mr Hancock: We would not be at all surprised if they
did not, given the hugely sensitive nature of that
discussion.
Q1092 Jim Cousins: You seemed to imply earlier
that you would have such an expectation?
Mr Madelain: What I said is that—. I said earlier
that—
Q1093 Jim Cousins: A lot earlier. My memory is
quite good.
Mr Madelain: I said earlier that we were expecting
systemic support to be made available to the bank,
yes.
Q1094 Jim Cousins: No, you said that Northern
Rock had told you that they had approached the
bank.
Mr Madelain: No, I did not say that, or if I said it I
should have—
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Q1095 Jim Cousins: If you did say that—
Mr Madelain: I do not think I meant to say that.
Q1096 Jim Cousins: You did not mean to say it?
Mr Madelain: No.
Q1097 Jim Cousins: Would you expect a bank
approaching the credit facilities of the Bank of
England to tell you?
Mr Prescott: I think they would only do that at the
very last minute.
Q1098 Jim Cousins: They would only do it at the
very last minute?
Mr Prescott: Yes.
Q1099 Jim Cousins: How many banks have in fact
told you that they have approached the credit facility
of the Bank of England? You have just said to this
Committee that you want very high standards of
transparency. I have asked you a rather simple and
obvious question and you are dumbstruck?
Mr Madelain: No, I think the answer to your
question is—
Q1100 Jim Cousins: How many banks have told you
that they have approached the credit facilities of the
Bank of England?
Mr Hancock: I think, certainly from S&P’s point
of view—
Q1101 Jim Cousins: How many banks have
approached S&P’s to tell you that they have
approached the credit facilities of the Bank of
England?
Mr Hancock: I think that would have to be
something, if we even have the information, that
would have to remain confidential, given the sheer
sensitivity and confidential sensitive nature of
banking.
Q1102 Jim Cousins: Do you take the same view,
Moody’s?
Mr Madelain: We also take the same view.
Q1103 Jim Cousins: You would say the same thing
to the French Finance Minister, would you?
Mr Madelain: I am not sure I understand your
question.
Q1104 Jim Cousins: Christine Lagarde, do you tell
her that it would be confidential if a bank told you
that they had approached the credit facilities of the
Bank of England? You would tell her that too?
Mr Madelain: We would, yes.
Q1105 Jim Cousins: A brave man. You do see the
point I am making. If such a simple and obvious
point as the one I am putting to you is lost in these
mysteries so that you neither know whether some
bank has approached you to approach the credit
facilities of the Bank of England, nor would you tell
us if they had, means that, frankly, the public cannot
have a lot of confidence in anything you say or do,
can they?
Mr Hancock: I think certainly information that we
are hearing on a confidential basis and retained
confidential within the rating agency, we
incorporate into our rating opinions, but we do not
necessarily disclose that information on behalf of
the client.
Q1106 Jim Cousins: But if you want a high level of
transparency and you are very happy and you are
very welcoming of all the eVorts that are going on in
the United States to increase that, why are you
telling us that you neither know, nor would you tell,
if a bank approached the credit facilities of the Bank
of England when it is an obvious, important
contribution to the markets?
Mr Bell: We are bound by confidentiality with our
clients and of course follow the code of conduct.
Q1107 Jim Cousins: If you are bound by
confidentiality then all your ratings are suspect?
Mr Taylor: I do not agree with that. One of the
guiding principles of the IOSCO Code of Conduct
that was applied to us was how we treat confidential
information and how we keep that information to
ourselves. So, in complying with the IOSCO Code of
Conduct, we would not be able to answer the
question on a specific-name basis. We answered it by
saying nobody has approached us, we have not had
any information that that happened, so we have
answered your question, but if it was confidential
information we could not do it.
Q1108 Jim Cousins: In your case nobody has told
you that.
Mr Prescott: Yes.
Q1109 Jim Cousins: What is the case with the
other two?
Mr Madelain: I would make two comments.
Q1110 Jim Cousins: We have actually been told noone has approached them. Has no-one approached
Moody’s?
Mr Madelain: I cannot make such a comment.
Q1111 Jim Cousins: So we do not know whether
anyone has approached you?
Mr Madelain: What I can tell you is two things.
Q1112 Jim Cousins: Fitch are willing to tell us that
no-one has approached them; you are not willing to
tell us that no-one has approached the credit
facilities of the Bank of England?
Mr Madelain: It is not that I am not willing. I am not
informed in a way that I can tell you that.
Q1113 Jim Cousins: You would not come to this
Committee today and not know whether a bank had
approached the credit facilities of the Bank of
England and they had told you.
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Mr Madelain: I believe it will be the responsibility of
the Bank to communicate that.
Q1114 Jim Cousins: What is all this stuV about
transparency and “we welcome it” and “we want
more of it”, when I ask you a very simple question
and total confusion and mystery comes?
Mr Hancock: I would repeat what Fitch said, that
we operate the IOSCO Code of Conduct, and that is
very specific on what we can say and cannot say in
terms of confidential information.
Q1115 Jim Cousins: If your code of conduct prevents
you from telling the market such a simple and
obvious issue about whether a bank has approached
the Bank of England credit facility (and I have not
asked you who, I have just said how many and you
are not willing to say), then I do not think your
ratings are worth anything?
Mr Madelain: Our ratings will reflect that
information.
Q1116 Jim Cousins: If you had had such
information, it would be reflected in the ratings?
Mr Hancock: We reflect all relevant information
that we have in our ratings, even if we do not disclose
confidential information.
Q1117 Jim Cousins: But you are not willing to tell
the Committee whether a bank has approached you
to tell you that?
Mr Hancock: Correct.
Q1118 Jim Cousins: You are not willing to tell the
Committee whether you would expect a bank to
approach you and tell you?
Mr Hancock: I think, as I said in the earlier
question—
Q1119 Jim Cousins: Would you expect a bank to tell
you that?
Mr Hancock: I would not be shocked if they did not,
given the nature—
Q1120 Jim Cousins: In that case, how can you tell us
it is reflected in your ratings?
Mr Madelain: The rating reflects information that is
made available to us.
Q1121 Chairman: Let us move on. As a general rule,
can we say that rating agencies do not change a
rating until something happens? In other words, you
use historical data.
Mr Hancock: I am sorry, could you repeat that? We
could not hear.
Q1122 Chairman: Rating agencies do not change a
rating until something happens; in other words you
use historical data to assess the ratings.
Mr Hancock: No, not necessarily so. We certainly
have our opinions about the future and we
incorporate our opinions for the future into our
ratings. They are forward-looking instruments.
Q1123 Chairman: Some submissions have indicated
to us that the credit ratings side of your business has
quite a high margin, something like 50%. What
margins does the credit rating side of your business
have?
Mr Taylor: I do not actually have—. It is a disclosed
number in our public accounts. I am more than
willing to provide it to you.
Q1124 Chairman: Roughly.
Mr Taylor: It is certainly less than 50%. We have a
diVerent business model, perhaps, to our
competitors.
Mr Drevon: Approximately 50%.
Mr Bell: Unfortunately, diVerent from the other
ratings agencies. Standard and Poor’s is part of
McGraw Hill, which is a listed US corporation, and
unfortunately McGraw Hill does not break out that
number, so under US securities laws I am informed
that I am not at liberty to disclose that information.
Q1125 Chairman: So if I wrote to you, could I get
that information: the credit business side of your
business?
Mr Bell: The McGraw Hill Corporation, if it were to
disclose that number, would have to do it in
accordance with the regulation FD on selective
disclosures. I am not an expert in American
securities law.
Q1126 Chairman: Moody’s you are 50%? That is the
only answer we have got.
Mr Drevon: Approximately, yes.
Q1127 Chairman: Okay. On Basle II you heard
Professor Buiter saying that no-one any longer trusts
the
rating
agencies’
judgment
of
the
creditworthiness of complex structured instruments
and, therefore, that puts a huge hole in Pillar 1. Do
you agree with that?
Mr Drevon: No, we do not. There is no, I think,
proof that investors have lost confidence in rating
agencies. In fact, over the summer we have done a
number of outreaches to investors, including very
large conference call conferences, and there is still a
large degree of interest from the investor community
on our opinion about credit risk. On Basle II,
perhaps I can refer to our earlier comment, which is
that we are not in favour of using ratings in
regulations.
Q1128 Chairman: You are all aggressively now
related with downgrading mortgage-linked
securities. I think it is because of that that Professor
Buiter has made his comment. It seems that it is a
legitimate comment that he has made.
Mr Bell: I think it is a legitimate comment, but I
would echo the words of my friends from Moody’s,
which is that during our interaction in Europe with
investors, what we have found is that there is a sense
that, yes, the ratings in the US sub-prime did not go
the way they were expected to go, but that has not
led them to lack confidence in all our work in
structured finance. Equally, with Basle I, as
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Ev 121
Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
and Mr Barry Hancock
Moody’s have always said, we were not in favour of
being incorporated in Basle I, we did not think it was
appropriate.
Q1129 Chairman: At the moment, in terms of
complex structured products and the downgrading
you have, do you think you still have the confidence
of the market in terms of your judgment of
creditworthiness of these structured instruments?
Mr Bell: I think that the market, quite legitimately,
is asking questions which I think it is incumbent
upon us to answer.
Q1130 Chairman: So it does not have full confidence
in you?
Mr Bell: I think the market is diverse. I think some
people continue to have trust in us.
Q1131 Chairman: Largely speaking—we are
addressing the generalities—you think that the
market does not have full confidence in you at the
moment?
Mr Bell: The market is not one single entity;
therefore it is not a binary answer.
Q1132 Chairman: But a large part of the market does
not have full confidence in you. Is that right,
Moody’s?
Mr Drevon: No, in fact if the market did not have
confidence or was not interested in ratings, it would
ignore completely our downgrades. It has been the
opposite. The downgrades have a significant impact
on the market and therefore—
Q1133 Chairman: You are keeping this whole
confidence in the market. You are coming here and
telling us that?
Mr Drevon: Again, I think the proof will be in the
future.
Q1134 Chairman: I am really asking you for the
present. We get lots of submissions into the
Committee, and the reason I am putting that
comment to you is that most people put that to me,
and that is why I am putting it to you. Fitch, do you
have the confidence of the market?
Mr Taylor: Actually I think we do. A comment I
made earlier was that investors had not been focused
on credit over the last couple of years. Sub-prime is
a very specific situation. It is about 3% of the credit
market, to keep it in perspective. Do you want me to
answer the question?
Q1135 Chairman: Of course?
Mr Taylor: So investors have not been focused on
credit. I think in the last few months they have
refocused massively on credit. We have never been
busier in terms of dealing with investor inquiries,
investor discussions, so I absolutely think they still
see value in what we do. It would be completely
arrogant to say we cannot learn lessons from what
has been going on, but I do think investors continue
to value the core product of what a rating is.
Q1136 Chairman: I would suggest maybe to people
in the market that could come across this that there
is a hint of arrogance in that answer, but there we
are. The Bank of England Financial Stability
Report, October 2007, says that it is unclear whether
the ultimate bearers of risk have suYcient
information of an underlying credit risk in the
product, in particular, the more complex instrument
in which they invest, and investors may have become
over-dependent on rating agencies’ assessments of
risk and also could have misinterpreted ratings,
assuming that they provide information on a range
of risk, such as liquidity and market risk in addition
to credit risk. Do you agree with the Bank of
England’s statement there?
Mr Bell: We have always been very clear as to the
nature of our ratings.
Q1137 Chairman: I am asking the question: do you
agree with the Bank of England’s statement here?
Mr Bell: We believe that certainly some investors—.
We do not believe that the investors misunderstood
the rating, i.e. we do not think that investors actually
believe that a rating was trying to encapsulate a price
or liquidity component. However, we think that, in
the absence of any other indicators, undoubtedly a
number of investors used the rating as a proxy for
liquidity or pricing components.
Q1138 Chairman: So the Bank of England are on to
something here then.
Mr Bell: I think, yes, but I do not think it is a
misunderstanding of the rating. I think this is “we
used the rating for another purpose because we did
not have the other tools, so we thought this was as
close as we could get”.
Q1139 Chairman: Do you disagree when the Bank of
England say that investors may have become overdependent on the ratings agencies’ assessment of
risk?
Mr Bell: That is entirely possible. We have never
advocated that investors should buy—
Q1140 Chairman: What about Europe when you
look at the Bank of England?
Mr Drevon: With respect to the last point, yes, I
think we agree that it is quite possible that some
investors took the rating as a proxy for the risks. We
do not disagree with that.
Q1141 Chairman: Fitch?
Mr Taylor: I agree. It is a valid point.
Q1142 Chairman: The Bank of England has some
suggestions for improvement in the Financial
Stability Report, saying that it is in the rating
agencies’ best interests that investors have a good
understanding of what ratings mean, and to that
end, for example, agencies could publish expected
loss distributions of structured products to illustrate
the tail risks round them. Would you agree that is
worth taking up?
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Mr Paul Taylor, Mr Charles Prescott, Mr Michel Madelain, Mr Frédéric Drevon, Mr Ian Bell
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Mr Drevon: I think it is something that we would be
ready to provide and we do provide in some cases.
The problem is that the market also is looking for
simple messages. If we start providing complex
answers, very statistically based, I am not sure it will
necessarily respond to the investor needs.
Q1143 Chairman: Okay. The second one: agencies
could provide a summary of information provided
by originators of structured products. Information
on the extent of originators’ and arrangers’ retained
economic interest in a product’s performance could
also be included, and that may satisfy investors that
incentives were well aligned or encourage investors
to perform more thorough risk assessments. Do you
agree with that?
Mr Taylor: I think it is a call for the originator of the
transaction, as opposed to us. What information is
sent out to the market is really a function of the
person originating that transaction. It is a
confidential information issue again. We would be
happy to see it.
Q1144 Chairman: Agencies could provide explicit
probability ranges for their scores on probability of
default, and that would provide a measure of the
uncertainty surrounding their ratings.
Mr Bell: It is an interesting idea. I think the problem
is that, expressing an opinion about the future
likelihood of default, if you try to encapsulate it in a
two decimal point percentage, it is probably
providing spurious scientific fact.
Q1145 Chairman: Agencies could adopt the same
scoring definitions. Converging in a single measure
would reduce the risk of misinterpretation by
investors.
Mr Bell: We take the view that there is benefit in
having diVerent agencies trying to encapsulate
diVerent kind of risks because it provides a greater
spectrum.
Q1146 Chairman: So you do not agree with a
single scoring?
Mr Bell: No.
Q1147 Chairman: You do not agree?
Mr Bell: We do not think that it will help investors.
Q1148 Chairman: Rating agencies could score
instruments on dimensions other than credit risk.
Possible additional categories include market
liquidity, rating stability over time or certainty with
a rating that is made?
Mr Drevon: Possibly. We are looking into that. We
are not sure if everything is feasible.
Chairman: Those are suggestions from the Bank of
England and I would suggest, given that they are
from the Bank of England, the rating agencies
should take this seriously and maybe, rather than set
up a working party, come back with your views to
this Committee on these suggestions from the Bank
of England, and we will let you do that, so that we
have that information in public as a result of your
submission. That is all. Thank you for your evidence
this morning.
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Treasury Committee: Evidence
Ev 123
Tuesday 4 December 2007
Members present
Rt Hon John McFall, in the Chair
Nick Ainger
Mr Graham Brady
Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Mr Andrew Love
Mr George Mudie
John Thurso
Mr Mark Todd
Peter Viggers
Witnesses: Mr E Gerald Corrigan, Managing Director and co-Chair of the Firmwide Risk Management
Committee, Goldman Sachs; Lord Charles Aldington, Chairman, Deutsche Bank, London Branch; Mr
Jeremy Palmer, Chairman and CEO, Europe, Middle East and Africa, UBS; and Mr William Mills,
Chairman and Chief Executive of City Markets and Banking, Europe, Middle East and Africa, Citigroup,
gave evidence.
Q1149 Chairman: Good morning and welcome to
the Treasury Committee’s inquiry into financial
stability and transparency following the Northern
Rock situation. For the record, will you please
introduce yourselves?
Mr Mills: Mr Chairman, my name is William Mills,
I am the Chairman and Chief Executive of City
Markets and Banking for Europe, the Middle East
and Africa.
Lord Aldington: I am Charles Aldington, Chairman
of Deutsche Bank in this country. I should also say
to the Committee that I do not sit in the House of
Lords.
Mr Corrigan: I am Gerald Corrigan, Managing
Director at Goldman Sachs in New York.
Mr Palmer: I am Jeremy Palmer from UBS.
Q1150 Chairman: Do you agree with the recent
comments of Peer Steinbrück, the German Minister
of Finance, that the snooty attitude of bankers who
believed they were cleverer than everyone else is
largely to blame for the credit crisis?
Lord Aldington: Mr Steinbrück’s comments were
made in the context of what has been happening
recently in Germany.
Q1151 Chairman: He spoke about the global crisis.
Lord Aldington: Yes. I am sure that it was intended
largely for a domestic audience. The developments
which we have seen over the past few months are the
result of things that have happened in the economy
over the past few years and are not the fault of
bankers.
Q1152 Chairman: You are as pure as driven snow?
Mr Corrigan: I think that as a general matter
bankers should conduct themselves with a legitimate
element of humility. While I do not want to associate
myself with the particular remark to which you refer,
I think humility should be a central part of the way
we approach our business.
Q1153 Chairman: The Governor of the Bank of
England said you had developed a range of
increasingly opaque and complex financial
instruments. That means investors while searching
for ever higher yields lose sight of the risks involved.
Mr Palmer, do you agree with the governor?
Mr Palmer: Over the past few years, as is now well
known, we have lived through a period of stability
and low interest rates which has led investors to
search for high yield. That search is often quite
legitimate. Institutions have their own clients and
liabilities in the form of pension fund-holders or
policy-holders and as intermediaries the banking
sector has sought to satisfy that demand, and the
housing market in the US provided opportunities to
do so.
Q1154 Chairman: Is that your answer?
Mr Palmer: Yes.
Q1155 Chairman: If I may start again, do you agree
with the Governor that you have developed a range
of increasingly opaque and complex financial
instruments that mean investors while searching for
every higher yields lose sight of the risks involved?
Mr Palmer: I believe that in all cases the investors
were sophisticated and given all the information
they required.
Q1156 Chairman: Therefore, you do not have
opaque and complex financial instruments?
Mr Palmer: Complexity is a fact of life and it has
resulted from people searching to satisfy their
particular needs.
Q1157 Chairman: Therefore, you have not lost sight
of the risks involved?
Mr Palmer: The information that was available was
considered at the time to be normal.
Q1158 Chairman: Mr Mills, has Citigroup lost sight
of the risks involved?
Mr Mills: Mr Chairman, I would just emphasise that
the end-buyers of these complex instruments were
sophisticated institutions that were provided the
opportunity to review all of the structures and all the
documents associated with them. I think as it relates
to losing sight of the risk, with the benefit of
hindsight there were some stress scenarios that
maybe should have been reviewed further.
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
Q1159 Chairman: Citigroup has lost reportedly
between $8 billion and $11 billion. The former chief
executive, Chuck Prince, said, “We have to keep on
dancing.” Are you keeping dancing? In other words,
you just keep going in the market and when the
music stops you will see where everything falls out?
Mr Mills: Mr Chairman, I believe that our former
chairman’s comments were in relation to leveraged
finance and in relation to the . . .
Q1160 Chairman: They were in relation to risk. He
kept dancing. Has Citigroup now stopped dancing?
Mr Mills: Sir, as you mentioned, we have taken our
fair share of losses on this.
Q1161 Chairman: You all come before us. Citigroup
lost between $8 billion and $11 billion. UBS has lost
$3.6 billion in subprime-related loss. Deutsche
Bank, the City-based investment arm, recorded a
pre-tax loss of $179 million. Pre-taxed earnings are
down by 19% to ƒ1.4 billion. Goldman Sachs’
flagship hedge fund fell by 12%. The BBC reported
that its losses caused by the subprime ran to about
£112 billion. I asked you about the comments of the
Bank of England. Have you lost sight of the risks
involved? It seems here as if you are flying in the face
of reality. You have not lost sight of the risks
involved and everything that you are doing is
somebody else’s fault.
Mr Corrigan: Let me take a stab at that. There is no
question that over recent years the inner workings of
the financial system have become enormously more
complicated and complex.
Q1162 Chairman: We are getting somewhere, Mr
Corrigan.
Mr Corrigan: In addition to that, the structure of the
system has tightened further the linkages between
markets and institutions. I think it is incumbent
upon all of us, whether we are in the private or
oYcial sector, to spare no eVort in seeking to master
our understanding of this highly complex
environment. Unfortunately, I think it is also
inevitable—it is a trait of human nature—that when
markets are strong and ebullient there is a natural
aversion to be, as we say, the last one into the market
or the first one out of it. That is a fact of life,
unpleasant as it may be.
Q1163 Chairman: Nobody wants to get caught with
their pants down because, according to Citigroup,
you are all dancing, but at the end of the day all of
you get caught with your pants down?
Mr Corrigan: I do not want to associate myself with
comments about dancing.
Q1164 Chairman: A split already!
Mr Corrigan: But I think we need to recognise that
there is here a basic element of human nature.
Q1165 Chairman: In other words, the herd
mentality?
Mr Corrigan: That is correct.
Q1166 Chairman: I come back to the complex
products. Last week we had before us Professor
Buiter, a former member of the MPC and a
distinguished economist at the London School of
Economics. He said of the process of securitisation
that “by the time you get to the ultimate investor,
who is six transactions or more away from the
originator of the loan, neither the buyer nor the
seller has any ideas as to the underlying risk
characteristics of the security they are buying. That
gets worse when securitised mortgage loans get
packaged with credit card receivables, the square
root of car loans and whatever else. The structure
they have put together became so complex they
probably were not even understood by their
designers.” Do you recognise that sentiment and, if
so, do you have some empathy with it?
Mr Corrigan: Speaking for myself, I certainly do.
Q1167 Chairman: Mr Palmer, do you agree with that
sentiment?
Mr Palmer: Things have undoubtedly become more
complex.
Q1168 Chairman: Do you have empathy with that
sentiment, Lord Aldington?
Lord Aldington: I certainly recognise that sentiment.
Q1169 Chairman: Mr Mills, do you have empathy
with that sentiment?
Mr Mills: I do recognise the complexities, Sir.
Q1170 Chairman: We have heard of CDOs-squared
and CDOs-cubed. Lord Aldington, can you explain
to me what a CDO-squared or CDO-cubed is?
Lord Aldington: I have not come before this
Committee as an expert on CDOs.
Q1171 Chairman: But your organisation is involved
in collateralised debt obligations?
Lord Aldington: That is true. My organisation is
involved in a very broad range of products and I
would not claim to be an expert on all of them.
Q1172 Chairman: You cannot tell me what a CDOsquared is? Can anybody tell me what it is?
Mr Palmer: A CDO-squared is a derivative structure
designed to give investors exposure to a CDO.
Q1173 Chairman: Mr Corrigan, can you try to
explain it to us in simple language?
Mr Corrigan: I think the easiest way to understand
what a CDO-squared is to start with what a CDO is.
If I were to take the example of mortgage-backed
securities, institutions package up a family of
individual mortgages into what is a fairly plain
vanilla mortgage-backed facility. I think it is entirely
fair to say that when those mortgage-backed
securities are issued the disclosures associated with
the issuance of those instruments are quite
wholesome.
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
Q1174 Chairman: What does “wholesome” mean?
Mr Corrigan: A CDO carves out of a plain vanilla
mortgage-backed security certain credit tranches of
that security and reformulates them in what is called
a structured credit product into a particular class of
credit standards aVecting those particular
mortgages, not the full pool of mortgages. That is
called a CDO. When you take a CDO and then roll
it into a second CDO that is called a CDO-squared;
in other words, it is a CDO made up of other CDOs.
Q1175 Chairman: If you put in another one it is
a CDO-cubed?
Mr Corrigan: Thank God, we have not got that far
yet.
Q1176 Chairman: At the end of the day it is
becoming more complex and opaque, is it not?
Mr Corrigan: It is certainly complex.
Q1177 Chairman: Professor Buiter cannot
understand it. If Lord Aldington cannot explain
what a CDO-squared is what does that mean for
ordinary people?
Mr Corrigan: With all due respect, it is important to
recognise, as I am sure you do, that the CDO
product, much less CDO-squared, is clearly one that
is aimed at sophisticated institutional investors. It is
not aimed at retailer investors and in my judgment
should not be.
Q1178 Chairman: But you have insurance
companies and others putting their money into these
things and the pensions and insurance of ordinary
people are involved in them, so at the end of the day
the ordinary man can lose?
Mr Corrigan: That is true.
Q1179 Mr Dunne: There has been an explosion of
issuance of structured finance instruments over
recent years. We were told by Fitch that there were
now only 15 industrials, 32 financial institutions and
16 sovereigns with triple A-rated debt paper. Would
any of the witnesses care to hazard a guess as to how
many structured finance products there are with
triple A-rated status? I can tell you that it is a trick
question and I know the answer. There are 8,409
compared with a handful of real companies with
triple A-rated paper. Clearly, that has been a
bonanza for all of your firms and investment banks.
Who would like to comment on the impact of the
explosion of issuance on financial stability?
Mr Corrigan: For starters, it is important to
recognise that in a very real way the fundamental
driving force that goes a considerable distance in
explaining the explosion of structured credit
products—I agree with that characterisation—was
the long period during which there were abundant
amounts of liquidity on a worldwide basis and very
low nominal and real interest rates. To a significant
degree it has been the reach for yield on the part of
institutional investors in particular that goes a
considerable distance in explaining this very rapid
growth of structured credit products. In my
judgment there will be at least some classes of such
products which will go the way of the dinosaur.
Experience over the past 18 months or so has shown
that in some classes of instruments there will
probably be a permanent retrenchment in these
kinds of activities
Q1180 Mr Dunne: Are you admitting that it takes a
shock of the kind we have just had for the banks to
recognise that there is something inherently wrong
with the structure?
Mr Corrigan: Unfortunately, that is a fact of life
which I cannot dispute.
Q1181 Mr Dunne: Did any of your institutions take
heed of the warnings that were issued in this country
by the FSA in January and by the Bank of England
in April about the consequences of this spiral of such
sophisticated instruments running out of steam?
Lord Aldington: The comments of the Bank of
England and the FSA at similar times were very
sensible observations about what was going on the
market. We read those and factor them into our
processes, as we do other opinions.
Q1182 Mr Dunne: Who within your organisations
looks at the fundamental building blocks of these
products? The rating agencies who came before us
the other day claimed that their models were
constantly being validated and challenged by the
investment banks, but models do not price as well as
markets, so there is a failing somewhere either
between the rating agencies or within your deal
teams in working out where the flaws are in the
models. Is any of the witnesses close enough to the
practices of his deal teams to know whether or not
the models have validity?
Mr Mills: I would answer that the models are based
on historic precedents. What all of our due diligence
has not taken into consideration is the impressive
level of delinquencies and defaults. I think that we
are in a period that is a scenario that should have
been tested more rigorously but, frankly, we were
basing most of our decisions on what the rating
agencies referred to as depression-type scenarios.
Secondly, I would also just mention thatin terms of
the guidance from the FSA and the Bank of
England, one thing that we did not anticipate was
the liquidity crisis—we did not anticipate that the
liquidity would dry up to the extent that it did in
August and that, frankly, added on to the issues.
Q1183 Mr Dunne: Most of us are not here to beat
you around the head but to try to find some
solutions to make sure it does not happen again. If
we are looking at historic data and carrying out
regression analysis without suYcient risk-testing of
what may go wrong going forward, how do we come
up with better models or methodologies for pricing
product that takes these things into account so this
does not happen again?
Mr Corrigan: As some Members of the Committee
may know, two years ago I was chairman of an
industry group that looked at the subject of complex
products, among others, which included institutions
not only in the United States but in the UK and
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Europe. We devoted a lot of attention to the
question you have just raised. I think the answer has
a couple of components to it. First, you are precisely
accurate when you suggest that models by definition
are backward and not forward-looking. That is a
reality that we all have to deal with. The way we try
to deal with it, with a great deal of impetus from the
regulatory side, including the FSA in London, is by
trying to enhance scenario analyses, stress-testing
and things like that to allow us to try better to look at
what we call the tails of these frequency distributions
which are the essence of these models. I think we
have become better at that. Do I think we are as
good as we could be? No. If you look at the recent
example of the subprime situation in the United
States with its unfortunate and tragic consequences
clearly almost no one anticipated the combination of
factors, including the bubble in the first place and
then declining home prices superimposed on a
rapidly changing credit environment.
Mr Corrigan: I think and hope the answer is yes.
Since you have made reference to the statement that
I submitted to the Committee, which I hope
Members have found useful, one of the points I
emphasise is that, having myself lived through more
of these financial disruptions than I would like to
admit to over 40 years, the fact of the matter is that
all of us need to continue to devote relentless energy
to learn from these experiences when they occur in
the process of what I call strengthening the so-called
shock-absorbers
in the
financial system.
Unfortunately, it is sad but true that in the nature of
things these periodic disruptions will occur. When
they do so we have to learn from them and step back
and rebuild certain elements of things we have done
in the past as with, say, the question of rating
agencies. But I think we must also be honest with
ourselves and recognise that as hard as we work at
this in some point in the future another surprise
will occur.
Q1184 Mr Dunne: But in the US you had identified
post-Enron a deficiency within the rating structure
and legislation was introduced to regulate the rating
agencies. Clearly, that has failed in this case. Are
there lessons we can learn internationally about how
rating agencies are essentially used by investment
banks to validate a product which does not do what
it says it will do on the tin?
Mr Corrigan: You are right that in the post-Enron
environment in the United States substantial eVort
was devoted to taking a fresh look at the rating
agencies which resulted in legislation. That was
finally passed in 2006, I think. That goes some
distance in terms of reform in the way the rating
agencies operate. In addition to that, international
security regulators as a group eVectively instructed
the rating agencies in 2006 to adopt formal best
practices, codes of conduct and ethics. I think those
things have helped but obviously they have not fully
resolved the issues to which you refer and as part of
the normal post mortem from this episode we need
to revisit that question. One thing I would like to
see—others may not agree—is a joint eVort by a
relatively small group of highly professional and
sophisticated investors to work in collaboration
with the rating agencies themselves to come up with
a fresh cut at a framework of best practices,
including the question of how better to manage
potential conflicts and interests. To get top quality
institutional investors involved in that review is a
very constructive way to think about how to we can
make still further progress.
Q1186 Nick Ainger: But, looking at your analysis,
with which I agree, it seems so obvious that if these
CDOs were so opaque—one American academic
described them as “too clever by half”—there would
be a major reckoning at some time. If you are buying
a product and do not know what the risks are
throughout its life surely that is reckless.
Mr Corrigan: I have a lot of sympathy with what you
say, but in fairness I would simply observe that for
sophisticated investors the disclosures associated
with CDOs were pretty good. Could they have been
better? Yes. I think the question of opacity must be
kept in a little bit of perspective, because even for
very sophisticated investors if you took the trouble
to read the disclosures and the oVer documents at a
minimum you should have been able to start asking
the right questions. Unfortunately, I suspect there
are cases in which the amount of diligence that went
into looking at and thoroughly studying these
disclosures was probably not always what it should
have been. Speaking from personal experience—I do
not consider myself to be exactly feeble-minded—
you have to work at it. Those documents are not
bedtime reading.
Q1185 Nick Ainger: Mr Corrigan, reading your
submission to the Committee24 it seems that
everyone is now wise after the event, but I am sure
that Members of the Committee and the British
public expect bankers to be cautious rather than
reckless. With hindsight, do you think that a number
of financial institutions to the degree that they
became involved in CDOs were reckless?
24
Ev 332
Q1187 Nick Ainger: But an awful lot of people in all
your organisations are paid extremely well to read
the detail of those products. Mr Mills, was
Citigroup reckless?
Mr Mills: As it relates to distributing product, I do
not believe that we were reckless but I believe we
gave all the appropriate disclosures and I believe
that we were dealing with what we thought were
sophisticated institutions. We thought that from the
point of view of suitability these were instruments
that they could analyse and understand. In response
to your earlier question, I think the issue around the
subprime and sub-structured product occurred
much earlier in the chain and I think that had to do
with basic lending to borrowers and as to whether or
not they were creditworthy or appropriate to lend
money to.
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Q1188 Nick Ainger: But errors made in the sale of a
mortgage to a householder in Chicago should not
end up with the crisis that we face in this country
with Northern Rock. Admittedly, the contagion
started with the mis-selling of a mortgage in
Chicago, but it was your institutions and the linkage
through CDOs that caused that contagion. If you
had done your job properly and deeply examined
these products, as Mr Corrigan says should have
been done, perhaps that contagion would not have
occurred. Clearly, that was not done, was it?
Mr Mills: I think that people used the best analytics
available to them. I think that with the benefit of
hindsight, you cannot disagree with your
conclusion.
Q1189 Chairman: Lord Aldington, one of your
analysts, Mike Mayo, is quoted as saying that the
whole question of CDO exposure and oV-balance
sheet vehicles is such a black box in many ways but
“that is investing in financials”. Do you agree with
him?
Lord Aldington: Chairman, this discussion is really
about the way—Q1190 Chairman: I am asking about Mike Mayo’s
comment about the black box?
Lord Aldington: Do I agree with Mike Mayo?
Q1191 Chairman: One of your analysts at Deutsche
Bank, Mike Mayo, has said that the whole question
of CDO exposure and oV-balance sheet vehicles is
such a black box in many ways but “that is investing
in financials”. Do you agree with your own analyst?
Lord Aldington: I would not have chosen those
words. This is a serious topic and sometimes analysts
are a little provocative in what they say. What we are
talking about here is the way in which the financial
markets for a sophisticated products work and what
is acceptable in terms of information is something
that is developed between the arrangers and
distributors and the sophisticated investors.
Q1192 Chairman: If you had agreed with him I
would have gone on to ask another question, but it
is more alarming that you do not agree with him.
You have people in your organisation saying to the
financial community that this is a black box and you
come here to say it is not. Whom do we believe? This
is a person who is on the street every day, if you like,
telling the financial community that it is a black box
and you disown that.
Lord Aldington: We are all aware of the role that
analysts play in our organisations.
Q1193 Chairman: Should you review the way
analysts play their role?
Lord Aldington: Analysts have always been required
to have an independent voice; indeed, in most
countries in the world that is now legally enshrined.
Q1194 Chairman: He describes CDO exposure as a
black box. How would you describe it?
Lord Aldington: The process of investing in CDOs?
We have just been addressing that.
Q1195 Chairman: Do you have some sympathy for
those who view it as a black box?
Lord Aldington: I would not view it as a black box
at all. The information is available if one chooses to
seek it.
Q1196 Mr Love: I want to ask about the
consequences for the individual financial
institutions that have suVered loss whether there are
any knock-on eVects on other financial institutions.
I start with Lord Aldington.
Lord Aldington: What type of financial institutions
are you talking about?
Q1197 Mr Love: I am referring to those that have
suVered loss through this process.
Lord Aldington: And the consequences for others?
Q1198 Mr Love: What are the consequences for
others in the marketplace?
Lord Aldington: Some of the large investment banks
have to varying degrees taken losses and those have
been absorbed within their capital base and loss
reserves. Speaking for my own house, we are in a
healthy position and will move forward.
Q1199 Mr Love: Mr Corrigan, do you have anything
to add to that?
Mr Corrigan: I have two thoughts. First, as you
know well, very substantial losses have been
incurred by a broad cross-section of financial
institutions over the past several quarters. I observe
that in some ways it was a testimony to the work of
those institutions over the years, including the
supervisory community, that they were able to
absorb those losses as well as they did. As far as I
know, despite the size of these losses in the major
institutions none appears to threaten their viability.
I go back to one observation by the Chairman a little
earlier. We know that on a smaller scale there are
other classes of institutions, including pension funds
for an example, that have undoubtedly experienced
some losses. I believe that major financial
institutions—I can speak only for one—have an
aYrmative responsibility to work with pension
funds, foundations and institutions like that to try to
help them better understand the nature of some of
these investments. On behalf of Goldman Sachs in
particular, I have spent a great deal of time over the
past couple of years doing exactly that. I have
worked directly with these institutions to help them
enhance their own risk management and due
diligence capabilities. I consider that to be an
inherent responsibility of major financial
institutions in this area.
Q1200 Mr Love: Mr Palmer, are there any
consequences for financial stability from the losses
suVered by the larger institutions?
Mr Palmer: So far, despite the losses suVered by
some major institutions the overall consequences
have been fairly well contained. Of course, the
process is never finished. We have seen the larger
institutions which have taken losses adapt and
modify. We have seen changes of management as
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
they take responsibility and eVorts to adjust and
improve risk management systems which are clearly
very important as we move from this backwardlooking way of thinking which in the past has driven
risk analysis to a much more forward-looking stress
analysis-type situation. From what we have seen so
far all of those things mean that the institutions that
are adapting reasonably well up to this point.
Q1201 Mr Love: Why is it that a lot of the banks
have failed to quantify the exact losses?
Mr Palmer: I think that is a matter of opinion. At
any one time the banks must assess, first, what their
exposures are, second, the likely losses and, third,
respond to their legal requirements in terms of what
they can and cannot say at any one time. As we move
into next year and see the audited full year results
coming from a lot of the bigger institutions that are
involved we will have a much clearer picture of
exactly what has happened.
Q1202 Mr Love: Mr Mills, one investment banking
institution assumed that its exposures were now
worth 63c/ on the dollar while other suggested 90c/ on
the dollar. Why is there such a huge variation in the
quantification of the losses being suVered?
Mr Mills: What occurred in August and September
was the fact that these markets stopped functioning
and so there was no visible trading taking place.
Typically, investment banks set their prices on their
inventory and their positions based on the visibility
of other trades that are taking place in the
marketplace.So, for a period of time—roughly two
or three weeks—investment and commercial banks
had to come up with a diVerent methodology for
establishing values on their portfolios and
fundamentally had to deconstruct these complex
securities, look at the underlying collateral and come
up with a valuation. So, there was a period of time
when there were significant diVerences between
institutions as it relates to that. I think that most of
those have converged at this point. I believe that
given the level of disclosure that has been
forthcoming through the month October that those
price distortions should not be as great as they were
in September.
Q1203 Mr Love: The 63c/ that I quoted would be
considered pessimistic by some. Mr Palmer, how
does UBS come to that conclusion?
Mr Palmer: First, the fact is that every institution
has diVerent types of exposure; they are not always
strictly analogous. Second, everyone has to make his
own estimate of what he thinks the future impact of
the economic environment will be and so there is
bound to be an element of subjectivity in these
things. Unfortunately, it is very hard to arrive at a
common number. The nature of every organisation
is diVerent, not just by degree but in terms of the
details of the actual exposure.
Q1204 Mr Love: If you look at your competitors,
would you assume there are any decisions taken to
admit only to a small amount of loss but to drip feed
it over a period rather than be more realistic in the
valuations they make? Is there any assumption that
that is happening in the marketplace at the present
time?
Mr Palmer: I can speak only for my own firm.
Obviously, we are driven by the natural principles of
transparency. Frankly, I think it is in everybody’s
interests to drive towards transparency as soon as
possible. Of course, the rules determine what we can
say and when we can say it.
Q1205 Mr Love: Lord Aldington, how long before
we overcome this problem?
Lord Aldington: The key to that lies in the answer to
the question you posed earlier: people retaining
confidence in the value of what is on their books.
That is the most important thing that must happen.
Markets have to be confident in the values that are
there.
Q1206 Mr Love: I understand that, but how long
will it take—three months, six months, a year?
Lord Aldington: I would say we have made a very
good beginning. One can always be a little
optimistic, but the start of a new year has its own
eVect. I hope that we see things settling down in the
first half of next year.
Q1207 Mr Love: Mr Corrigan, companies report
quarterly in the States. In this country that does not
happen yet. Everyone tells us that all should be open
and transparent about what the losses are. Why is no
one doing that?
Mr Corrigan: With all due respect, I am not sure I
agree with that characterisation. On the whole, what
we have seen so far, certainly compared with earlier
experiences, suggests that loss recognition at
individual institutions has been pretty good.
Another observation directly germane to your line
of questioning is that one of the single most
important things we should look for in major
financial institutions is the true independence within
those organisations of the people who are
responsible for price verification. That is usually
found in something like the controller’s division.
How it is labelled across individual institutions
probably varies, but when inevitably there are
diVerences of judgment as, for example, a sales
person and a controller’s person about the best
possible valuation of a particular trade or item in
inventory naturally there should be discussions, but
at the end of the day the controller’s judgment
should prevail. That independence as the basic
principle of corporate governance is the single most
important thing we can do to help ensure the best
possible job is being done in response to the question
you phrased. In the international supervisory
community, certainly including the FSA in the UK,
a renewed and aggressive eVort is being directed at
that issue.
Q1208 Chairman: Mr Palmer, my colleague asked
you about the figure of 63c/ on the dollar. Given that
the market for many credit instruments has frozen
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
up, thereby making it impossible for the banks to
mark their assets to either model or market, are these
figures not largely pie in the sky?
Mr Palmer: Obviously, the biggest problem is that
there is no visible benchmark in the market which is
normally from where you start. When that does not
exist you have to use your best eVorts through
statistical analysis.
Q1209 Chairman: It is a guesstimate?
Mr Palmer: The modelling process is very complex
and must take into account an estimate of what is
likely to happen in the economy. There is always an
element of judgment in it. How fast will the US
economy decline? How bad will delinquencies be on
mortgages? These kinds of things are very diYcult
to assess.
Q1210 Chairman: Mr Mills, do you agree that these
figures are pie in the sky in light of the frozen
market?
Mr Mills: No Mr Chairman, I would not
characterise them as pie in the sky but as a fairly
sophisticated eVort to try to determine the value of
the underlying collateral.
Q1211 Chairman: Just explain to us in simple
language how, if it is impossible for banks to mark
their assets to either model or market, there can be
an accurate assessment.
Mr Mills: I think you can come up with a range of
values. As we mentioned, if there is a lack of a
marketplace and there is no visible price
benchmarks that you can look to, you have to look
at the underlying collateral and look at the
underlying cash flows of that collateral, because they
are performing, and determine through diVerent
statistical analyses.
Q1212 Chairman: On a scale of one to 10 how
accurate do you think they are?
Mr Mills: Mr Chairman, what I can benchmark for
you is when we announced our earnings warning we
gave a range. We said that the losses we would incur
would be in a range of $8 billion to $11 billion.
Q1213 Chairman: I am a simple chairman looking
for a range.
Mr Mills: I would say it is 80% to 90% accurate.
Q1214 Chairman: Lord Aldington, what do you say?
Lord Aldington: A valuation is a valuation and I
think to say that it is only 90% accurate is always a
diYcult thing to say.
Q1215 Chairman: You say it is nine?
Lord Aldington: We arrive at our valuations and
attach huge importance to what Mr Corrigan has
said, what our IPV (independent price verification)
people say and then there are the accountants.
Q1216 Chairman: What valuation do you give?
Lord Aldington: We stand by the valuations that we
have on our books.
Q1217 Chairman: To go back to my question, Mr
Mills has given eight in the range of one to 10. What
do you give?
Lord Aldington: I can only repeat what I have said.
We stand by the valuations we have on our books.
Q1218 Chairman: Therefore, you do not give any
range at all?
Lord Aldington: A valuation is a valuation, and it
has to be supported by the accountants.
Q1219 Chairman: Mr Corrigan, what do you say?
Mr Corrigan: Let me respond at two levels. First, I
make it my own personal business to review in great
detail the procedures and policies that we as a firm
follow in the area of price verification. I have spent
a lot of time kicking the tyres, if I may put it that
way, to try to satisfy myself as best I can that what
we come up with in terms of valuations is state of the
art. To answer your question, on a scale of zero to 10
I would say it is 934 based on my experience and the
amount of time and eVort I have put into the task.
Q1220 Chairman: You have flown across the
Atlantic. Here there is a BBC programme called
Strictly Come Dancing which has a scale of one to
10. On that basis you are doing well. Mr Palmer,
what was your figure?
Mr Palmer: I did not give a figure.
Q1221 Chairman: That is why I am asking.
Mr Palmer: I am not going to give a figure. We do
the best job we possibly can.
Q1222 Chairman: Are you sure it is 10 out of 10 if it
is 63c/ on the dollar?
Mr Palmer: It is 10 out of 10 in terms of eVort and
integrity. History will prove whether we are right
or wrong.
Q1223 Chairman: You have taken the Cistercian
vow of silence?
Mr Palmer: I am telling you that as far as we are
concerned to the best of our ability we performed the
task of independent verification.
Mr Mills: I just wanted to clarify my comments. We
gave a range of $8 billion to $11 billion in terms of
what we could anticipate as losses. That was the
number I gave you. In terms of our books, records
and in terms of our disclosures, we make our
absolute best determination; we do that to a
standard of 100%.
Chairman: Looking at it from a simple point of view,
if the banks cannot mark their assets to either model
or market to try to understand where we are in this
situation is very diYcult.
Q1224 John Thurso: I turn to the question of oVbalance sheet vehicles. Perhaps I may start with Mr
Mills because his group has about $141 billion of
exposure at the moment. What is the purpose of
hiding assets and liabilities oV balance sheet?
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Mr Mills: I would not characterise it as hiding assets
oV balance sheet. I think, these vehicles have been
appropriate in the sense they have helped facilitate
the raising of capital for various endeavours. We
have a number of . . .
Q1225 John Thurso: What is the financial purpose of
not having it on your balance sheet? If it is an asset
it makes you look good and if it is a liability you
ought to disclose it, so what is the purpose of not
having it on the balance sheet?
Mr Mills: The vehicles that you are referring in our
instance are arm’s length transactions. We have not
invested any equity in these vehicles and do not have
any obligation to make sure that we support these
vehicles. We have helped the sponsors of these
vehicles by raising capital for them, but we are not
equity investors in these vehicles. They have been
somewhat misclassified as vehicles that we have
provided.
Q1226 John Thurso: What do you need to bring
them back onto your balance sheet now?
Mr Mills: We have made a public statement that we
are not going to bring them onto our balance sheet.
Q1227 John Thurso: Other institutions do. Why is
your institution not bringing them onto the
balance sheet?
Mr Mills: I cannot comment on other institutions.
From our perspective, these have all been arm’s
length transactions set at commercial terms.
Q1228 John Thurso: You have an arm’s length
transaction in which you have invested nothing and
for which you have no liability. Can you explain why
you have an exposure of $141 billion?
Mr Mills: I think the numbers that people are
throwing round are somewhat exaggerated and they
are, frankly, more along the lines of what we would
potentially be supporting in the commercial paper
market and what would be the potential exposure if
we chose to bring these vehicles onto our balance
sheet.
Q1229 John Thurso: I am now thoroughly
perplexed. You have something that is not an asset
or a liability; it is classed as an exposure by other
people. If you did bring it into your balance sheet it
would have an impact but you do not intend to do
so. Can you help me?
Mr Mills: I will do the best I can. The facts are: we
have sponsored vehicles that have outside investors
that have provided the equity to support these
vehicles. Those equity investors have an economic
interest in these transactions. The exposure arises
from the fact that from a business model point of
view they are funded short term and their assets are
long term. What the market is trying to estimate is,
if, in fact the liquidity crisis continues, will we,
Citigroup, provide the liquidity to fund these
vehicles so they do not have to go into an asset
disposal mode, especially in an environment where
people feel that that would just add more fuel to the
fire. What we have said, particularly because we
understand the assets in these vehicles, is that these
vehicles are in the process of orderly unwinding. The
vehicles have sold . . .
Q1230 John Thurso: You are saying that you do not
have an exposure?
Mr Mills: There is the moral hazard issue as to
whether or not from a reputational point of view if
we do not step in and support these vehicles it will
somehow hurt our reputation in the market.
Q1231 John Thurso: But as far as your stated public
balance sheet goes there is no asset or liability on you
involved in these things?
Mr Mills: Right now, Sir, we have supported the
vehicles. I can get back to the Committee with an
exact number, but it is somewhere in the
neighbourhood of $8 billion.
Q1232 John Thurso: Mr Palmer, I put the same basic
question to you. It is my understanding that there
are assets and liabilities that are oV-balance sheet.
That has been stated in a great deal of press
comment and there are various filings and other
things to indicate that. The evidence of Mr Mills is
that it is oV-balance sheet because there is no asset
or liability and no exposure. Is that also true of
your firm?
Mr Palmer: As a general rule, my firm does not have
any activity in oV-balance sheet vehicles of this kind.
Q1233 John Thurso: Lord Aldington, does Deutsche
Bank have oV-balance sheet items?
Lord Aldington: We do have oV-balance sheet
vehicles. The original purpose of those vehicles
which remains is to provide a service to clients on
both sides of their balance sheets, that is, clients
wanting financing or a slightly enhanced return.
That is the origin of these vehicles; in other words, it
is of perfectly proper commercial origin. As a matter
of fact, under IFRS they have to be consolidated
and, further, under Basel II they would be subject to
prudential regulatory control.25
Q1234 John Thurso: Mr Corrigan, for completeness
what is your response?
Mr Corrigan: I think that most financial institutions
have at least some form of oV-balance sheet
activities, typically in the form of special purpose
vehicles. In the context of these so-called SIVs some
institutions have them; others do not. We at
Goldman Sachs do not. The important point here is
that there are fairly clear standards of accounting in
USGAAP, ISB here in the UK and in Europe that
stipulate the ground rules under which any
25
Note by witnesses: a) Whilst DB has structured oV balance
sheet vehicles, in answer to this question I was specifically
referring to ABCP (IE asset backed commercial paper)
conduits rather than all oV balance sheet vehicles. b) The
vast majority of these conduits have to be consolidated
under IFRS. As of 30 September, DB had EUR 32 bn of
sponsored conduits of which EUR 5 bn were not
consolidated under IFRS. c) Under Basle II, the exposure
of the Bank to these vehicles will need to be reflected in a
more risk sensitive manner, which may trigger higher
regulatory capital charges.
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
instrument may qualify for oV-balance sheet
treatment. At the risk of considerable oversimplification, the defining principle in making this
determination is whether the purpose of the
instrument in question and the risks associated with
it have been transferred to that vehicle such that the
sponsoring organisation unambiguously is not at
risk by virtue of that instrument or vehicle. As we
have learned, it is not always quite as easy in practice
to determine whether or not the risk has been fully
transferred to that vehicle, but that is certainly the
principle.
Q1235 John Thurso: Perhaps I may ask for
clarification for my simple Scottish mind. It always
seems to me that the risk should be relatively clear,
inasmuch as I lend you some money and am taking
a risk. The level of the risk is whether or not you will
pay me back. What you are saying is that these are
elements where the risk I have taken has somehow
been laid oV.
Mr Corrigan: That is correct.
Q1236 John Thurso: That is done in such a manner
that if you fail to pay me back I do not take the hit.
If that is 100% true then it is oV-balance sheet, but
the problem is that these things are so complicated
and complex that I may think I have laid it oV but in
reality I have not.
Mr Corrigan: I have some sympathy for what you
have just said. I fully expect that as a result of some
of the things we have seen in the recent past
accountants and others will take a fresh look at the
precise criteria that satisfy the conditions of that sort
of risk.
Q1237 John Thurso: The exposure of Mr Mills has
to do with the potential loans he may have to make
to fulfil the obligations that may or may not be in
those vehicles.
Mr Corrigan: With all due respect, Mr Mills made a
point that should not be ignored. Even if it is true, as
I expect it probably is in this case, that the risk
diVerentiation is clear enough it still does not solve
the reputational risk problem. Over the decades and
centuries we have seen cases in which financial
institutions have made a determination that even if
they are fairly confident that the legal and
accounting risk is clear considerations of reputation
may leave them with little or no choice but to step up
anyway. The reputational and financial risks have to
be thought out in juxtaposition to each other.
Q1238 John Thurso: Ultimately, on the grounds that
the objective of a balance sheet is truly and fairly to
state the assets and liabilities of an entity with a view
to the outside observer being able to have proper
view of net worth, do you agree that we need to take
a long hard look at oV-balance sheet vehicles and be
a lot more rigorous about them? Perhaps we can
have quick answers from the panel.
Mr Mills: I think that the answer clearly is yes. I
would say that in response to your point, the equity
market is already assuming that risk when it looks at
the valuation of the stock.
Lord Aldington: Yes. I add that in all of my banking
experience the issue of what should be on and oVbalance sheet always comes up for discussion.
Q1239 John Thurso: I think Mr Corrigan has given
me his answer. What do you say, Mr Palmer?
Mr Palmer: I agree, and I think it is already
happening.
Q1240 Peter Viggers: When banks were in the world
of buying securities and taking on mortgages in
order to hold them they would have a vested interest
in making sure that the security was solid. As banks
have moved to a diVerent model of originate to
distribute and put together or buying packages
which they know they will pass on, I put it to you
that they do not have the same vested interest in
ensuring that the security is completely solid. I am
thinking here of subprime mortgages in the United
States in particular. Do you agree that there has been
a loosening in borrowing and lending standards?
Mr Corrigan: I think the evidence is overwhelming
that in the origination process in the subprime
markets in the United States the answer is yes. It is
however important to recognise that the
development of the subprime mortgage market was
a noble idea, because what it sought to do was
provide access to home ownership on the basis of
individuals and families who by historic standards
never had any realistic hope of being able to own
their own homes. Unfortunately, that novel idea fell
asunder in part because it is unambiguously true that
the credit standards particularly with regard to some
of these exotic and complex mortgages have not
been what they should have been. That is something
we have to fix. As I suspect you know, there is
legislation pending in the US Congress that will go
some very considerable distance to try to repair that
problem, but there is no question as far as I am
concerned that at the origination point the standards
of diligence, credit checking, marketing and
promotion some of these mortgages got out of hand.
Q1241 Peter Viggers: I put it to you that when such
mortgages, loans and other commercial paper are
collateralised or securitised at the first cut of
securitisation, as it were, the individuals would have
a good understanding of what is involved, but I put
it to you that when they have been repackaged
several times the people who make the investment do
not know exactly what they have. Can each of you
look at your loan books and the CDOs you have
taken on and unpick them? Can you pull pieces out
of the tapestry and know exactly what the value is of
what you hold on your books?
Mr Palmer: There is a well established process of due
diligence of portfolios of mortgages and the
securities that arise out of them. The process is to
look at a sample of the mortgages within each
bundle, as it were. There is also a stage when the
portfolio is held for a period so see the delinquencies
and defaults in the first few months. There are wellestablished processes for getting as much
information as possible and providing that to the
buyers of the securities.
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
Q1242 Peter Viggers: Lord Aldington, are you that
confident in your involvement?
Lord Aldington: As I said earlier, I am not an expert
in this industry, but I support what Mr Palmer has
just said.
Q1243 Peter Viggers: Mr Mills, when after
management changes there is an £11 billion write-oV
within Citigroup some commentators were
concerned that many of the losses were in the £43
billion of oV-balance sheet exposures. Does this
follow through from what has been said before? The
word “sophisticated” has been used quite
frequently.
While
sophisticated
investors
understand the distinction between a bank’s own
assets and oV-balance sheet items, the fact is that you
have suYcient reputational risk to require you to
make financial commitment to oV-balance sheet
vehicles?
Mr Mills: The specific reference I made was to an $8
billion to $11 billion potential loss that would be
crystallised in the fourth quarter. That directly
related to assets that we have on balance sheet, so
that is directly related to our mortgage-backed
exposures. As it relates to oV-balance sheet
exposures, we do have some exposures to some very
distant third-party investment conduits that we are
supporting from a commercial paper point of view.
As it relates to our own sponsored conduits, we have
not disclosed or made any provisions in terms of
losses. Those conduits are in the normal course of
business selling down assets to meet their funding
targets and have plans in place to have an orderly
unwind. The good news for us, Sir, is that those
conduits have very good assets and so they do not
rest in any subprime product.
Q1244 Peter Viggers: Do you discuss this with your
auditors?
Mr Mills: We discuss it with our auditors and our
regulators on an ongoing basis.
Q1245 Peter Viggers: Mr Corrigan, you have $65.5
billion worth of activities related to collateralised
debt obligations, real estate investment, mortgagebacked bonds and principal-protected notes.
According to the Financial Times of 8 November,
auditors will be looking very closely at this area. Are
all of you discussing these issues with your auditors?
Mr Corrigan: Absolutely. I do not recognise the
number you cited, but we can deal with that
separately to the extent you wish. The auditors
carefully review the preparation of financial
statements. I should also acknowledge that in this
area the supervisory authorities have spent a great
deal of time in recent weeks and months looking at
the same questions. Whether it is auditors, internal
management or supervisory authorities, we can say
without the slightest hesitation that all of these issues
are under our microscope, and they should be.
Q1246 Chairman: Do you agree with Christopher
Cox, chairman of the Securities and Exchange
Commission, that in his opinion there is a need to
consider whether rating agencies were unduly
influenced by issuers and underwriters who paid for
credit ratings?
Mr Corrigan: I do not like to monopolise the
conversation. First, in the United States legislation
was passed in 2006—it may have been in 2005—that
was essentially an outgrowth of the earlier Enrontype events. That put in place a fresh oversight
function as it pertained to the rating agencies.
Among many other things the provisions of that
legislation established new standards for recordkeeping, authorisations and so on. In addition,
international securities regulators in eVect told the
rating agencies in 2006 that they had to come up with
formal statements of best practices and codes of
ethics and behaviour, which has been done. I have
looked at one of those codes of conduct for at least
one of the rating agencies and it is pretty good. Is it
good enough? We are in the process of learning.
Recent experience suggests that there are still
further things.
Q1247 Chairman: But is there a need for this?
Christopher Cox wants to probe whether they have
been unduly influenced by issuers and underwriters
who have paid for credit ratings.
Mr Corrigan: I think that is fine.
Q1248 Chairman: Does everyone agree with that?
Lord Aldington: Yes.
Q1249 Chairman: Is there an inherent conflict of
interest in the fact that rating agencies are paid by
the same banks whose products they provide
ratings?
Lord Aldington: This debate about rating agencies
has been going on for years and years and nobody
has yet found a better solution as to how to pay or
compensate the rating agencies. Certainly, in the
“lessons learnt” department in all of this it would be
very sensible to bring that question into it.
Q1250 Chairman: There could be a conflict of
interest here?
Lord Aldington: We all have to manage conflicts of
interest, but it is a sensible thing about which to ask
a question.
Q1251 Chairman: Does everyone agree that there is
a conflict of interest here?
Mr Corrigan: There is certainly a potential conflict
of interest.
Q1252 Chairman: Mr Corrigan, as to the depositor
protection scheme it has been suggested to us by one
US commentator that the Northern Rock crisis
could have been avoided if the UK had adopted the
US model of depositor protection. Do you share
that view?
Mr Corrigan: Certainly, I agree that deposited
insurance is a prominent and necessary element of
the so-called safety net that surrounds financial
institutions in all countries. Whether there is
anything absolutely unique and magical about the
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Ev 133
Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
US system as opposed to the current or a newer
system in the UK is a judgment that you and your
colleagues have to make.
eye—I have not done the arithmetic—my sense is
that on balance we have probably made some
money.
Q1253 Chairman: I just wanted a US perspective,
because the issue of adequate legislation and instant
return of moneys is important. I shall be going to
Washington next week to speak to the FDIC.
Mr Corrigan: There are two observations I oVer.
One is that the US deposit insurance system has a fee
system applied to the depositary institutions that is
risk-based; in other words, not all institutions pay
the same fee. It is diVerentiated based on the risk
characteristics of individual institutions. I think that
is a pretty good idea.
Q1258 Mr Mudie: Can you give us some idea of the
timeframe? This started in the States. When did you
start to go to subprime in such a massive fashion and
begin to securitise it? Mr Mills and Mr Palmer have
said they think they have lost money; Mr Corrigan
believes he may have made money. It would be
interesting to discover what period of time we are
talking about.
Mr Corrigan: As an approximation, our assessment
of the underlying conditions in that segment of the
market was in the timeframe of our second quarter
which ends in May.
Q1254 Chairman: It is an upfront payment model?
Mr Corrigan: Now it is an upfront payment model,
but what institution A pays may not be the same as
institution B based on the risks characteristics as
determined by the FDIC. The other point I make for
your consideration is that the payout provisions
should be very simple and straightforward; in other
words, in the United States the payout provision is
$100,000—full stop. As I understand it, the current
system here in the UK is a bit more complex than
that and it has diVerent layers and percentages. I am
a little concerned that that may be a bit of a
structured product in its own right.
Q1255 Mr Mudie: Listening very closely to your
evidence, you seem very regretful about it. I put a
question that perhaps the ordinary man in the street
might ask. You have declared interim losses, but in
the course of the business you have been conducting
for several years in this field—the subprime
market—do your profits exceed your losses; in other
words, although you are all very sorry that you have
been left with this exposure you have certainly made
a lot of money over the years in this field, have you
not?
Mr Mills: I can answer for Citigroup. Our losses
greatly exceed the profits that we made in this field.
Q1256 Mr Mudie: Over what period?
Mr Mills: Several years.
Mr Corrigan: I am not sure, but I suspect that in the
case of Goldman Sachs on balance we have made
money over the period in question.
Mr Palmer: To be honest, I am not sure. My
suspicion is that it is in the same direction as Mr
Mills. I have not made the calculation, but I think it
is going in that direction.
Q1257 Mr Mudie: Why do you think you are
diVerent from the others?
Mr Corrigan: That is a good question. First, part of
it is that Goldman Sachs is not involved in the front
end of this; in other words, we are not in the
residential credit origination space or the servicing
space. Second, we have had a measure of success—I
do not want to overstate it—in hedging some of our
exposures in this space in the recent period. When I
try to put the whole thing together in my mind’s
Q1259 Mr Mudie: I do not mean that. When did
subprime lending in the States take oV in a
noticeable way? How many years are we talking
about?
Mr Corrigan: The key benchmark for that would be
the approximate timeframe of 2003–04. There were
elements of it before that. It really emerged as a
major business in that timeframe.
Q1260 Mr Mudie: You are saying that in those three
or four years you did not make enough profits to
cover the exposure you now have?
Mr Mills: In our case it’s actually quite simple and
the arithmetic is fairly straightforward. We were not
involved in terms of the origination of the product
and we were not involved, in the early years, in the
structure and distribution of the product. We put
together a team 18 to 24 months ago and got
involved.
Q1261 Mr Mudie: You got in too late?
Mr Mills: With the benefit of hindsight, yes.
Mr Palmer: I have not done the math, but the huge
growth of subprime lending in the US is a relatively
recent phenomenon.
Q1262 Mr Mudie: We have had it for three or four
years, so how long have you been in?
Mr Palmer: Over that period of time, but I think the
huge growth came about in 2005 and 2006.
Q1263 Mr Mudie: Why have you not made money if
you were in at the beginning and you have had three
good years? Have the good years not compensated
for you being caught with late exposure?
Mr Palmer: It is pretty clear that diVerent decisions
were made in diVerent firms at diVerent times and
they have led to diVerent outcomes.
Q1264 Mr Mudie: Lord Aldington, I have left you
out. What about your position?
Lord Aldington: I do not know whether anybody has
even done that piece of math. It is an interesting
question.
Q1265 Mr Mudie: Why would you not do it if you
were running a firm? If you have a product and are
suddenly caught with this exposure the one defence
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Ev 134 Treasury Committee: Evidence
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Mr E Gerald Corrigan, Lord Charles Aldington, Mr Jeremy Palmer and Mr William Mills
of anybody dealing with it is to say that the company
has made brass out of it over the years. Why have
you not got that figure?
Lord Aldington: I did not say that we had not done
it; I said I did not know whether anybody had done
it. We certainly have not made it public. My guess,
just based on the provisions we have taken, is that we
would be more in the Goldman department than in
the other, but I honestly cannot tell you.
Q1266 Chairman: Mr Corrigan, you stand out from
the pack here by making money. Is it not the case
that you have done that because you bet the other
way from these guys and you saw this could end in
tears?
Mr Corrigan: Approximately in the timeframe of
our second quarter which ends in May we sensed
that deterioration particularly in the subprime space
was mounting. In that timeframe we began to hedge
our exposures in ways that turned out reasonably
well from a financial point of view.
Q1267 Chairman: In summary, is it fair that
collectively you say you provided all the information
needed to enable an institution to buy a complex
product from you and analyse such risks that might
ensue from that purchase?
Mr Corrigan: You use the word “all” and that
always makes me nervous. I do not think I would
want to be wed to that word, but certainly a
systematic aggressive eVort was made to provide
adequate disclosure to help investors make informed
decisions.
Q1268 Chairman: What about you, Mr Mills?
Mr Mills: I think we made adequate disclosures and
I think we have tried to assist.
Q1269 Chairman: So that people knew the risks?
Mr Corrigan: Real eVort was made to provide
adequate disclosure.
Q1270 Chairman: Lord Aldington, what do you say?
Lord Aldington: I support what Mr Corrigan has
said. The key to all of this is making the information
available.
Q1271 Chairman: Mr Palmer?
Mr Palmer: Information was provided, but I do not
think anyone can pretend that the types of market
conditions were foreseen.
Q1272 Chairman: I come back to the question asked
by my colleague Mr Ainger about the mortgage in
Chicago. If there are information problems early on
about, say, the sale of a mortgage in Chicago is it not
the case of garbage in, garbage out?
Mr Corrigan: There is obviously a truism in what
you say, but I do not want to leave you with the
impression that I defend every single thing that was
done. There is no question that mistakes were made,
but it is also true that the conditions that have
materialised especially in the subprime mortgage
market by any standard are quite extraordinary.
There were obvious breakdowns in the credit
origination process.
Q1273 Chairman: I understand, but I go back to the
point about garbage in, garbage out.
Mr Corrigan: I would not characterise it in that way.
Who would have anticipated that in key segments of
the residential mortgage markets in the United
States house prices, which have not declined in
absolute terms in over 30 years, would do so by 5%
or 6%? You can characterise that as “garbage” if you
will. Freely admitting that mistakes were made, I
would not go as far as to characterise it as “garbage
in, garbage out”. There are opportunities and
situations in which people make mistakes.
Q1274 Chairman: In your opinion, were investors
sophisticated enough to understand what you were
telling or selling them?
Mr Palmer: There are two things happening here:
first, the complexity of the instruments and the
decisions to invest in them; second, the unforeseen
marketplace conditions. You have to remember that
both of those things are happening at the same time.
Q1275 Chairman: Lord Aldington, were they
sophisticated enough to understand what you were
telling or selling them?
Lord Aldington: We have always treated our
investors in this as if they are professionals and we
take steps to satisfy ourselves that that is the case.
One must say that in certain isolated cases—I can
think of a couple in Germany which have been in the
press—it is not clear that the investors fully
understood what they were buying or that they took
advantage of the possibility to do their homework.26
Mr Mills: Mr Chairman, I think that there are
diVerent classes of investors—those who
participated directly in the purchase of CDOs, I
think, were given all the information and all the
analytic tools to make a decision. I think some of the
investors, particularly investors in commercial paper
that were buying commercial paper that was rated
A1 and P1, and not necessarily understanding some
of the underlying assets probably did not have
suYcient information.
Q1276 Chairman: As a result of this crisis do you
agree that you have suVered reputational damage?
Mr Mills: I believe that we have suVered
reputational damage, yes.
Lord Aldington: I do not think so.
Mr Corrigan: Sure we have.
Mr Palmer: We have.
Chairman: The UK stands alone. Thank you very
much for your evidence this morning.
26
Note by witness: The comments and the cases to which I
referred were observations based solely on press reports,
and I have had no personal involvement with the relevant
matters, I have no have personal knowledge that any
investors that purchased products from Deutsche Bank
failed to understand them.
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Treasury Committee: Evidence
Ev 135
Witnesses: Mr Richard Sexton, UK Head of Assurance, and Mr John Hitchins, UK Banking and Capital
Markets Leader, PricewaterhouseCoopers, gave evidence.
Q1277 Chairman: Good morning and welcome to
the session. Please introduce yourselves for the
record.
Mr Sexton: I am Richard Sexton, head of the UK
Assurance practice of PricewaterhouseCoopers
which includes our audit practice.
Mr Hitchins: I am John Hitchins, a banking audit
partner of PricewaterhouseCoopers.
Q1278 Chairman: What are the aims of an auditor
when auditing a company?
Mr Sexton: The audit is performed in accordance
with standards and regulations in the UK now
issued predominantly by international bodies. It
seeks to provide comfort about historical financial
information as embodied within the financial
statements included in a company’s annual report.
That is the role of the statutory audit. In the UK we
do perform other work at times at the request of
companies predominantly in connection with
interim announcements. That is also performed in
connection with guidance issued by the Auditing
Practices Board in the UK.
Q1279 Chairman: Does auditing a bank present any
additional problems compared with a non-financial
company?
Mr Hitchins: The only extra requirement placed on
us when auditing a bank is our statutory duty to
report to the FSA if we become aware of anything
that is material to the exercise of the FSA’s
functions.
Q1280 Chairman: In the independent auditor’s
report on Northern Rock’s 2006 accounts you state
that “you are not required to consider whether the
Board’s statements on internal control cover all risks
and controls”. Given what has happened to
Northern Rock, do you think this is a possible area
of reform of auditing standards?
Mr Sexton: That statement is derived specifically
from the combined code which requires us to look at
controls over financial information, not the
operational risks. I suspect that it would be a matter
therefore for those responsible for the combined
codes and others to consider that issue. At the
moment we are explicitly not required to look at
those aspects.
Q1281 Mr Fallon: You are required to look at the
operating and business review, are you not?
Mr Sexton: It is correct that we have a duty to
consider the operating and business review to ensure
that it is not inconsistent with information presented
on which we express an opinion in the financial
statements.
Q1282 Mr Fallon: But the operating and business
review of Northern Rock had three or four
paragraphs on liquidity risks, so you reviewed those
paragraphs presumably?
Mr Sexton: They would have been reviewed by the
audit team as part of its duty.
Q1283 Mr Fallon: Why is there nothing in the 2006
report or interim report pointing out the risk of
illiquidity?
Mr Sexton: The audit opinion in both the annual
report and interim review covers the financial
statements. The financial statements set out in very
detailed note disclosure, as required under IFRS,
information on the liquidity profile of Northern
Rock.
Q1284 Mr Fallon: Were you content with the
liquidity risk?
Mr Sexton: Our opinion explicitly covers the
disclosures required under international financial
reporting standards in connection with the historical
information.
Q1285 Mr Fallon: That does not answer my
question. Were you content with the liquidity risk
that Northern Rock was running?
Mr Sexton: Our job is to look at the presented
historical information and whether it represents
fairly the actions of management and the board in
managing the assets and liabilities of Northern Rock
in this case. That is what is presented in the notes to
the account on which we have expressed an opinion.
Q1286 Mr Fallon: Northern Rock told us that at 30
June, 73% of its total liabilities were in wholesale
funds. Excluding the main banks, no other mortgage
lender comes anywhere near that. The nearest would
be Alliance & Leicester at 55% or Bradford at 53%.
Were you aware of the extent to which there was
such a liability?
Mr Sexton: I should say that I am not directly
involved in the audit of Northern Rock. I oversee
that audit and I have therefore regular contact with
all of our audit partners, so the answers I give are in
that context. The information presented by
Northern Rock clearly set out its portfolio of
mortgages. Yes, it is diVerent from others. The
accounting standard on which we base our opinion
requires that information to be disclosed.
Q1287 Mr Fallon: Did it not occur to you that this
was something of an extreme business model, as the
FSA chairman described it?
Mr Sexton: The information required to be audited
was thoroughly audited and presented in the
financial statements for all to see.
Q1288 Mr Fallon: Why did you approve the peculiar
trust status given to Granite Finance whereby 70%
of Northern Rock’s mortgages were placed oVbalance sheet in a separate vehicles?
Mr Hitchins: First, I should make one correction.
They are not placed oV-balance sheet. You will see
that all of those mortgages and the related Granite
funding are disclosed in the annual report on
Northern Rock’s balance sheet. Securitisation is a
normal structure in the market whereby notes are
issued to note-holders who have recourse only to the
pool of mortgages that backs those notes. They are
placed into a special purpose vehicle which
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Mr Richard Sexton and Mr John Hitchins
eVectively ring-fences the pool of mortgages for the
benefit of the note-holders. They are not taken oV
balance sheet because accounting standards still
require that vehicle to be consolidated as if it was a
subsidiary of Northern Rock. Overarching that is
the Granite master trust that owns those vehicles
and that is itself also part of the special purpose
vehicle structure. That has nothing in it other than a
small amount of income to cover its expenses. At the
end of a securitisation structure it is normal to have
a small amount of residual profit left in the vehicle
company and typically that money is given to
charity eVectively in the form of a legacy.
Q1289 Mr Fallon: Are you aware that a charity had
been nominated without its knowledge to be the
beneficiary?
Mr Hitchins: We were not aware that the charity did
not know, but in securitisation it is quite normal for
the residue to be given to charities. In some cases it
is just left as a charitable trust with the charity to be
decided at the time the money is available; in other
cases it is specified just as a testator in his will directs
that an amount of money is to be given to a charity.
There is no requirement to notify the charity.
Q1290 Mr Fallon: Do you not think it is somewhat
improper not to notify the charity?
Mr Sexton: Neither of us was involved in the detail
of that review. As auditors we were interested in
whether the structure was properly consolidated
into the balance sheet of Northern Rock and the
assets and liabilities of those structures were
properly reflected in the liquidity analysis. The
status of the trust from a legal perspective is not a
matter that is relevant to the presentation of those
assets and liabilities properly in the financial
statements.
Q1291 Mr Fallon: Did PricewaterhouseCoopers
advise on the two securitisations in the current year?
Mr Sexton: We did not advise on the securitisations.
The work of PricewaterhouseCoopers has been to
provide comfort letters on historical information
included in the prospectus oVerings, as is normal for
any such oVering in the United Kingdom market
and around the world.
Q1292 Mr Fallon: Therefore, you were an adviser?
Mr Sexton: We provided comfort letters as auditors
and reporting accountants on information in a
prospectus, in the same way that as auditors we
provide short form reports on IPOs.
Q1293 Mr Fallon: Last year you charged Northern
Rock an audit fee of £500,000 in addition to nonaudit fees of over £1.3 million. Do you think that
ratio is appropriate?
Mr Sexton: I think we have to be very careful about
understanding the disclosure in the statutory
accounts of our fees to Northern Rock because the
manner in which we disclose them in buckets is
mandated. The numbers you quote include: work as
statutory auditor, the first number, for Northern
Rock group; work as the statutory auditor of the
subsidiaries which has to be disclosed separately;
work as the statutory auditor in connection with the
regulatory responsibilities that my colleague
mentioned; and work that we provide as auditors in
an audit-related sense on the oVering circulars for
securitisation, that is, comfort letters on the financial
information in those circulars. That is normal
practice and is required by the banks.27
Q1294 Mr Fallon: The problem is that you were
earning in fees three times as much from consultancy
advice which further securitised Northern Rock’s
borrowing as you were getting for checking whether
or not that securitisation was placing the
organisation at risk. There was a conflict, was
there not?
Mr Sexton: With respect, I do not believe that it was
three times our audit fees as statutory auditors. I
believe the number is £1,100,000 if you include the
three relevant disclosures, and the other fees are in
the nature of audit-related activity providing audit
and comfort letters on oVer circulars which amount
to £700,000.
Q1295 Mr Fallon: The non-audit fees are listed at
£1.3 million.
Mr Sexton: As I have explained, the non-audit fees
are a categorisation under UK law which includes
the statutory audit responsibilities around
subsidiaries and regulatory reporting in the case of
a bank.
Q1296 Mr Fallon: Do you see nothing wrong in the
same firm doing the audit and checking whether the
bank is liquid and at the same time charging
consultancy fees for arranging securitisation that
increases the risk of illiquidity?
Mr Sexton: We did not charge fees for consulting on
the creation of further securitisation. Our fees were
in connection with very specific comfort letters in
relation to historical financial information that
appears in those documents. Our audit covers the
historical financial information in the annual report.
Q1297 Mr Fallon: Altogether last year you took fees
of £1.8 million and probably £1 million or so already
this year. The taxpayer has now had to lend
Northern Rock £19 billion. Do you not think you
should repay your fees to the taxpayer?
Mr Sexton: All I can say is that fees were charged in
connection with the work we performed and the
annual report and accounts and the presentation of
the historical information therein and subsequently
in providing comfort in connection with
securitisation oVerings and in relation to specific
financial information.
Q1298 Mr Fallon: You have audited and provided
comfort to the biggest banking disaster for 150
years.
27
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Mr Sexton: We have provided audit services in
connection with auditing standards and guidance
from the UK Auditing Standards Board and the
International Auditing Standards Board and
performed the duties required of statutory auditors.
Q1299 Mr Todd: Have subsequent events caused
you to revisit your audit practice in this particular
bank; in other words, do you think there is
something to be learnt from your contribution to
this disaster?
Mr Sexton: Perhaps I may answer that on a general
basis and then ask my colleague to pick it up
specifically in relation to the banking sector. The
auditor is always cognisant of market developments
in order to understand all of the information
available to it to give those opinions that it does give
on that historical financial information. We are
reviewing and thinking about the market
information now available to us and how that might
influence the level of audit evidence we might require
and the nature of our procedures in today’s
circumstances.
Q1300 Mr Todd: Do you think this episode has
enhanced your ability to win audit business in this
particular sector?
Mr Sexton: I think our ability to win business is
dictated by our ability to deliver a quality audit in
whatever market.
Q1301 Mr Todd: Therefore, you think it has done no
reputational damage at all?
Mr Sexton: I believe that the audit process as judged
by reference to the specifics of Northern Rock in the
annual and interim reports—our opinion on the
latter was signed on 25 July—discloses very accurate
information about liquidity and other structures
within Northern Rock.
Q1302 Mr Todd: Financial institutions do not have
to get their audit from you; there is a competitive
marketplace here. You think it has made no
diVerence and the market believes that you have
performed a technical task to the best of our ability
and you are a good provider of these services in
future?
Mr Sexton: I believe that to be the case.
Q1303 Mr Todd: Good! I am glad you are so
confident. I turn to events in April when the bank
chose to alter its lending pattern, at least so it told us,
to reduce the level of new loan activity. Did you have
any role in suggesting that it might need to do that
to reduce the level of risk?
Mr Sexton: I am not involved in the detailed delivery
of audit services to Northern Rock, but to the best
of my knowledge, no.
Q1304 Mr Todd: Mr Hitchins, do you have anything
useful to add to that? Were you closer to this?
Mr Hitchins: No.
Q1305 Mr Todd: Looking at Granite, you have said
that it is a small vehicle. To what extent did you audit
the function of Granite? Did you see that as a
material part of your audit of Northern Rock?
Mr Sexton: The assets and liabilities that sit within
the so-called Granite structure appear on the
balance sheet of the group accounts and, therefore,
they were subject to audit.
Q1306 Mr Todd: Did you examine the risk that
obviously was faced in the end by Northern Rock
that it would not be able to securitise through the
vehicle it chose and obviously that was a material
factor in the eventual collapse of the bank? Was the
scenario that securitisation opportunities would
eVectively dry up one that you examined?
Mr Sexton: A specific requirement of auditing
standards is to consider the work that management
and the board have done in connection with their
ability to continue as a going concern. The primary
reason for that work is to ensure that the assets and
liabilities are properly valued, but as part of that
work we look at all the information available.
Q1307 Mr Todd: You have not quite answered the
question. Bearing in mind that the vehicle of Granite
and the securitisation of loans were absolutely
critical steps in the ongoing operation of Northern
Rock, did you examine a circumstance in which this
would cease to be a functioning alternative?
Mr Sexton: The audit team would have considered
the availability of continuing funding based on
historical trends.
Q1308 Mr Todd: Do you imply that because it had
not happened before they did not think it was a risk
worth considering, because it is an historical
function looking back?
Mr Sexton: That is not what I am implying or
saying. I am saying that they would have considered
many, many scenarios but they would have regard to
historical performance and the ability to raise funds.
It was in February that we issued our report.
Q1309 Mr Todd: When eventually the Bank of
England found itself having to support this
institution, not surprisingly people wanted a clear
picture of the assets and liabilities of the bank. It
appeared that that picture was not readily available
to any of the tripartite partners. Was the preparation
of an appropriate picture of the assets and liabilities
of Northern Rock at that point something in which
you played any role?
Mr Sexton: For the purposes of discussion with the
Bank of England in September?
Q1310 Mr Todd: Yes.
Mr Sexton: I do not know the answer to that
question.
Q1311 Mr Todd: Could you ask your team? I am
slightly surprised that you have not had more
detailed conversations with the team involved in
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Northern Rock before coming here, because you
have qualified a number of your responses by saying
that you were not directly involved and you are not
too sure exactly what happened.
Mr Sexton: I believe I have said that I oversee the
audit. I have spoken to the audit team about the key
elements of our reporting dates, both the annual and
interim reports. I cannot answer your very specific
question in relation to that matter.
process. Can you provide us with a summary of how
you worked with Northern Rock on the
assumptions of impairment that they produced?
Mr Sexton: What we will more than happily do is
provide you with a commentary on the nature of the
information we sought that the company had put
together in January for the purpose of its review.28
Q1312 Mr Todd: Presumably, a critical issue in
valuing the assets and liabilities of Northern Rock
because it is a mortgage institution is the assumption
about the future housing market in the UK. Is that
reasonable?
Mr Sexton: I would imagine that to be the case.
Q1317 Mr Todd: The other aspect I am interested in
is your role of the September process in trying to sort
out the valuation of Northern Rock and its assets
and liabilities at that particular time when, very
understandably, public authorities were wondering
quite what they were getting themselves into. You
said you were not too sure what happened then.
Mr Sexton: I said I was unaware of the precise work
that we might or might not have done.
Q1313 Mr Todd: Therefore, what assumptions did
you have in place when you gave Northern Rock
advice on valuing its loan book?
Mr Sexton: I am slightly confused. The implication
of your question is that we gave them advice on
valuing their loan book.
Q1318 Mr Todd: Will you also provide a note on
that?
Mr Sexton: Yes.29
Q1314 Mr Todd: Presumably, you tested whatever
its assumptions were to see whether or not they were
reasonable?
Mr Sexton: That is correct. In February as part of
the going concern review for the annual report we
would have looked at its forward-looking
assumptions for the purposes of the balance sheet
presentation, and for the purposes of our 25 July
opinion we would have updated those again
basically by reference to management discussion as
required by the APB guidance notes.
Mr Hitchins: It is important to bear in mind that the
mortgages are in the balance sheet of Northern Rock
at cost with the amortisation of relevant fees and
expenses. The work that the auditors have to do is
to assess whether or not the bank has made suYcient
provision for impairment of the mortgages. In that
context as one element we look at what assumptions
management has made as to the future trend in UK
house prices. Another element is the percentage of
cover—the loan to value ratio—that the mortgage
has. All of those factors are looked into. It is not
really a valuation, but we are responsible for
auditing management’s impairment allowance.
Q1315 Mr Todd: What was your take on that at the
time you conducted it? Obviously, one of the current
speculations is that Northern Rock’s loan book may
not be quite as resilient as it might have appeared in
the past because of the expectations in the UK
housing market.
Mr Hitchins: I cannot comment on the details of it
because, obviously, I did not do that piece of work
myself, but in principle we signed a clean opinion in
February and so we would have had a look at it and
satisfied ourselves.
Q1316 Mr Todd: I have been a bit frustrated by the
absence of much detailed knowledge of what PwC
actually did for Northern Rock during this audit
Q1319 Mr Love: It has been reported that the big six
accountancy firms, if I may call them that, have
produced a report on valuing bank holdings. The
getting together of the big six is unprecedented. Why
is this being done?
Mr Sexton: It is not unprecedented. From time to
time the so-called big six do get together when there
is a matter of public interest. We feel that we can be
helpful to the markets in general in encouraging
people to think about particular issues. A short
paper has been produced which reiterates largely the
existing accounting standards in connection with the
calculation and presentation of value-based assets.
That is the paper to which you are alluding and the
one to which the Financial Times article referred.
Q1320 Mr Love: As I understand it, as reported that
takes a very tough line on the use of market prices
for making that valuation. We have just heard from
four of the large institutions. Do market prices exist
for the particular vehicles we are talking about?
Mr Sexton: We have not gone through the audit
period of 31 December 2007 which will undoubtedly
be a challenging period in relation to obtaining
appropriate evidence. The market values would
have been looked at as at 31 December 2006. That
market did exist. The models to which you refer and
the nature of the paper refer to the fact that the first
port of call ought to be market value. When market
value does not exist or there is no reasonable liquid
market one needs to look to models to establish what
if any value can be placed on the assets.
Mr Hitchins: The paper was intended to be a
companion to a similar paper produced in the US
under USGAAP. Basically, it put together into one
paper all the references in the accounting literature
on how to prepare fair value accounts for financial
instruments. It therefore goes through the fair value
28
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hierarchy. If you do not have a quoted market price
what do you then do? What other sources of
evidence do you obtain?
Q1321 Mr Love: One of your colleagues, Pauline
Wallace of PwC, who is leading the production of
this report has said that it was there not to provide
guidance but context. What does she mean by that?
Mr Sexton: Pauline Wallis is one of our technical
specialists in that area in PwC. The intent of her
comment is that it is there to alert the market as a
whole to this being a significant issue and to
reinforce the need for people to consider the
valuations very carefully.
Mr Hitchins: It is not intended to provide new
interpretations of accounting standards because that
is not the job of the big accounting firms. If that is
needed it should be done by those who set
accounting standards.
Q1322 Mr Love: I am interested in the view
expressed about the so-called model-based
calculations. If you were here earlier and listened to
the discussion you would have heard that there are
obviously very diVerent models, assumptions and
calculations. To what extent will this paper bring
consistency to that?
Mr Sexton: We cannot dictate to the market or those
who prepare those models what assumptions they
should make. Our job is to make sure they have gone
through a very thorough process and that their
assumptions are reasonable and based on
supportable information wherever available.
Q1323 Mr Love: The obvious question to arise from
that is whether you can find yourself auditing two
diVerent large financial institutions with very similar
vehicles which have used very diVerent assumptions
and models and therefore have arrived at very
diVerent valuations and you then agree with their
decisions on these matters?
Mr Sexton: Whether or not we would agree with
them is a matter for the future, but we can certainly
come across the circumstance where diVerent
institutions use diVerent models, as they do. That is
absolutely the case.
Q1324 Mr Love: How confident are you that by the
use of this report we will get more confidence and
trust in the marketplace? There is a lot of concern
that there is not just a lack of transparency about the
valuations but where there are valuations they diVer
so much that nobody can have any confidence in
them. Do you think this will make a contribution
towards restoring confidence?
Mr Sexton: I think that if financial institutions
ensure they provide appropriate and detailed
disclosures where they use those models it will
provide greater transparency so everybody can
understand exactly what is going on.
Q1325 Mr Love: You mentioned earlier in response
to Mr Fallon that a lot of the work you do is not
concerned with just standard auditing procedures;
you are brought in by companies for a whole variety
of interim auditing purposes. Why has there not
been a large-scale move among financial institutions
to bring in auditors to look at the valuations? There
is a great deal of talk among all of them about the
need for transparency but a total lack of
preparedness to be transparent themselves. Why is
that happening?
Mr Sexton: The only way I can answer that is to refer
to the amount of disclosure that is mandated under
international financial reporting standards IAS 39
and IFRS 7 as recently reissued which are required
to be put into the financial statements. The banks of
their own accord will go about their valuations and
employ a lot of people to do them.
Q1326 Mr Love: I am minded to ask you for a value
judgment about international financial accounting
standards because that seems to be the response to
all of these questions but I shall not do so. Have you
been advising your clients on the need for
transparency and suggesting to them that they might
wish to undertake some interim auditing procedure
in order to get out into the marketplace the best
estimated true valuation of some of their vehicles?
Mr Sexton: We have encouraged all of our audit
teams to talk to their clients over the period about
the need to look at the valuations of their assets and
liabilities, be that in the banking or corporate
environment.
Q1327 Mr Love: As I understand it, for most firms
the accounting year will end either at the end of this
year or early next year. That means you will not get
fully audited accounts for some considerable period.
Are you giving your firms any advice on bringing
forward valuations in order to get them into the
marketplace?
Mr Sexton: Perhaps I may answer that in two parts.
First, you are absolutely correct that the tradition in
the financial services world is to have a 31 December
year end. Typically, they would issue preliminary
results reasonably early in January through the
month of January. Indeed, if one uses Northern
Rock as an example its interim announcement in
relation to 2006 was on 24 January and for most
financial institutions the audited financial
statements followed approximately a month later.
There are also continuing obligations under
regulation in the UK for all listed institutions to
keep the market informed of material developments.
That is outside the scope of the work of auditors, but
it is a continuing obligation on those companies.
Q1328 Jim Cousins: How much do you charge for
writing a comfort letter?
Mr Sexton: That depends very much on the nature
and volume of the information required.
Q1329 Jim Cousins: You appear to have received
fees of £500,000 for auditing Northern Rock and
£700,000 for writing comfort letters. How much per
comfort letter did you charge?
Mr Sexton: As I have explained, that depends
entirely on the scope of the specific comfort letter.
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Q1330 Jim Cousins: How many comfort letters did
you write?
Mr Sexton: There were a number of comfort letters
in 2007.
Q1331 Jim Cousins: How many?
Mr Sexton: No more than 10.
Q1332 Jim Cousins: You charged £70,000 for a
comfort letter. Therefore, there is more money in
writing comfort letters than in auditing the
company?
Mr Sexton: When we are requested and required to
provide things like comfort letters we provide that
service to our clients. I am not sure we would look at
it on the basis that there is more money in providing
comfort letters to the client. That depends entirely
on their level of activity in relation to those
particular matters.
Q1333 Jim Cousins: You have to agree that in the
wider world it would seem pretty extraordinary that
your fee for auditing the company was £500,000 and
your fee for writing 10 comfort letters was £700,000.
Mr Sexton: As I have explained, the £500,000 is for
a statutory disclosure in connection with the fee for
auditing the company Northern Rock Plc. There are
additional subsidiary companies within Northern
Rock that are subject to audit and regulatory
responsibilities that fall on the company that must
be fulfilled. If you take those numbers together what
you see is that we charged fees of £1.1 million as
statutory auditors to Northern Rock and £700,000
in connection with comfort letters and
securitisation.
Q1334 Jim Cousins: In your discussions with the
FSA about Northern Rock what did you tell them
that was material to your function as auditor?
Mr Sexton: I do not have a transcript of the precise
comments made to the FSA by the audit partner at
the tripartite meeting.
Q1335 Jim Cousins: Just give us the general flavour.
When you talked to the FSA what sorts of things did
you tell them?
Mr Hitchins: The first point here is that which I
referred to earlier in terms of our duty to report
when we become aware of something that is material
to the FSA. I am not aware of when or how we had
those discussions with the FSA.
Q1336 Jim Cousins: Did you report anything to the
FSA about Northern Rock?
Mr Sexton: We would have had normal
conversations as part of tripartite meetings with the
FSA, with Northern Rock management and the
regulator.
Q1337 Jim Cousins: Could you charge £300,000
for that?
Mr Sexton: The work that we provide to the
regulator as statutory auditor is mandated by the
FSA and subject to the very competitive
marketplace to which you have referred.
Q1338 Jim Cousins: In the tripartite discussions that
you had with the FSA, about which you have not
really been able to tell us anything, where did your
duties lie?
Mr Hitchins: I do not know whether there was a
tripartite meeting. They do not happen every year
but only at the FSA’s request.
Q1339 Jim Cousins: Did any happen?
Mr Hitchins: I do not know.
Q1340 Jim Cousins: Can you tell the Committee
whether they did happen about Northern Rock?
Mr Sexton: Yes.30
Q1341 Jim Cousins: In your relationship with the
FSA where do your duties lie? Do they lie to
Northern Rock who are paying you £300,000 or to
the FSA and the wider markets?
Mr Hitchins: The £300,000 referred to was to report
on regulatory returns to the FSA where we have a
duty of care to both the company and FSA.
Q1342 Jim Cousins: Could you spell out what your
duty of care is to the FSA?
Mr Hitchins: In terms of regulatory reporting, our
duty of care is to make sure the information in the
regulatory returns is consistent with the information
we have audited.
Q1343 Jim Cousins: Did you ever draw to the FSA’s
attention that in terms of assets and liabilities over
three months Northern Rock’s liabilities were four
times its assets?
Mr Hitchins: I do not know whether we specifically
did so.
Mr Sexton: That information is included in the
regulatory returns and therefore is brought to the
attention of the FSA.
Q1344 Jim Cousins: It is up to the FSA to spot it?
Mr Sexton: The FSA has a very well developed
procedure.
Q1345 Jim Cousins: You are not under any duty to
point it out?
Mr Sexton: Not explicitly, no.
Q1346 Jim Cousins: What is your duty as auditor to
the depositors?
Mr Sexton: Our duty as statutory auditors to any
UK plc is primarily to the shareholders; it is they
with whom we contract through their board.
Q1347 Jim Cousins: So, you do not have any duty of
care to depositors?
Mr Sexton: We have no duty of care to depositors.
Q1348 Jim Cousins: What are your fees so far for
preparing the documents for the sale of Northern
Rock?
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Mr Sexton: I do not know that number. It is an
ongoing process and as the bid process proceeds as
auditors we will almost certainly be involved in
providing opinions on historical financial
information predominantly in relation to periods
already reported.
Q1349 Jim Cousins: Perhaps you could let the
Committee know in due course what those fees are.
Mr Sexton: Those fees will be thoroughly disclosed
in the annual report and the prospectus.
Q1350 Jim Cousins: Can you let the Committee
know what the fees are so far?
Mr Sexton: Those fees will be thoroughly disclosed
under regulatory requirements.
Q1351 Jim Cousins: In preparing those documents
obviously your duty is to the board of Northern
Rock.
Mr Sexton: The duty in preparing a prospectusrelated document will be to the shareholders of the
company—we contract with the company—and to
the purchaser to the extent we contract with the
purchaser. It will depend entirely on with whom we
contract.
Q1352 Jim Cousins: One of your former colleagues,
Rosemary RadcliVe, was a director of Northern
Rock and served on the audit committee.
Mr Sexton: That is correct.
Q1353 Jim Cousins: Did you raise any issues about
that?
Mr Sexton: We did. That was why she stood down
from the audit committee in December 2006 and
only after we had obtained explicit clearance with
the regulators that her independence was not
impaired, she having left our partnership in 2001,
did she go back onto the audit committee.31
Q1354 Jim Cousins: Therefore, you sought the
assurance of the regulators that it was perfectly
proper for her to be on the audit committee and she
went back onto that committee?
Mr Sexton: She did. The specific arrangement is that
she steps out of any discussion involving
PricewaterhouseCoopers and its appointment to
Northern Rock.
Q1355 Jim Cousins: What about her involvement
with the regulatory returns that you prepared?
Mr Sexton: I am afraid that is a matter for the
company. I do not know the answer to that.
Mr Hitchins: We do not prepare the regulatory
returns and eVectively we provide an assurance
opinion on them.
Q1356 Jim Cousins: In your reporting to Northern
Rock shareholders in the annual report you say that
you are not required to consider whether the board’s
31
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Note by witness: For completeness, the regulator I was
referring to in my reply was the Securities and Exchange
Commission.
statements on internal control cover all risks or form
an opinion on risk and control procedures. Do you
think you should be required?
Mr Sexton: The requirements of the combined code
which drive the work we do and do not do have been
subject to repeated review involving all market
participants—regulators, companies and standardsetters—and the conclusion they have reached is that
the best use of auditors is to focus upon financial
reporting controls, which is what we do, not provide
an overall opinion on internal control in the way the
American environment has moved.
Q1357 Jim Cousins: I was asking you, not them. Do
you think it would be right for you as auditor to
report on the risk and control procedures of the
bank? Do you think you should be required to check
out the board’s statements on its internal controls
on risks?
Mr Sexton: What I am saying to you is that the
regulators dictate the work we do as statutory
auditors, so if your question is directed to us as
statutory auditor I can answer only as to the nature
of what the regulators might require us to do.
Q1358 Jim Cousins: This is dissembling. I am asking
for your view about this. Do you think it would be
sensible if you were required to report on these risks?
Either you do or do not.
Mr Sexton: I think that firms like my own can add
value when they look at all kinds of control. It is one
of our areas of expertise, so we could certainly add
value to companies if they requested us to do that
work.
Q1359 Jim Cousins: To be very clear about what you
are saying, that would be additional to your work as
auditor and it would be a specific new task for which
you would charge an additional fee, presumably.
Mr Sexton: If it were requested by the company
outside statutory regulation that would be the case.
Q1360 Mr Brady: You have been very particular in
responding to one or two colleagues to make clear
that the proportion of your fee income derived from
audit-related activity is higher than has been
suggested. Do you think there is an acceptable and
unacceptable ratio between those two things?
Mr Sexton: The purpose of the disclosures of fee
ratios is to ensure that users of financial statements
are aware of the amount of work we do. We take
independence incredibly seriously and look at every
piece of work, whether or not it approaches some
sort of magical ratio, to see if it can possibly impair
our independence. We decline to act where we feel
that would be the case. I do not believe that a cap in
itself is the right way to look at things. You have to
look at each individual piece of work and be
comfortable that it has no impact on independence.
Q1361 Mr Brady: In the past accounting period
what has been the ratio of fees as between auditrelated services and other services?
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Mr Sexton: In all companies?
Q1362 Mr Brady: In Northern Rock?
Mr Sexton: In Northern Rock it is disclosed in the
accounts. The ratio in terms of our role as statutory
auditor and the work we have to do is less than one
to one.
Q1363 Mr Brady: What ratio would give you cause
for concern?
Mr Sexton: I merely observe what the market
analysis as a whole shows. If one looks at the
FTSE100 analysis in the 12 months broadly to 31
December—you will appreciate that year ends are
diVerent for diVerent companies—the ratio is of the
order of 1.1 to one.
Q1364 Mr Brady: Looking at some of the fee income
that you have received for assurance services in
relation to securitisation transactions, it appears to
me that a significant amount of it was dependent
upon the particular business model being pursued by
Northern Rock.
Mr Sexton: It was a fee income reactive to the
transactions that they performed.
Q1365 Mr Brady: So, the more securitisation
transactions were performed the more letters of
assurance you would expect to provide?
Mr Sexton: That is correct, but under our ethical
standards we cannot provide any kind of
management input to a company to encourage it to
perform one transaction or another. That is
completely forbidden under our ethical standards.
We cannot create a transaction flow in order to
charge fees; it is purely a reaction to the level of
transactions that a company may or may not choose
to undertake.
Q1366 Mr Brady: When Northern Rock decided to
pursue a business model which led to a great
expansion of certain types of transactions clearly
that provided an increased flow of fee income for
PwC.
Mr Sexton: Northern Rock’s entry into those
transactions has that consequence given market
practice that typically requires the audit firm to
provide comfort.
Q1367 Mr Brady: There seem to be some parallels
between what happened to Northern Rock and the
German bank Sachsen LB which in some ways was
pursuing similar business models, particularly
through its Irish subsidiary. There was a report in
the Financial Times on 23 November which
commented that KPMG had undertaken a review of
the activities of Sachsen’s Dublin-based market
business. The FT reported that as early as 2005
KPMG had cautioned, presciently, that the Dublin
strategy was based on the premise that markets
never malfunctioned and it warned that the bank
could be forced to sell assets if investors stopped
buying the bonds being used to finance the various
funds. Was KPMG able to see something that PwC
could not?
Mr Sexton: I am afraid I do not know on what facts
KPMG based that report. Presumably, it would
have been a private report commissioned by the
bank or other parties. I do not know the information
behind it or on what they would have based that
conclusion.
Q1368 Mr Brady: But in your dealings with
Northern Rock or your statutory audit function
there was no point which would have caused you to
raise concerns of a similar nature as to whether or
not the model was sustainable.
Mr Sexton: I think that what you describe is a
specific piece of work that KPMG as consultants to
the bank were engaged to do on behalf of that
institution. We cannot act as consultants to our
audit clients.
Q1369 Mr Brady: I accept that, but during the
course of the work that you undertook in terms of
your assessment of the bank’s practices as statutory
auditor there was nothing that led you to have
concerns of a similar nature.
Mr Sexton: For the purposes of looking at the
annual accounts, the interim report and preparation
of our opinions thereon we would have looked at all
pertinent information, including the liquidity in the
markets at those points.
Mr Hitchins: I think it is important to remember
how liquid those markets were in the first half of
2007. In May, June and July there was over $30
billion of residential mortgage-backed security
issues.
Q1370 Mr Brady: I accept that. My point however is
that albeit KPMG may have been acting in a diVerent
capacity for Sachsen LB two years ago when there
was significant liquidity in those markets it was
cautioning that the strategy was based on the premise
that markets never malfunctioned.
Mr Sexton: As auditors clearly we have been
conscious of the fact that for a number of years
valuations have been rising in respect of various asset
classes. Therefore, part of our work has been to focus
carefully on the values based on the information that
we have available at the time we do our work. That
encompasses a whole load of facts. Our opinions at
that moment in time are based on the best
information available to us, so we would have been
cognisant of that kind of issue for the purpose of
looking at annual financial reports.
Q1371 Mr Brady: You would have been cognisant of
that presumably not only for the purposes of the
financial report but also in relation to letters of
assurance relating to securitisation transactions?
Mr Sexton: During the first half of 2007, yes. The last
securities issue that Northern Rock entered into of
which I am aware was in June.
Q1372 John Thurso: First, is it right that neither of
you was involved in the audit of Northern Rock and
neither of you is a client partner or anything like that?
Mr Sexton: We are both client partners but not of
Northern Rock.
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Mr Richard Sexton and Mr John Hitchins
Q1373 John Thurso: In other words, you are not in the
direct client relationship chain?
Mr Sexton: That is correct.
Q1374 John Thurso: Clearly, I understand that an
audit is really about establishing the veracity of what
has happened in the past rather more than about the
sagacity of the actions that have been taken. I want to
turn to the questions that my two colleagues have
been asking about the relationship between the audit
committee and risk committee and the auditors. It
seems to me that the core failure of Northern Rock
was the fact that the risk committee failed to see the
risk of an illiquid market. When they came before us
they said that it was unforeseeable. From the
conversations that have just been going on it seems
that others, including KPMG, foresaw it, so maybe it
was foreseeable. Asking you not as this company’s
auditors but as serious practitioners in this field, what
can be done to improve the performance of a risk
committee of a financial institution and the way in
which it interacts with an audit committee? One of the
points which struck me was that the chairman of the
risk committee and audit committee was the same
person and mostly the same independent executives
were involved. Is there anything that you would like
to see done in that part of the mix of corporate
governance?
Mr Hitchins: Banks tend to have risk committees at
diVerent levels. There is usually a management risk
committee that manages the business day to day.
Many banks have now established risk oversight
committees as committees of the board. The reason
for their establishment is that the workload of audit
committees has become too great for the committee
itself to handle both audit and risk oversight. What
one needs is a clear link and common membership,
not exactly the same. Having common members is an
important way to ensure that the audit committee is
aware of what the risk committee is doing.
Q1375 John Thurso: Would you think it a wise
precaution to say that the risk committee chairman
should not be the same individual as the audit
committee chairman?
Mr Hitchins: I do not believe that would necessarily
be a weakness.
Mr Sexton: One of the challenges is that there are pros
and cons. Obviously, on the positive side they are
aware of both aspects of that part of the management
of the business, but, frankly, the downside is the
amount of work involved to do both jobs. Therefore,
one has to balance the two. As with all committees of
the board, they are acting on behalf of the board as a
whole, so there is a role for it.
Q1376 John Thurso: My worry is that the audit
committee’s job is basically for the independent
directors to ensure the audit is being done correctly
and you as client partners have been given the
opportunity to meet with the audit committee
without any members of management. All of that is
designed to try to make things as robust as possible.
But if you have exactly the same chairman and people
on the audit committee as are on the risk committee
the chances are that the same problems can occur as
between the audit committee and the full board.
Mr Sexton: Having variation in committees and
diVerent people looking at diVerent aspects is a good
thing, and we see that today in many of our client
companies. They will select their independent nonexecutive directors for specific skills and deploy those
in particular ways.
Mr Hitchins: Today some banks still have combined
audit and risk committees.
Q1377 Chairman: From the questions put by a
number of my colleagues it appears they are not
particularly satisfied that you have adhered to
general principles, for example the issue of regulatory
returns raised by Mr Cousins. In light of those
comments I shall be writing to you for further details
and I hope you can reply as quickly as possible, say,
within a couple of weeks.32
Mr Sexton: We will certainly do that. We did come in
the spirit of answering questions on financial stability
rather than Northern Rock specifically, so I hope we
have been able to help you.
Q1378 Chairman: Northern Rock is the elephant in
the room, is it not?
Mr Sexton: I understand that as well.
Chairman: Thank you very much.
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Ev 144 Treasury Committee: Evidence
Witnesses: Mr Chris Hitchen, Chairman of the National Association of Pension Funds and Executive
Chairman of the Railways Pension Trustee Company; Mr Peter Montagnon, Director of Investment AVairs,
Association of British Insurers, Mr Guy Sears, Director, Wholesale, Investment Management Association,
and Mr David Pitt-Watson, Chairman, Hermes Equity Ownership Service, gave evidence.
Q1379 Chairman: Welcome and good afternoon.
Perhaps you would introduce yourselves for the
record.
Mr Montagnon: I am Peter Montagnon, Director
of Investment AVairs at the Association of
British Insurers.
Mr Sears: I am Guy Sears, Director, Wholesale,
Investment Management Association.
Mr Pitt-Watson: I am David Pitt-Watson from
Hermes and I am Chairman of their Equity
Ownership Service.
Mr Hitchen: I am Chris Hitchen, Chairman of the
National Association of Pension funds and Chief
Executive of the Railways Pension Trustee
Company.
Q1380 Chairman: What factors explain the rise in
demand over the past decade among investors for
a range of higher-yielding but riskier financial
products, including US subprime residential
mortgage-backed securities?
Mr Hitchen: Certainly, from the perspective of
pension funds our forays into the areas you
mention have been relatively limited. We try to run
diversified portfolios. But the secular change over
the past 10 years among UK pension funds is that
they have increasingly been maturing and marked
to market by accounting standards, et cetera. They
are now brought onto company balance sheets.
Therefore, there has been a desire among pension
funds to de-risk their investments and move
towards more bond-like investments which might
be closer to their liabilities. The problem is that the
yields on long-dated bonds are very low and there
may be a supply/demand imbalance there. It may
be that some investors look for instruments which
appear to have the characteristics of bonds but
perhaps have a slightly higher yield.
Mr Pitt-Watson: In looking at the issuance of this
paper one needs to look at the supply as well as the
demand. Clearly, banking regulation made it very
attractive for people to dis-intermediate loans and
package them up as high yield securities.
Obviously, people want as high a yield and return
as they can possibly get and this can be achieved
because special purpose vehicles do not have the
same capital requirements that would be required
if they were held on the balance sheet.
Mr Sears: I think there are three points. With low
interest rates people look for yield. There is the
originate and distribute model that has been
pushed. There is also a matter that has not been
mentioned by the investment banks. Part of the
explosion was caused because mathematicians
started to put together better models on which
people could rely to assess joint risk.
Q1381 Chairman: Do you think there are better
models, Mr Montagnon?
32
Ev 342
Mr Montagnon: Our members are quite large
investors in the corporate bond market but they do
not have a huge amount of asset-backed securities.
We have asked them. What comes back is
something in the region of 0.5% of their portfolios.
We have not been particularly large in this and it
is diYcult to know why others have gone into it.
Our impression is that a lot of the paper we have
been talking about has been bought by banks
around the world, not necessarily by traditional
long-term institutions. There has been some buying
by such institutions to diversify risk and get the
right risk/return balance in the portfolio, and
clearly there has been some push down the risk
curve as interest rates have been very low and
spreads have been compressed, but we do not count
ourselves as large players in this market.
Mr Sears: Generally, with asset managers we have
about three point something trillion pounds under
management. We act for others; we do not do
proprietary trading. A very small part of that will
be in this infected stuV. There will be some pockets
of stress, but they are a very small part.
Q1382 Chairman: Do investors have a suYciently
good understanding of credit ratings? Does more
need to be done on that?
Mr Montagnon: As provided by the credit-rating
agencies?
Q1383 Chairman: Yes.
Mr Montagnon: I think they do, at least insofar as
they understand the limitations of a credit rating.
When I talk to our members who are large
institutional investors they regard the credit rating
as only one factor in their investment decision; they
do not rely on them. Sometimes their clients give
them a criterion which requires them to invest in
paper above a certain credit rating—an investment
grade—and that aVects their behaviour, but in
terms of individual ratings they like to make their
own judgments. They take note of a credit rating
but do not rely on it completely.
Mr Hitchen: I reiterate that. Certainly, the bond
managers we have employed in our scheme would
make their own credit assessment. The credit-rating
agency rating would often be something that they
could use in a way to gain an advantage over the
market by assuming that other investors are relying
on it, if you like. I believe that the credit-rating
agencies provide to the market a good basic level
of information.
Mr Pitt-Watson: I would put a caveat on that and
consider where the question is coming from and
some of the Committee’s earlier questions. People
do use external credit-rating agencies in thinking
about value, but the bond market like the equity
market, is characterised by trading rather than
ownership. You will probably remember Keynes’
description of professional investors. He described
them as those who try to guess who it is will win
a beauty contest, which requires not just knowing
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which person you think is beautiful but which one
you think the other person thinks is beautiful.
Therefore, when people trade bonds what they look
at is how it is they beat the market, whatever it is
that the market does. That means that the
concentration on ownership and fundamentals is
perhaps less than it ought to be, whereas masses of
resources are put into thinking about how it is, over
a relatively short period of time, you can manage
to out-perform the other actors in the market in
which you are trading.
Q1384 Chairman: Is there an inherent conflict of
interest in the fact that rating agencies are paid by
the same banks for whose products they provide
ratings?
Mr Montagnon: Yes. We have been aware of and
concerned about the conflict of interest particularly
in some of the structured finance products where
the credit-rating agency is involved both in assisting
the bank prepare the product and in rating it. That
is a source of concern. We do not however believe
at this stage that it needs to be addressed by formal
regulation. We would prefer that it be done
through a robust code of practice, probably under
the sponsorship of IOSCO, rather than formal
regulation because we believe that the latter may
have some unintended negative consequence with
regard to competition and choice.
Mr Pitt-Watson: Some of you may know that last
year I wrote a book entitled The New Capitalists:
How Citizen Investors are Reshaping the Corporate
Agenda which raises precisely this question.
Clearly, if you are paid by somebody there is an
inherent conflict of interest.
Q1385 Chairman: I have read it.
Mr Pitt-Watson: I will add that as a blurb on the
back of the second edition! It is not just the
payment for the credit rating; it is also that they
(the ratings agencies) will provide additional
services to the companies they are rating. The three
credit-rating agencies are a protected oligopoly and
there may be a question about whether or not that
is a constructive thing to do in terms of having
appropriate competition in the market.
Mr Hitchen: The way credit-rating agencies get
paid is nothing new, but the job has become more
complicated. Despite the fact that clearly they do
get paid for providing the ratings, my perception
as an outsider is that their business model is not
as robust, say, as that of investment banks, ie they
cannot pay for quite the same level of talent as the
issuers of paper. There might be something there
that we need to think about.
Mr Pitt-Watson: But they did get Worldcom,
Enron and Parmalat wrong, and that is why they
are mentioned in The New Capitalists. Now they
have got this wrong. There are some things that
perhaps we should dig up by the roots this time,
and sort out.
Mr Sears: We have been talking about the conflict
of interest in this area for years and years, but in
this context sometimes credit-rating agencies are
almost given a special role by the regulators or
those who set capital treatment. This conflict also
appears in the context where there can be a massive
diVerence between, say, getting investment grade
and not getting it. There is a very high risk area of
conflict as well as just generally.
Q1386 Mr Dunne: Mr Montagnon, you said just
now that you believed your members held a very
small proportion of asset-backed securities. The
banks tell us that the process of dis-intermediation
means they are not holding liens on their books,
although one of you said earlier you thought that
banks did so. Who knows where this paper is? How
do we get to the bottom of this? If you are the
institutional investors and you do not hold it and
the banks do not have it where has it gone?
Mr Montagnon: That is a very good question and
one of the reasons why this present moment is so
diYcult. Nobody really knows where the risks have
ended up and who hold them. I repeat that our
impression is that a lot of this paper has found its
way into banks. It is slightly diVerent from
traditional lending, but you have seen a couple of
German banks where there have been problems. It
has definitely been a banking rather than a longterm institutional problem. All we can say is that
we cannot trace a lot of it back to our members.
Mr Sears: I am not sure either. We have not gone
through all the clients of all of our firms to work
it through. I certainly think that the percentage
across some of the institutional funds may well be
above 0.5%, but it is certainly not significant.
Perhaps some is sitting inside hedge funds. I think
that in particular the enhanced yield money market
funds, not the constant net asset ones, will be
carrying some of it as well.
Q1387 Mr Dunne: That is a very interesting point.
Is that not where the public at large may get hurt
by this? There may be more sophisticated financial
products created to provide a pooled money
market fund that holds instruments which,
although they have been rated triple A, are
contaminated and may start to unravel. Is that not
where the man in the street can get hit but so far
it is hidden?
Mr Sears: There are two ways in which the man in
the street may be hit. To explain, there are money
market funds and money market funds. The French
enhanced-yield ones are somewhat diVerent from
the institutional money market funds that will be
triple A-rated. They will have quite a small
percentage of this asset-backed security, and
certainly over the past couple of months they have
been exiting that. One of the advantages is that the
maturities are very short so you can get out. There
are two very diVerent products out there: treasurytype products in the form of institutional money
market funds and more investment-type products.
I believe that those do have infection and mainly
institutional people have gone into them, but they
are in France and across Europe. You are
absolutely right that through repackaging, whether
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Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
it is direct or through secondary eVects, with loss
of liquidity, retail people will be hurt, as we all will
if this continues.
Q1388 Mr Dunne: Do you agree that we are only
a short way through the process? The contagion
eVect of the potential of other funds being unable
to price because one risk goes wrong is yet to be
unravelled. It has happened. How long will the
process take before it becomes apparent how
widespread it is?
Mr Sears: I think it is spread across the whole
economy. When we get to the year ends,
construction companies may worry about getting
their facilities renewed. How long will it take? I do
not know, but there will be a certain critical points.
I believe that the interim results that come out in
January will be another moment of confidence and
perhaps crisis of confidence.
Mr Hitchen: Commentators are now talking about
maybe two years for the full eVects to become
apparent, but if you go back less than one year
given that the market was not focused on these
issues much at all I suspect that may be an
underestimate. I agree with Mr Sears that if we get
an economic downturn as a result of the credit
crunch it may be much more long term.
Q1389 Mr Dunne: Mr Pitt-Watson, do you believe
that investors understand the relative pricing of
investment grade and non-investment grade
tranches of some of these CDOs? Are they relying
entirely on what the rating agency says or because
they are so sophisticated are they looking behind
that?
Mr Pitt-Watson: More sophisticated investors
know what is going on but are typically motivated
to try to trade in the market rather than be good
owners in the market. The person whose
investment money they are investing is the ordinary
man in the street. You asked who has lost from
this. Clearly, the pension funds that own Northern
Rock have lost up to £4 billion. I would guess that
public sector pension funds have lost between £250
million and £300 million simply as a result of the
fall in the value of Northern Rock since this crisis
began. Lord knows how much they have lost
through their equity holdings in the banks overall.
Clearly, the banks did have these investments
(subprime CDO’s) because they have been writing
them down; that is where the losses have come
from. Pension funds with lots of hedge fund
investments will not even know what those hedge
funds are invested in. I checked for Hermes. I was
told they are not entirely sure about the many
hedge funds in which the British Telecom pension
scheme is involved but they know that one of them
bet against subprime mortgages because it came
back to tell them what a good return they had had
as a result of the crisis. We do not know whether
the money of ordinary people is directly aVected by
what is happening here. We do not know the value
of these things. Accounting standards have focused
on mark to market rules instead of prudence,
principles. When the market dries up and we start
marking to model (as people were already doing
perhaps because that helped with the bonus at the
end of the year, if it appeared markets were going
up). The accountants simply do not know how to
give a market value when there is no market. That
knocks back on all your banking ratios. People
start to get scared about credit. The banks hold on
to their credit and the interbank lending market
that works any longer. The man in the street is very
firmly aVected by this. Did sophisticated investors
know what they were doing? Yes, they did and they
were trading; they were trying to beat the market.
In my view what sophisticated investors were not
doing to the extent they should have done, was
behave as owners, like the old bank manager would
have done when he took on a mortgage. He would
ask, “Does this person have a secure job and will
he be able to pay back the mortgage? Do we have
a house that has security?” That was what failed. It
went straight through the system. The credit-rating
agencies and the accountants did not do their job
and as a result we have this problem today.
Mr Hitchen: Pension fund trustees will have a
varying level of understanding of these things, but
what they are not doing is trading in the market
day to day. What they do is appoint professional
investors and ask them to beat a benchmark. It is
the action of trying to beat that benchmark that
results in the behaviour to which Mr Pitt-Watson
refers.
Q1390 Mr Dunne: Perhaps this is a question for Mr
Montagnon. Are your professional investors not
relying on the credit rating as their primary
determinant not just of the creditworthiness of the
instrument but whether or not it will have liquidity?
Do they use a separate measure to determine
liquidity?
Mr Montagnon: Our large investment members
certainly do not rely solely on the credit rating. The
credit rating does not in itself say anything about
liquidity. That has been a problem. In some parts
of the market they may not have been properly
understood. What our members believe is that
sometimes the information they need to assess the
issues they get—this applies more generally across
the bond market—is not as available, accessible or
readily forthcoming as it might be. Certainly, with
regard to structured products they need
information about collateral in order to be able to
assess the risk they are taking. They would like to
know more about the models underlying these
transactions and sometimes that is not so easy to
get at. The investment banks said it was there. It
may be there but in a format that is not at all
digestible. That is diYcult sometimes when one has
to make quite quick decisions.
Q1391 Mr Dunne: Do you believe that the treasury
departments of local authorities, for example, who
may be deciding where to plant their cash deposits
through the year have the capability to look behind
the credit rating and do anything other than take
it just because it is investment grade?
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Mr Pitt-Watson: Obviously not. The credit ratings
are often used to give the mandate. Funds are
allowed to invest in bonds that have got a certain
credit rating. That is why getting good credit rating
is worth so much to the issuer, because it means
the interest rate is lower, and the amount of money
it raises can be a lot higher.
Q1392 Mr Dunne: If we look beyond the confines
of the CDO market we see liquidity starting to dry
up across the economy. Today we read in the
newspapers that property funds are starting to
impose non-redemption periods because of issues
aVecting the property market. Do you see evidence
of contagion spreading into other financial
instruments?
Mr Sears: As I read in the FT this morning, the
property funds which imposed in this 12-month
period are institutional funds. Because of the way
the FSA rules work, you cannot for a retail fund
impose a 12-month period, so the ones that have
been announced have been the institutional side of
it. Are people seeing stress everywhere? Yes, they
are. Certainly, as far as asset managers are
concerned the diVerence at the moment is that
compared with the period prior to the summer
people now manage this full-time. People are
exiting and becoming more liquid as time goes on.
I suggest that that is a very diVerent dynamic from
six months ago when some of the signs were there.
Q1393 Chairman: I asked the banks about
problems with a mortgage in Chicago. I asked
whether it was a matter of garbage in, garbage out
if they did not have the market information. How
do you view that?
Mr Pitt-Watson: When suddenly the very basis on
which securities are traded and valued is called into
question it is quite dangerous. That was the
problem with the credit-rating agencies to whom
you talked. I go on to say that there is a continuing
problem—Mr Cousins has focused on it in some of
the things he has written in the past few years—
with the way in which accounting standards are
developing. Accounting standards are based
considerably less on the principles (on which they
used to be based) than they on market prices. That
is another continuing issue.
Q1394 Nick Ainger: I asked the banks whether they
considered their actions to be reckless or cautious.
You seem to be saying from the way you react to
CDOs that you are being cautious. Do you think
the banks have been reckless in the way they
became involved?
Mr Hitchen: The banks operate in a diVerent
environment and over very diVerent timescales. We
represent in the main institutions that invest very
much for the long term and that colours the way
we think about things. We are naturally cautious
about getting into areas of which perhaps we do
not feel we have a perfect understanding.
Q1395 Nick Ainger: Mr Pitt-Watson, earlier you
referred to the issuing of mortgages and the image
of the old-style bank manager. Do you think that
within their organisations the banks have old-style
bank managers?
Mr Pitt-Watson: No. It is not being done in that
way any longer. The central point is that loans were
being “originated” and then put onto the money
market providing a rating for them could be
obtained. One of my colleagues in the States is a
director of a bank which got out of subprime in the
past year. He told me that one of the numbers he
looks at is the first payment default on auto-loans.
A person buys a car and does not make the first
payment, let alone the second or third payments.
These defaults have gone shooting up in the United
States. Those sorts of indicators simply mean that
people have been giving out injudicious loans and
the market has been happy to accept them because
it has not been thinking of itself as the owner of
those loans but as the trader of them. I do not
criticise trading; it is very important that we have
it, but if we trade without ownership and move
from the old bank manager system, to loans being
monitored by traders on Wall Street, without
anything else taking place, ultimately it is the
pension funds, insurance companies and little
savers who lose because the market collapses, as it
has done this summer.
Mr Sears: We talk about sell and buy side firms. I
think it is a very diVerent dynamic. All of our firms
will be remunerated by performance over time.
There are two lifestyles, one of which is
transactional: people are paid transaction by
transaction just to sell something. The other
activity is performance-oriented. These are two
very diVerent ways to approach the market. I think
that is the modern analogy to your bank manager
and the salesman.
Q1396 Mr Mudie: That is what worries me. I shall
ask about pension funds. The answer is that they
are not in these products, but those products that
would deliver money. If you are benchmarking you
would not your advisers be pushing into that field?
Why are you not in it?
Mr Hitchen: I can speak only for the pension fund
which I run. We set guidelines for all our external
professional fund managers; we set not only a
benchmark but the rules of the game that they play
against. It just so happens that for CDOs as an
example of what we are talking about, although we
are not talking about them specifically today, we
have told our managers they cannot invest in them.
If they want to do so they must come back and
make a very reasonable case to us. We have
adopted the same approach to most other
investments.
Q1397 Mr Mudie: I read your submission.33 You
say that only 1% to 2% are involved but it still
represents £60 billion which is a lot of money. That
is just your estimate. Does that estimate also
include private equity, for example?
33
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Mr Hitchen: Pension funds tend to take the equity
part of private equity investments. They will have
some investments in the loan part of the deals, but
they are mainly in the equity piece. Clearly, that
brings its own risks, but we accept that when we
invest in equity we do so for return and we have to
take it on the chin if a particular equity goes wrong.
Q1398 Mr Mudie: When we have investigated
private equity we were particularly worried about
your industry in terms of pils in returns and then
something happens and you have real problems in
terms of paying pensions. You are quite relaxed in
terms of the amount of money invested in these
particular financial instruments. How firm are you
on that 2%?
Mr Hitchen: It is the best estimate we have at
present.
Q1399 Mr Mudie: You spell out your investment
policy or strategy which is apparently coming out
of equities and going into bonds. In your paper you
complain about the shortage of bonds, so where is
your money going?
Mr Hitchen: You hit on a very good point. There
is a definite shortage of good quality bonds in this
country and the world in general in which
institutions can invest if they want to de-risk. The
approach that we have tended to take as pension
funds is to diversify as much as we can into
diVerent kinds of assets. We still have large
amounts of money invested in quoted equities;
certainly, my fund of £20 billion has about half in
quoted equities diversified around the world. For
the other half we have tried to invest in as many
diVerent kinds of assets as we can.
Mr Pitt-Watson: We do not know how much
pension funds have invested directly, but both Mr
Hitchen and I say that, as large pension funds, we
both have a large hedge fund programme. We are
not quite sure in what those hedge funds will have
been invested, but we know that one and possibly
two are coming back to us to say they have “short
positions”. They have been short and have made a
lot of money in the past three months. Typically,
the ones which will have been long in this market
will not be picking up the phone to tell us how
badly they have been doing. When you ask whether
pension funds are investing here we need to be
careful. This is a very complex market where
money, securities and investment start with the
individual but end up with a hedge fund manager.
At the end of the day it is to do with railway
workers’ or telecom workers’ pensions, but it is
often being managed in a way that is at several
layers distant from that pension fund. The people
who manage it tend to try to make their money by
trading and the concern is that there is no one
sitting there saying, “Hang on a minute! I want to
make sure the security in this company is as strong
as it ought to be.”
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 aVected 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 eVects 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
aVecting people’s livelihoods and jobs. It could
aVect 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
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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 stuV on
their books and are scared stiV 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 diVerent ways to report losses in
accounts. It may be that some banks are just dripfeeding 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 oV, 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 oV its nonattributable, non-balance sheets assets rather than
one that still finds diYculties 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 aVect
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,
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Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
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 diYcult. The same general partners
now have to accept more diYcult 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 diYcult 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 diYcult, 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 creditrating 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.
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Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
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 suVer.
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 socalled 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
aVects the model. What we would like to see is a
market for savings where choices are not distorted.
If we can oVer 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.
Q1420 Jim Cousins: Where should the money
come from?
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Mr Chris Hitchen, Mr Peter Montagnon, Mr Guy Sears and Mr David Pitt-Watson
Mr Montagnon: Essentially, from the banking
system if the banks are the ones whose customers
are being protected.
My view is that it could be huge if we do not
respond to this sensibly and with judgment. It
aVects all savers.
Q1421 Chairman: Has there been a change in the
profile of hedge fund investors with institutional
investors increasing their presence in the market?
Mr Hitchen: That has certainly been true over the
past few years. My fund has invested directly in
hedge funds for perhaps the past four years, and
it may be Hermes is quite similar in that regard.
Essentially, we went to hedge funds in search of
security. Hedge funds provide capital protection in
a way that the equity markets cannot. We have a
need for real returns and that is just one way of
getting them with less downside risk.
Q1423 Chairman: Do you think that bonus and
option policies in Northern Rock and in general
encourage executives to take too many risks?
Mr Montagnon: Sometimes that may be true. In the
case of Northern Rock the ABI felt that its bonus
policy was too generous and we had flagged it.
What that reveals may also be a system whereby
the balance on the board is not necessarily
operating terribly well because the executives are
able to persuade the non-executives to award them
too generous pay increases. That may say quite a
lot about the relative balance and the way risk is
approached and accountabilities on the board.
Mr Hitchen: We do always try as far as we can to
promote this, but the basic problem I suppose is
that whereas we are trying to invest over 20, 30 or
40-year periods and be owners you cannot really
expect an executive to take such a long timeframe
into account.
Mr Pitt-Watson: The answer is yes and it is
exacerbated by marking things to market and
marking things to model. Therefore, in the years
when things look good you can take your bonus
and hope that that is still in the bank when things
go bad. Of course, the original investment is from
other people’s money.
Chairman: I do not think you have any messages
left unsaid. It has been a long session. Thank you
for your evidence.
Q1422 Chairman: Banks have reported very large
losses on derivative holdings. The question for us
is: how much more has been lost by clients? You
referred to insurers who bought similar products
sold earlier by the banks. Do you have any ballpark
figure? Is it a significant multiple?
Mr Pitt-Watson: I think the question is: where does
the contagion start? Do you take just the CDOs
that are absolutely bankrupt, the ones that are
marked to model, or the ones that are marked to
market, or do you take the knock-on eVect on the
bond market? Do you look at what has happened
to bank shares and then add in what happened to
Northern Rock? Do you then think about what has
happened to economic confidence overall? These
were the kinds of issues Mr Mudie explored earlier.
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Treasury Committee: Evidence
Ev 153
Tuesday 11 December 2007
Members present
John McFall, Chairman
Nick Ainger
Mr Graham Brady
Mr Colin Breed
Mr Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Mr Andrew Love
Mr George Mudie
Mr Siôn Simon
John Thurso
Mr Mark Todd
Witnesses: Sir Callum McCarthy, Chairman, and Mr Hector Sants, Chief Executive, Financial Services
Authority; Ms Loretta Minghella, Chief Executive, Financial Services Compensation Scheme, gave
evidence.
Q1424 Chairman: Sir Callum, welcome to you and
your colleagues. We have met before. Can I ask
why you are pushing ahead with reforms to the
FSCS funding ahead of the Government’s
consultation on the future of the entire deposit
protection scheme?
Sir Callum McCarthy: Chairman, because for a
long time we had in train changes, changes
designed to make the scheme more resilient and to
give it better funding power, and we thought that
whatever changes come about from the legislation
the Government plans to introduce next year, it
would be sensible to make those changes in the
meantime because we did not think there would be
any conflict between improvements we are planning
to make and had planned for some time and
whatever comes out of that legislation.
Q1425 Mr Todd: In the discussion over the FSCS
there has been debate over how to define the
boundaries of it and the implications in terms of
moral hazard, both for the depositor in not perhaps
being fully aware of the products they are
purchasing and the method of protecting their
deposit, and also the financial institutions that they
have placed their deposits with. How do you
address those?
Sir Callum McCarthy: The moral hazard question
was particularly predominant at the very early
stages of the scheme. When the scheme was first
introduced in the 1970s it was a 75% deposit
insurance, and it only went up to 90% relatively
recently, and it is only post Northern Rock that we
have increased it to 100% for the first £35,000. The
diYculty is forming the right judgment on that
because, for example, if you look at the experience
in the US during savings and loan problems, it was
quite clear that that resulted in some distortion of
behaviour and some serious moral hazard.
Q1426 Mr Todd: So what advice do you give,
because you have said there is a question of balance
to be struck here, is there not, in addressing how
to design this, both in terms of the concept of
co-insurance, of the depositors bearing some
proportion of the risk and therefore incentivised to
understand what they are involved in, and also in
terms of the limit of protection on the deposit to
encourage the financial institutions to manage its
aVairs responsibly and not recklessly?
Sir Callum McCarthy: First, I do not think that this
is a science. There is no algorithm we can apply to
give you the right answer; it has to have elements
of judgment in it. We are looking at this very
carefully. The present £35,000 probably covers
something like 95% of individual depositors; it
probably covers something like 50% of deposits,
and getting that balance right so you get the right
protection for individuals but do not encourage
irresponsible behaviour by institutions is what the
judgment has to be.
Q1427 Mr Todd: Do you think that the current
limit, or the limit as it was, was properly
understood by consumers in the first place, because
for this to have any value consumers really have to
understand the level of protection that is oVered,
and I think I would not have been alone in not
knowing the details of this until Northern Rock
filled our screens—and I tend to take the view that
I am a reasonably well-informed consumer. There
must be many, many who knew nothing about it,
and did not know the limits or any co-insurance
element within it?
Sir Callum McCarthy: That is true, and I think one
of the questions is how to explain the reality and
that reality is both a question of the amount of
coverage, when this no longer applies when there
is co insurance, and also the speed with which an
individual can expect to receive a payment under
the deposit insurance.
Ms Minghella: It is important that consumers
understand the protection that is available to them
in the event of a failure, and that is why when a
business does fail we take steps to inform every
consumer who is aVected that they have a right to
claim on the scheme. We also do work with a
number of stakeholders, Consumer Advice Centres,
Money Advice Bureaux, journalists, and MPs, to
try and bring the scheme to general attention in
advance.
Q1428 Mr Todd: Do you not think there should be
a clear obligation on a provider of a deposit-taking
service to communicate regularly with the person
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having that deposit the limits of a scheme of this
kind? Without wanting to spread alarm about it
they can couch it in appropriate terms of “in the
unlikely event” and all the other things, but surely
there should be an absolutely clear obligation
placed on a business to do that, and that has not
been done.
Ms Minghella: I would agree with you, Mr Todd,
that a firm should have an obligation to
communicate with its customers; it does have that
obligation at the point of giving any explanatory
information about a product, and I think that
could be further enforced.
essentially that this was a matter of social policy,
really, and had no particular role in terms of
financial stability. Would you agree with that?
Sir Callum McCarthy: I am not sure if I would
completely agree with that because I think if there
is greater understanding of the position of
individual depositors, if they know they are 100%
covered up to a certain amount, if they know they
get very rapid repayment, it is much less likely that
there will be a retail run, and that has implications
again for financial stability. So I think it is not just
a question of the social aspects of this, though those
are important—
Q1429 Mr Todd: What about the research into
institutions which might be safer than others? To
what extent do you think humans are able to make
reasonable judgments to spot, if you like, the
Northern Rock circumstance and say: “Well, I
would perhaps rather not place my money there but
in an institution which might be regarded as safer”?
To what extent does that information exist in a way
that consumers can regularly understand and, if it
does not, should the Financial Services Authority
not be providing that?
Sir Callum McCarthy: First, unlike, say, the FDIC
which does have a pre-funding basis and where the
contribution from the diVerent institutions is
adjusted according to the assessment of risk given
by the FDIC, we do not do that, partly because we
do not have a pre-funded system. One would have
to be quite careful about that process because it is
not self-evident that one wants all the time to be
marking institutions up or down, and there would
have to be a considerable degree of care in how any
approach was taken to that.
Mr Sants: We might add that in making the
decision to go to the 100% of the £35,000 we were
reflecting a belief that it is probably unrealistic to
expect the consumer to have the necessary
information and ability to judge funding risk I
think possibly that would be asking too much of
the consumer. I certainly think in our view it would
obviously be something we could discuss and take
views on as we go through the next stage of the
process, but our current thinking, and it certainly
was behind the 100%, is that it is a little too
ambitious to expect the consumers to have detailed
understanding of funding risk.
Q1432 Mr Todd: It is consumer confidence—
Sir Callum McCarthy: Yes.
Q1430 Mr Todd: You do not think even a
rudimentary information provision would be of
value?
Mr Sants: I think that is highly debatable, to be
honest. We have discussed in this group before, of
course, the complexities of the events that overtook
Northern Rock, and I think a rudimentary
description of funding issues might well cause
more issues.
Q1431 Mr Todd: I think I can appreciate that. We
had a discussion with two academics on the issue
of the role that depositor protection might have as
a financial stability tool, and their view was
Q1433 Mr Todd: —which, if it is absent, certainly
has an eVect on financial stability.
Sir Callum McCarthy: Yes.
Q1434 Mr Todd: But the primary aim of this
scheme I think was described as widows and
orphans. It certainly extends to a lot more than
widows and orphans but the principle is of people
of relatively modest means having their savings
properly protected so they need not worry about
them, and providing a scheme which, for example,
encompassed the deposits of businesses or relatively
wealthy individuals should not be an objective. Is
that reasonable?
Sir Callum McCarthy: Broadly I would agree with
that. The basis is it is unreasonable to expect
ordinary individuals to assess matters.
Q1435 Mr Todd: Fair enough. Lastly, obviously a
depositor protection scheme of this kind cannot
protect against all possible circumstances of failure,
and there is a recognition that if a very major
financial institution failed then it would not be
adequate to cope with that circumstance. How
should that be expressed?
Sir Callum McCarthy: It is important that, even if
there were a very large failure, people should know
that the guarantee that they had received would be
met, but that essentially would have to be met in
the last resort by Government.
Q1436 John Thurso: Prior to October this year the
scheme would only cover 90% deposits between
£2,000 and £35,000. I understand the rationale for
deciding upon an upper limit figure but I do not
understand the rationale for an intermediary band
of only 90%. What is the rationale behind that?
Sir Callum McCarthy: The rationale was a view of
the moral hazard and the importance of some
degree of co-insurance, in a sentence.
Q1437 John Thurso: Do you think it is appropriate
that the individual depositor at the under £35,000
level should be obliged to partake in that moral
hazard, given clearly the Government have decided
since October that is not the case?
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Sir Callum McCarthy: In answer to a previous
question I explained that the background of the
introduction of this scheme started oV at 75% then
went up to 90%. Originally it did not have any fixed
element at all and if you look at the development
of it you can see where it started from and where
it has moved to.
Q1438 John Thurso: UK banking generally over
the last 12–15 years has enjoyed a long run of very
strong profits, and it may be not for me to guess
where the markets are going but there was reason
to suspect they might be going into a cyclical
downturn. The compensation scheme appears to
lack funds to do its job. Is that correct?
Ms Minghella: The compensation scheme has a
very strong levying power, and it has been further
improved by the Financial Services Authority’s
recently announced changes so that from 1 April
next year we will be able to levy £4 billion per year
according to need. We are not constructed, the
Statute does not allow us to be constructed, as a
pre-funded scheme, we can only levy on a pay-asyou-go basis, but the £4 billion a year we believe
will enable us to deal certainly with a wider range
of failures than we can now and will be suYcient
to deal with the sort of failures we would
normally expect.
Q1439 John Thurso: That levy would normally
have a degree of ex ante in it as opposed to ex post
funding for the future?
Ms Minghella: It will not be an ex ante levy
mechanism because we will just levy each year for
the failures we can see ahead on the basis of our
forecasts.
Q1440 John Thurso: Can I just have a go at your
crystal ball? What failures do you see ahead next
year that you are going to be raising money for?
Ms Minghella: We are in the process of preparing
our forecasts for next year at present—
Q1441 John Thurso: But you are forecasting that
there will be failures and you will raise money?
Ms Minghella: Yes, that is right, based on our past
experience and on the information available to us
at the time of the levy decision. If a failure were to
occur that was not in our forecast we would levy
for it at the time, and the industry would be obliged
to pay our levy invoices within 30 days.
John Thurso: That is such a wonderful minefield of
information that you have given us there that I do
not think the Chairman would let me prosecute all
of the possibilities –
Chairman: Try your best!
Q1442 John Thurso: One begins by saying was
Northern Rock in your forecast?
Ms Minghella: No, it was not.
Q1443 John Thurso: So what confidence can I have
in the forecasts you have got?
Ms Minghella: It is not bust; it has not gone bust;
and we only levy for firms that we believe are likely
to come our way for pay-out.
Q1444 John Thurso: Do you think anything will
go bust?
Ms Minghella: Based on our past experience we can
anticipate a number of failures. We have since we
took our power six years ago declared 1,800 firms
in default and, based on that pattern, we can
foresee—
Q1445 John Thurso: But none of those are major
deposit holding banks?
Ms Minghella: Absolutely not, no. In the deposit
taking area we have only had 29 credit union
failures, and that is it, and they are small.
Q1446 John Thurso: In your forecasts do you
forecast that any major deposit taking institutions
are up to fail?
Ms Minghella: Not at present, no.
Q1447 John Thurso: So in fact, if you come down
to the major banks and the principal secondary
banking institutions, you are not forecasting any
failures and therefore you are not going to be
raising any funds, in fact?
Ms Minghella: Not in advance, that is right, so we
levy according to need, and should the need arise
mid-year we would levy at that point.
Q1448 John Thurso: Thank you for that. One of
the problems with the protection system or the
reasons why it has to exist is that if a bank is put
into administration the depositors become creditors
in line with ordinary law and, as a result, they are
unsecured and therefore take their chances
following what the receiver or administrator will
do, whereas that is a politically unacceptable
situation and therefore governments step in and
have schemes. Is there any merit in considering
changing the legal status of depositors such that
they are in a secured creditor position so that it
changes the balance of moral hazard?
Sir Callum McCarthy: Clearly the Government
could, if it wished, change insolvency law. You
would have to be very careful in approaching those
changes because it would also change the relative
attractiveness of advancing money in other ways
for the funding of banks, and before making a
particular change it is very important to consider
the overall eVect on the banking system.
Q1449 John Thurso: The fundamental point here is
that the banking system in virtually every country
depends on the fact that governments will not allow
banks to fail and will therefore have some form of
scheme or rescue always in place, so what the
banking industry are asking us to do is to publicly
underwrite that. If you change the structure of the
law, you put that cost and that responsibility back
on to the banking system earlier in the process.
Does that not have some merit?
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Sir Callum McCarthy: I would point out that it is
not the case that all banks in all circumstances have
been saved. I can understand the merit of the
argument but I also think it has to be weighed
carefully with the continuing need to make banks
attractive as institutions to either invest in or to
lend to.
Q1450 John Thurso: The Governor of the Bank of
England admitted that our system for dealing with
insolvency of banks and depositor insurance is
markedly inferior to all other countries. What
changes could we make in particular to the release
of depositor funds in the event of a bank failure
that we could learn from other countries.
Sir Callum McCarthy: I would not agree with that
statement in comparison with “all” other countries;
I am not sure if the Governor intended it as such.
Q1451 John Thurso: I think he was selecting his
countries.
Sir Callum McCarthy: I think there are certainly
things we can learn from the US experience where
they have the ability to deal with a failure rapidly
and in a way which enables them to take powers
to deal with a failing bank.
Q1452 John Thurso: So you would share John
Bovenzi’s view that, had the UK had a system
rather like the US model of depositor protection,
the Northern Rock crisis could have been avoided
in the UK?
Sir Callum McCarthy: It would have undoubtedly
been of real help in preventing the retail run.
Q1453 John Thurso: The final question, if I may,
and it really goes back to what I was touching on, is
this. If we had had an eVective depositor protection
scheme and a more suitable insolvency regime in
place at the time, would the Tripartite Authorities
simply have allowed Northern Rock to fail? And
maybe I should not ask the question “would” they
have, but “could” they have? Would it have been
easier?
Sir Callum McCarthy: I honestly do not know, I
am sorry. I understand the question but I am not
sure if I can deal with the hypothetical
circumstances. The issues that would have been
involved would have been serious and I do not
know the answer, is the only truthful answer I
can give.
Q1454 John Thurso: I am probably asking you to
speculate, then, but do you think there are any
banks that are simply too big to rescue?
Sir Callum McCarthy: No. If you look at those
instances where there have been very big banking
failures, the Swedish experience, for example,
people have been rescued on a very large scale.
Going back to the other question, just thinking
about it in terms of the US experience, I do not
think the answer is self-evident, that if you had a
deposit insurance and the insolvency regime you
have in America it necessarily makes it easier to
take a decision not to save institutions. I think it
is still a diYcult decision.
Mr Sants: Indeed you could argue it might have
been the converse because, taking your earlier point
that the Tripartite would have been more confident
that there would not be a run on the Bank then the
cost of saving it would probably have been
estimated to be less, but it is obviously a finely
balanced call.
Q1455 Chairman: What constraints does the
Deposit Guarantee Schemes Directive, Sir Callum,
impose on the design and operation of the UK
scheme? For example, would a US style system be
permissible here if so desired?
Sir Callum McCarthy: My understanding is that it
represents minimum levels, and does not
constrain us.
Q1456 Chairman: Are any changes afoot on the
European Commission’s Deposit Guarantee
Scheme Directive that you are aware of?
Sir Callum McCarthy: Not that I am aware of, no.
Q1457 Chairman: How should the UK deposit
insurance system deal with the issues of home
versus host regulation?
Ms Minghella: The way it works now is that if a
UK deposit institution were to fail it would be for
the UK as a home state to look after the depositors,
not only the depositors in the UK but the
depositors of any EEA branch, and if a EU bank
from overseas passports into the UK, it is for the
home state of that EU bank to look after the
depositors and for us only to become involved if
the bank has topped up into the UK scheme, which
a number of banks have done. That is basically the
way it works under the Directive.
Q1458 Chairman: Sir Callum, the Chancellor
assured this Committee that the 100% guarantee
given by the Government to the depositors of
Northern Rock did not extend to any other
institution; rather “each case will be assessed on its
merits”. How credible is that assurance?
Sir Callum McCarthy: I see no reason to doubt it,
Chairman. It was a statement made to you
seriously by the Chancellor.
Q1459 Chairman: So it is 100% credible?
Sir Callum McCarthy: I absolutely believe that the
Chancellor meant what he said.
Q1460 Chairman: What a fine answer, Sir Callum!
I am asking you, is it 100% credible? Would those
very words have come out of your mouth, if you
were in that position, in other words?
Sir Callum McCarthy: I should make clear that the
only person who can make that guarantee of 100%
of deposits is the Chancellor, and that has always
been the case.
Q1461 Chairman: We understand that, but I am
asking you, Sir Callum, is it credible?
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Sir Callum McCarthy: I think it is.
Q1462 Chairman: 100% credible?
Sir Callum McCarthy: Yes.
Q1463 Chairman: What factors might make a
financial institution less deserving of a 100%
guarantee than the Government assessed Northern
Rock to be?
Sir Callum McCarthy: Sorry, Chairman, I am not
sure I am qualified to answer the question.
Q1464 Chairman: But you understand the
question?
Sir Callum McCarthy: I understand it. If I were the
Chancellor I might have addressed my mind to it
but since I am not the Chancellor I have never
addressed my mind to the question.
Q1465 Chairman: You are a lucky man, you are not
the Chancellor. On the issue of financial stability,
Sir Callum, what are the financial stability
implications of the shift we have seen towards an
“originate and distribute” business model, and is
that irreversible?
Sir Callum McCarthy: I think they have very
substantial implications and they do not all go in
the same direction. First of all, the “originate and
distribute” model, as the shorthand suggests, it
distributes risk much more widely, and that in itself
is attractive because it stops risk being concentrated
in highly geared banks. The questions that go the
other way, which we have always been conscious
of, as have other regulators around the world, is it
makes it much more diYcult to identify where risk
lies. There are also two major questions that the
“origination and distribute” model has to address
more clearly than has been addressed: the first is the
standards of underwriting by the originator, where
failures in those standards have been one of the
fundamental causes of the sub prime problems,
and, secondly, it is important that those who invest,
those to whom the risk is distributed, understand
what they are investing in. It is clear that there has
been a degree of complexity of product which has
been distributed, and not everybody who has
bought those products properly understood them.
Mr Sants: Just to add, if I may, and to develop that
theme a bit further, what we are thinking is clearly
the structure of the market place will change as
reflected in your question, and that those complex
structures which were previously part of that
distribute model are not going to find favour with
investors going forward because of the issues we
have seen. So we see a disappearance, or certainly
a significant diminution in the use of complex
structures, but not necessarily a disappearance
altogether of a distribute model. It is more that the
banks will have to think about distributing through
clearer and simpler processes, so we see the model
evolving but not disappearing entirely. But, of
course, these are all crystal ball forecasts and it
could go in other directions.
Q1466 Chairman: So the idea of dispersing risk
which would increase the resilience of the financial
system to shocks still holds, but it needs one or two
adjustments?
Sir Callum McCarthy: I think it holds but we have
always been concerned to make sure that the
distribution of risk is real rather than apparent, and
one of the things that is diYcult is to make sure we
can identify the channels by which that distributed
risk may become reconcentrated.
Mr Sants: The other aspect that we have talked
here about before is that when you are dealing with
this distributed risk model: almost by definition
you will not know where all the risk has gone. The
focus of the regulatory community is clearly on the
major transmission mechanisms to make sure they
are in good health, namely the core banks, and
therefore it is important going forward that those
core banks are operating in a very transparent way.
We have, of course, had this slightly opaque
proposition in place with regard to the conduits
and the SIVs which needs to be addressed, so that
the core transmission mechanisms are able to work
in a transparent way.
Q1467 Chairman: I notice that Josef Ackermann,
Chairman of Deutsche Bank, as a member of the
Institute of International Finance made the point
that a number of structural problems need to be
addressed and included in that: improved risk
management, review of the role of oV-balance sheet
conduits and special investment vehicles, the
valuation of complex products, the examination of
credit agencies, and improved transparency. I do
not want you to go through every one of them, but
is that a reasonably comprehensive list to you?
Sir Callum McCarthy: Those are the major items.
Q1468 Chairman: And you would agree with those?
Sir Callum McCarthy: Yes.
Chairman: Good.
Q1469 Mr Mudie: Would you please tell me what
the core transmission method means?
Mr Sants: One of the key issues here is, if we are
having disruptions in the financial system, is that
going to then aVect the real economy, your
constituents, the man in the street. From the
regulatory perspective one of the key ways of
managing and assessing that risk is through making
sure that the mainstream banks which, as it were,
sit on the interface between the financial system and
the consumers, are in good health. The
transmission mechanism is another way of
describing the large banks.
Q1470 Mr Mudie: I suppose that answer deals with
the bigger question of stability, but what about
investor protection? What we have are securities
that were contaminated. I think some of the
bankers did not know what the hell were in them,
and they more or less said: “We were selling them,
they were buying them, nobody was worried
because we were all making money from them”.
Did you at the Financial Services Authority ever
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flag up, ever analyse, the various securities with a
view to saying whether you should be warning
investors about the possible risk? It is one thing to
look at the wider stability but I am just thinking
why were these allowed to pass through for such
a length of time without anybody in the Financial
Services Authority—well, perhaps you did. Did
you?
Mr Sants: Just to remind ourselves, of course, the
buyers of these complex instruments are
institutions, not the consumer in the street. The
consequences, however, of that development of the
financial market has ultimately been to cause
disruption to the consumer in the street—
Q1471 Mr Mudie: But, Hector, just stopping you,
we had the pension funds in here and it was an
interesting session. What you are saying is: “Well,
I blame the buyers”, but one of the things that I
would take comfort from as a buyer is you. After
all, the industry is paying a lot of money—not to
you personally but to the Financial Services
Authority—to give that regulatory structure and
comfort. Now, your answer seems to be: “Well, you
should know better”.
Mr Sants: It is a two-part answer, actually, and
that was the first part. It is the case, nevertheless,
I think we should remind ourselves, that
institutions are meant to be sophisticated enough
to make good judgments, but having said that the
Financial Services Authority and the Bank of
England as well, have repeatedly over the previous
few years warned of the risks of the evolution and
the development of the credit derivative and related
complex securities market, and a variety of our
publications have highlighted those risks to the
institutional investors—
Q1472 Mr Mudie: Let me take your latest one—we
have a later one but it is less relevant—of January
this year, a whole paragraph that will cover you in
terms of warning, but in the middle of it: “Financial
markets have been increasingly complex since the
last financial stability crisis”. Nothing about the
individual securities. If you were regulating in a
parallel industry: say supplying blood, I would
want you to assure me if I were in hospital facing
a transfusion, that the regulation was working and
that the blood supply was not contaminated. This
is what is happening in terms of these securities.
These securities were coming in bundled up to
avoid people seeing the real risk and the real
original basis of the loan, and you were letting them
come into the market, traded, with people making
money from them. Now, it is not that we are
looking for you to say you made a mistake: we are
looking for some comfort for the future. Did you
think, first of all, you recognised the dangers and,
if you did, did you adequately tell the market about
the dangers?
Mr Sants: I think this takes us back a bit to the
comments I made to the Committee earlier, that we
absolutely acknowledged and made clear in our last
appearance that we did not foresee, and nor do we
think any other market commentators or regulators
foresaw, the precise set of circumstances which
have arisen since, and that includes the liquidity
crisis.
Q1473 Mr Mudie: I understand that, and we can
all be wise after the event. I am just asking, as
somebody in the street might ask, as a pension fund
might ask, and maybe a pension fund with no great
resources because we heard last week about how
deep the analysis would have to be, how deep you
would have to go in to see the make-up of these
things, and a lot of purchasers—even if they are not
individual and are institutions—are not going to
have those resources so they are depending on you,
amongst others. What comfort can you give us in
the future?
Mr Sants: I think we were clear in our advice as to
the risks inherent in complex derivative products,
and we have made clear in a variety of our
publications, the complexity and potential liquidity
risks that accrue to credit derivatives. What
obviously is the case is that on top of that, in
addition to the liquidity point I have made, we have
seen a failure with regard to the income stream
accruing from the US sub-prime marketplace
which has then led to those securities falling
significantly in value. If you are asking whether we
are placing ourselves in a position where we would
be looking to make all the commercial judgments
that we think mainstream institutional investors
should be making, no, we are not seeking to put
ourselves into that position, but I do think in terms
of a structural observation on the market we were
clear on the risks that the increased complexity in
the marketplace was creating for institutional
investors, but we placed the onus on them then to
draw the conclusions from that process, otherwise
eVectively we would be running the market which
I do not think is desirable in terms of the overall
process here and the type of marketplace that the
community is looking for.
Q1474 Mr Mudie: So, to bring that all together, a
pension fund that finds itself losing money and
looking to you will find on record the clear
warning: “Be careful about these products”.
Mr Sants: About the inherent liquidity and
complexity that these products—credit derivatives
or related products—carry.
Q1475 Mr Mudie: It is all about transparency. Did
you feel these products were transparent enough?
Mr Sants: I think I have said before here—
Q1476 Mr Mudie: Yes or no. Did you think these
products were transparent enough?
Mr Sants: I think they are transparent enough to
those who have the right level of competence and
the time and the resource to look at them. I think
there is a risk that because they are highly complex
not all institutions have devoted the necessary time
and resources, and have chosen to make
assumptions, be over dependent on the rating
agencies, which has proved to be unwarranted and
inappropriate and not wise in the circumstances,
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but in principle, if you choose to and you take the
time and you have the expertise, you can unpick
these structures.
Q1477 Mr Mudie: Are you intending, are you
working on, are you investigating, any fresh
approach to these securities? Or are you lying in
the sand? Is that your industry? Are the Financial
Services Authority doing anything further to give
comfort that this sort of thing will not happen
again?
Mr Sants: Well, of course, as we mentioned before,
the market place will itself adjust as it does in the
event of circumstances—
Q1478 Mr Mudie: I am asking about the FSA,
though, Hector.
Mr Sants: —but I think on top of that there are a
variety of initiatives that the worldwide regulatory
community—
Q1479 Mr Mudie: No, Hector. Again,
“worldwide”. I would be very interested, because I
think it is key, that the Financial Services Authority
should be operating worldwide, but what are you
doing as the Financial Services Authority?
Anything?
Mr Sants: Yes, indeed, and I was telling you that.
I was just making the point that as the Financial
Services Authority on our own we would not
generally be able to solve these problems as a
national regulator. Having said that, we will take
the lead in and be fully active in looking at a
number of the issues which includes the credit
rating agency point which has already been
mentioned, which is an important aspect of
providing the right information and a clear
understanding of how those organisations operate;
we certainly do have our initiative with our
institutional community to encourage them to give
consideration to the lessons they can learn and the
actions they should take; and we will also be
obviously looking carefully around the issue of
transparency, which is a point mentioned earlier by
the Chairman, around these special purpose
vehicles and related points. All those initiatives are
part of the list that was mentioned earlier, and we
will pursue those nationally and internationally
with vigour.
Q1480 Nick Ainger: Mr Sants, you have told us of
the warnings that the Financial Services Authority
gave, and also the Bank of England were warning
about the complexity of these packages. Specifically
in January you say: “The financial markets have
become increasingly complex since the last financial
stability crisis, which implies a transmission of
mechanism for shocks, have also become more
complicated, and possibly more rapid. Market
liquidity remains abundant, but it is still important
for market participants to consider how they would
operate in an environment where liquidity is
restricted”. Remarkably prescient, if I may say so.
Between that warning that you gave in January and
the warning which the Bank also gave in its
Financial Stability report in April, have you any
evidence that the institutions that you regulate did
anything to address the problems that you and the
Bank had highlighted only months before?
Mr Sants: We certainly do have evidence that some
of the institutions were taking steps to manage their
financial aVairs on the assumption that market
conditions would get more diYcult, yes.
Q1481 Nick Ainger: “Some”? All?
Mr Sants: Not all. As I mentioned before in the
July press conference we re-stated our concerns
that we thought that not all institutions had
properly anticipated the possibility of an abrupt
change in market liquidity and ratings, which I
think was a quotation from myself at a press
conference at the end of July, so we have been
concerned that not all institutions had properly
anticipated the possibility or the likelihood of a
significant deterioration in credit markets.
Q1482 Nick Ainger: I asked a question last week
of the investment banks that came before us, about
whether they felt some of them had been reckless
rather than cautious. In the spectrum between
reckless and cautious, do you think some of our
financial institutions have been on the reckless side
of the spectrum?
Mr Sants: If you define “reckless” as endangering
the corporate entity in a way which was identifiable
and which could have been seen as probable by the
management, then that is not a statement I would
be making about the mainstream institutions here
in the UK.
Q1483 Nick Ainger: What has surprised me from
the evidence we had last week from the investment
banks was their basic admission that they did not
know the extent of the risk involved on the CDOs
they were trading. Surely that is reckless? If you are
going to spend many, many millions, perhaps
billions, of pounds on these packages and you do
not know what the risk is, is that not reckless?
Mr Sants: I do not particularly want to get drawn
into commenting on individual institutions. In
general we have said that the UK large banking
community, and as the Chairman has said this a
number of times, it is well capitalised and has gone
into this downturn in generally good shape. We are
talking here about our UK regulated banks.
Q1484 Nick Ainger: Mr Mudie was asking you
questions about lessons that were learnt and so on.
Do you think that you will now be regulating
diVerently our financial institutions, particularly in
relation to credit risk assessment and also liquidity,
bearing in mind what has happened in the past
six months?
Mr Sants: Yes. There are two elements to that, as
we have touched on before. There is the question of
ensuring at the coalface that our supervisory teams
rigorously pursue our current framework, which
already includes a requirement for comprehensive
and eVective stress-testing by institutions, and
specifically with regard to Northern Rock we have
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Q1485 Nick Ainger: That is in relation to liquidity,
but what about credit risk assessment? Is that a role
you should be playing as a regulator, do you feel?
Looking at the particular performance of some of
these institutions some have acted quite markedly
diVerently from others in their exposure to these
risks.
Mr Sants: It is already part of our framework that
institutions obviously should have a proper
controlled framework which includes a proper
credit control framework and an analytical
approach. We will obviously continue, as I think
we already do, to have that as a key focus of our
regulatory engagement. I have made the
observation already with regard to the large UK
banks headquartered here in the UK that they are
well capitalised at the current time, but clearly that
is an area of supervisory focus and needs to
continue to be so. Just to be clear, we do also think
we should engage with the credit rating agencies,
who are a key part of that mechanism by which
people make credit judgments.
their appearance, is to measure credit risk as
opposed to liquidity risk, and it is important that
is done in as comprehensive and transparent way
as possible and ideally in a way which is easily
understood by investors and allows people to have
confidence in similar methodologies being used by
all agencies, so I think the first group of points talk
to that aspect and we fully support that. We are
part of IOSCO, as you know, which has recently
introduced a code of conduct for credit rating
agencies and we are very active in encouraging
IOSCO, which I am sure they will do, to revisit that
code to look at exactly those sorts of issues. The
fifth point is an interesting point in that clearly an
element of the problem that has occurred here has
been institutional investors choosing to use a rating
agency’s process as a shorthand way of potentially
evaluating liquidity as well as credit, and that has
not been helpful and is not, indeed, what the
agencies were intending their measurements to be
addressing, so it does open the question, given
liquidity is clearly as important an issue as credit,
and in the current circumstances more important
though it can depend on the set of circumstances,
should they not also be bringing forward liquidity
measurements. We know from our conversations
with them that they are considering it; it is quite
complicated; so I think what I would say about that
fifth point is, if it could be done in a way that was
credible and robust and simple to understand, then
that would be a good idea, but I think we have to
leave it to the agencies to see whether that is really
something they can deliver, and to be fair to them
they are commercial organisations and they have
to also decide whether that is commercially
worthwhile oVering to make. But it is vitally
important going forward that people understand
the limitations of the service that a credit rating
agency delivers, and do not use it as a shorthand
way of avoiding their obligations to look properly
at the structures and the risk they are taking on.
Q1486 Mr Dunne: That leads very nicely to my
question. We had the credit rating agencies in front
of us last month and you have just made the point
you would need to engage with them. Could you
give us your views on the Bank of England’s five
proposals which they think should be considered in
relation to the credit rating agencies, and I can
remind you what they are if you have not got them
at your fingertips. The first was that they should
publish expected loss distributions of structured
products to illustrate the tail risks surrounding
them; secondly, that they should provide a
summary of information provided to them by the
originators of structured products; third, that they
should provide probability ranges for scores on
probability of default; fourth, that they should
adopt the same scoring definitions between them;
and, finally, that they should consider scoring other
aspects of the products such as liquidity, stability
and so on.
Mr Sants: The first four are eminently sensible and
are all around the point that the principal purpose
of the credit rating agencies, as you will know from
Q1487 Mr Dunne: You also identified the conflict
of interest that the issuer pays the agency who
provides the rating. Do those proposals help to
address that problem?
Sir Callum McCarthy: Just before we deal with
conflicts of interest, could I reinforce what Hector
said? One of the comments I think made correctly
is that people have relied too much on the rating
agencies rather than doing their real analysis of
whether “This investment is something that I
understand”. It is somewhat ironical that one of the
responses is to try and seek from the rating agencies
even more work and even more assessment not just
of credit but of liquidity, and I, like Hector, think
that is an idea that has to be subjected to a lot of
thought before simply signing up to it.
Mr Sants: On the matter of conflicts, obviously it
is a conflict and that is an uncomfortable position
for those organisations to be in and, as regulators,
when we see a conflict we rightfully are concerned
as to what consequences might flow from such a
conflict. The conclusion that has been reached in
the past, and at the moment there is no reason to
mentioned here before that we think it is a matter
we should properly review and publish the
conclusions of in March, but I think it is reasonable
to say that a more rigorous on-the-ground
supervisory engagement could have been made.
Then there is, of course, a wider question. I think
you have to take a global perspective, of this
unusual set of events in the round. It is right and
proper that we should also then be looking at that
liquidity regime and seeing how we should
modernise and learn from the experience in the last
few months. We are committed to publishing a
discussion paper shortly on the issue of liquidity
framework, both looking at the national element of
it and the international element, which will be out
before the end of the year, and we will engage in
a rigorous debate with the community in terms of
improving the framework.
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
go away from that, is that it is not obvious that
without that model the credit rating agencies would
be able to continue to thrive commercially and
exist, so we are in a position where that conflict has
to be managed rather than removed because if it
was removed the service probably would not exist
as well and we do need to be pragmatic. But I think
we need to revisit again, and that is part of the
IOSCO initiative that we just referred to, whether
or not we are addressing conflict management as
rigorously as we should.
Q1488 Mr Dunne: Briefly, you touched on the
international ramifications of this global crisis and
increasingly
internationally
sophisticated
organisations. The EU Commissioner was here last
week—not before this Committee—and said there
are 45 banks with cross-border activities engaged
in Europe, and the challenge for the regulators is
determining who takes responsibility if one of these
major cross-border organisations fails. What role is
there for a supranational regulator, or the IMF or
some other such body, to help with bank
supervision?
Sir Callum McCarthy: I do not believe that is the
right solution. There is a major task to identify the
responsibilities and rights of home and host
supervisors for these major institutions, and we
have set out our views on and we are working
closely with other regulators and central banks to
try and find practical solutions. I do not believe the
right answer is to move towards some form of
supranational supervision.
Q1489 Chairman: Sir Callum, I believe there is an
individual designated as a grey panther at the
Financial Services Authority for banking asset
management insurance and markets, and that
individual is on the Challenge Panel preparing
supervisors for Arrow visits. Is that correct?
Sir Callum McCarthy: There are a number of grey
panthers who do the things you describe.
Q1490 Chairman: And they ask questions like:
“Are you supervising the right area? Are you asking
the right questions?” Given what happened to the
Northern Rock share price earlier in the year,
should that have flashed a red alert with the
Financial Services Authority and taken Northern
Rock out of the normal procedure of Arrow visits?
Sir Callum McCarthy: One of the matters we are
looking at in terms of the examination that is being
done of how we supervise Northern Rock up to the
time when these risks crystallised, is to answer
questions exactly like that, but overall I do not
think that we paid enough attention to various
signs.
Q1491 Chairman: Is Northern Rock still solvent?
Sir Callum McCarthy: Yes. In our judgment.
Q1492 Chairman: What risks are there to the
continued solvency of Northern Rock?
Sir Callum McCarthy: I suppose the risks would be
the same risks that would apply to many
institutions: an abrupt decline in the asset values
or—yes, I think that is probably the biggest risk.
Q1493 Chairman: When did you last look over the
books of Northern Rock, or are you doing that
right now?
Sir Callum McCarthy: I am not quite sure what you
mean by “look over the books”. We are not
auditing Northern Rock but we have detailed
certainly weekly, if not daily, discussions with
Northern Rock.
Q1494 Chairman: What role is the Financial
Services Authority playing, if at all, in facilitating
a takeover of Northern Rock?
Sir Callum McCarthy: Our principal responsibility,
when there are particular bidders for Northern
Rock, is to make sure we subject them to the
normal regulatory challenges and we are doing
that—that is the question of change of control as
far as a change of control is concerned,
authorisation of individuals, and a view of any
proposal and whether it meets our threshold
conditions.
Q1495 Chairman: How would you respond to the
suggestion that a false market has developed in the
shares for Northern Rock?
Sir Callum McCarthy: We do not believe that a
false market has developed. We believe there are
considerable uncertainties which account for the
sometimes very considerable variation in the UK,
both in the volume of trading and in the share
price, but we do not believe that any of the
conditions that are necessary to be met for us to
suspend trading have been met.
Mr Sants: Volatility is, in itself, not a reason for
suspension.
Q1496 Chairman: Some suggest that there is a case
for a new team to run Northern Rock as soon as
possible, and that changes need to be made with
speed. Mention has been made regarding
nationalisation. Do you see any merit in
nationalisation being used to break the log jam? In
other words, to stop any parties being a legal
impediment and have legislation in the House of
Commons, and indeed the House of Lords, over
the period of a couple of days with a new team
already identified, so they can get on with the
business of reviving this institution?
Sir Callum McCarthy: We have at the moment,
Chairman, two proposals which do not depend on
that, and it is important that those two proposals
are investigated and pushed through to find out
whether they will work or not before intervention
through legislation.
Q1497 Chairman: I understand but if speed is not
of the essence here then we could find ourselves
with further problems, so would you say you have
any sympathy with the notion of having
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Ev 162 Treasury Committee: Evidence
11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
nationalisation to ensure over the period of a day
or two that we get everything up and running
quickly?
Sir Callum McCarthy: I agree that speed is highly
desirable. That is why we would like to be in a
position so that the board and the Government
can, as quickly as possible, come to a view on one
of the two proposals that are on the table, and it
would be better to see whether those can be
advanced before discussing nationalisation, or any
legislation.
Q1498 Chairman: It is not oV the table, perhaps?
Sir Callum McCarthy: I think the Chancellor made
clear that everything remains.
Q1499 Chairman: Within the public sector, where
are the resources needed to manage a nationalised
bank in the interests of taxpayers and consumers?
Sir Callum McCarthy: If that eventuality occurred
it would be necessary to find a team to do so.
Q1500 Mr Fallon: Sir Callum, if Northern Rock
cannot find the funding it needs to finance its
operations without nearly £29 billion worth of
support from the taxpayer, how do you still
describe it as solvent?
Sir Callum McCarthy: Because we have looked at
the assets it has and the demands on those assets
and believe that those assets meet those demands.
The amount that has come from the taxpayer is
secured against the assets of Northern Rock.
Q1501 Mr Fallon: But if it is not able to finance its
future liquidity, how can you regard it as solvent?
Sir Callum McCarthy: Because there is a distinction
between liquidity and solvency.
Mr Sants: We are clear that it would not meet its
thresholds conditions if it were not for the
availability of the finance from the Bank of
England.
Q1502 Mr Fallon: But you still think it is solvent?
Mr Sants: Yes. In clear accounting terminology,
threshold conditions is regulatory terminology and
we have answered the question.
Q1503 Mr Fallon: Yes. I think you have also
explained to us exactly what has been happening.
You have said there are regulatory lessons to be
learned here and you are going to publish a
discussion paper on liquidity. Is that right?
Sir Callum McCarthy: No, there are two quite
diVerent things and let me explain what they are.
One is a paper on liquidity as a general set of issues
and, as Hector said, we plan to publish a discussion
paper on that before the year end. The second and
quite diVerent aspect is that we have undertaken to
do a review of the way in which the FSA discharged
its responsibilities in relation to Northern Rock
during the period up until August and we have
undertaken to do that and publish the results of
that in March and that is not a discussion paper,
it is a quite forensic investigation.
Q1504 Mr Fallon: Will that include the possibility
of somebody else supervising liquidity?
Sir Callum McCarthy: No, this is to do with the
question of how the FSA discharged the
responsibilities it had up until August 2007.
Q1505 Mr Fallon: I thought we were pretty clear
now that you did not discharge your
responsibilities. We have had the worst banking
crisis for 140 years. Somebody failed.
Sir Callum McCarthy: I repeat, we are looking at
the lessons that we are going to learn.
Mr Sants: We have already said quite clearly that
we think the supervisory process with regard to
Northern Rock in the period prior to July should
have addressed the liquidity issues through more
aggressive engagement around the question of
stress testing and ensuring that the board, whose
primary responsibility is ultimately to run the
institution, fully understood its business model and
its limit to its business model and the risks it was
running. We would agree with you that process did
not take place, so the purpose of the review will be
to ask the questions as to why that did not take
place and what lessons should be learned from that.
That is about our application of our regulatory
regime as it then was. There is then a second
question as to whether or not the regulatory regime
should be modified which will be looked at through
the combination of the liquidity discussion paper
and, of course, if there are any issues relating to the
tripartite review, that will be handled through the
tripartite review. We are in no way not
acknowledging the fact that our supervisory
engagement with Northern Rock prior to July
should have looked into these scenarios and it
would appear on the reading of the file to date not
to have done so.
Q1506 Mr Fallon: If you were charged with
supervising banks, including their liquidity, and
you failed, is not one of the answers to return that
supervisory duty to where it once was, which is to
the bank?
Mr Sants: I think we need to look at a couple of
points here and they will come out in the review.
There is a question as to whether or not the overall
regulatory proposition is in some way flawed and
in addition whether the narrow engagement of that
group of supervisors with that institution not
properly discharged. It would be wrong to prejudge
the conclusion of these various reviews, but my
preliminary thoughts would suggest that the
approach we were taking in terms of emphasising
stress testing in principles-based regulation was
right. I do not think that events here undermine the
basic regulatory philosophy of principles-based
regulation, the crux of which is about asking
management to take responsibility for the
outcomes and consequences of their decisions and
you could well argue here that is something the
board should have been doing more rigorously
than it was. I do not think the philosophy of
regulation is undermined here, there may well be
questions, I think there are questions, as I have just
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
indicated, about the particular engagement with
this particular company. As to the question of
whether or not it would have made any diVerence
if administratively those supervisors had reported
to the bank rather than to the FSA—Sir Callum
may wish to comment—I do not think there is any
evidence at all if the reporting line of that
supervisory department had been moved that
would have made any diVerence to the set of
circumstances which transpired prior to July, nor
would it have made any diVerence to the
information being passed over to the relevant part
of the bank with regard to monetary operations
during the course of August and September.
Sir Callum McCarthy: Could I just add one point,
which is I think that the idea of transferring
banking supervision separately from insurance and
security supervision is an idea that has severe
disadvantages.
Q1507 Mr Fallon: It is a pretty severe disadvantage
with the background and all the damage we have
seen to British banking as a result. You seem to be
simply defending your empire. The supervision of
liquidity was done perfectly well by the Bank of
England until you started it in 1997.
Sir Callum McCarthy: People can have diVerent
views on the ability of diVerent supervisory regimes
historically. I would point out that if you look at
the problems that the events have caused, they have
caused severe problems in Germany, where
banking supervision is shared between BaFin and
the Bundesbank, so the idea that making bank
supervision the responsibility of the Central Bank
is the answer to these is not necessarily supported
by the facts.
Q1508 Mr Fallon: You think you are still the best
people to supervise banking liquidity?
Sir Callum McCarthy: I believe that it is impossible
to take the question of banking liquidity from
overall supervision. There are questions, as Hector
has absolutely indicated, about whether we did that
suYciently well, but I do not believe you can take
bank liquidity supervision from other aspects.
Mr Sants: Also you have to ask the question, what
particular benefit do you think would accrue from
aligning a supervisory group with a money markets
management group; a central banking liquidity
function? There is no particular evidence that the
issue with regard to Northern Rock would have in
any way been changed by that alignment. I think
you do have to ask the counter-factual question
what is it you think would have been brought to
this issue that was not brought to the issue as a
result of making that organisational change.
Q1509 Mr Breed: Could I return to your view on
the solvency of Northern Rock. I think you said
that there is a diVerence between solvency and
liquidity. Of course, one of the tests of solvency is
all to do with liquidity and, indeed, the vast
majority of businesses that go bust go bust because
they have not got cash, not because they have not
got assets, so liquidity is a fundamental of solvency.
That test is that a business can meet its obligations
within the normal course of its business and
therefore looking forward, including in Northern
Rock’s case, of course, the repayment of £25 to 29
billion—whatever it is—of taxpayer’s money, and I
understand that is in place until February, do you,
therefore, believe at this moment in time that
Northern Rock is solvent on the basis that it can
meet all its obligations within the normal course of
its business, including that taxpayer’s loan to it?
Sir Callum McCarthy: The answer is yes. We would
not deem it solvent unless we believed it could do
that. The fact that it is getting liquidity from the
Government is undoubtedly the case and without
that liquidity the bank would have failed.
Q1510 Mr Breed: It is totally dependent upon the
Treasury contribution which lasts until February
according to the Chancellor. By February, when
the taxpayer may expect to have all its money back
which would be in the normal course of its current
business, you expect that to happen which is an
assessment therefore of its solvency today?
Sir Callum McCarthy: No, I do not think we are
necessarily saying that we believe the taxpayer will
have all the money which has been advanced
returned by February because I think if you look
at the Chancellor’s statement he said February or
the time at which other events have been reached.
It is clear that the Treasury, in discussions with the
bidders, has been prepared to discuss timetables for
repayment which go beyond that. All that is in the
public domain, I am saying nothing new.
Q1511 Mr Breed: You consider that suYcient to
consider that Northern Rock remains solvent?
Sir Callum McCarthy: We do believe that Northern
Rock remains solvent.
Q1512 Mr Breed: Could I ask finally then, when is
Northern Rock’s next trading statement to be
published?
Mr Sants: The next trading statement would come
with the final results.
Q1513 Mr Breed: Is there not one due in the middle
of December?
Mr Sants: That would be its pre-close and then it
would have to make a full statement by the spring.
Q1514 Mr Breed: We are now 11 December, so
within the next few days you would expect
Northern Rock to produce an interim trading
statement?
Mr Sants: Coming back to the quoted company
point you have just made, I think it is clear to
investors that without the support provided by the
Bank of England at the current time then Northern
Rock would not be able to continue in its current
form. There has to be a presumption, as Callum
has already laid out, that support would remain in
place unless an alternative mechanism can be put
in place, to justify continuing the meeting of the
threshold and conditions, and that analysis is
correct. In a narrow sense we are clearly dependent
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
on that funding stream to continue to make the
assertions we have made and that is absolutely
right and any statement by the company will have
to reflect that.
Q1515 Mr Breed: Just to repeat, you are expecting
the company to make its interim trading figures
available by the middle of this month?
Mr Sants: It would make a pre-close statement and
then a statement after the end of the year.
Q1516 Mr Breed: You are expecting that to
happen?
Mr Sants: In order to fulfil its listing conditions it
will have to so do.
Q1517 Mr Breed: If it does not, then its listing
might be in jeopardy?
Mr Sants: Its listing could be in jeopardy.
Q1518 Mr Dunne: With hindsight, should the
lender of last resort facility have been extended to
Lloyds TSB in order to have allowed a private
sector solution?
Sir Callum McCarthy: I think it is very diYcult to
form a judgment on that because, as I think I said
last time I was before this Committee, it was not
quite as cut and dried as I think it has been
suggested that there was a complete proposal on
the table. It was the case that it was made clear
slightly later than that that the facility which had
been oVered to Northern Rock would be oVered to
other bidders, ie they could take advantage of it,
but it is a diYcult set of circumstances to take a
view on even in hindsight.
Q1519 Mr Dunne: You just explained that you do
not believe it would be appropriate for liquidity
supervision to be separated from regulatory
supervision and the regulatory supervision restored
to the bank. Do you think there is an alternative
scenario in which the liquidity supervision should
be brought into the FSA so it is brought under a
common roof?
Sir Callum McCarthy: No. There is a question
about whether the only route providing finance
should be via the Bank of England or whether the
Government should have other agencies that it
could use. I think that is something which is a
possible route. I should make clear that I am not
arguing for the FSA to have a very large balance
sheet. That is the last thing I want.
Mr Sants: We obviously have a mandate to
facilitate private sector solutions and, as was
demonstrated by the retail bank point you just
made, you could argue that is a diYcult mandate
to discharge when the FSA has no locus with
regard to providing funding with regard to
institutional specific situations. That is a question
that could be reasonably considered but, as the
Chairman indicates, there are diVerent ways that
mechanism could be considered.
Q1520 Mr Dunne: If Northern Rock is
nationalised, will Granite have to be nationalised
too?
Sir Callum McCarthy: I am sorry, it is a
hypothetical question and I do not know the
answer at all.
Mr Sants: Granite is, as you know, an on-balance
sheet vehicle in that sense. I know the obligations
which are carried by Northern Rock to Granite
would have to be carried through the
nationalisation process, I would imagine.
Q1521 Mr Dunne: That would survive? Events of
default would not be triggered or it could be
organised so they did not trigger through a
nationalisation, do you envisage?
Sir Callum McCarthy: It is diYcult. It would
depend on the details of the Granite trust.
Mr Sants: It would depend. I have a view, but I
am hesitant to express a definitive view. I could
send you a note on it. I am pretty sure that it could
be organised in such a way, but I hesitate to be
absolutely definitive.
Mr Dunne: If you could send a note, that would be
appreciated, Chairman.34
Q1522 Mr Brady: When we took evidence from
Northern Rock it was not readily suggested that
the first contact specifically about the liquidity
problems between the FSA and Northern Rock
was initiated by Northern Rock and not by the
FSA. I think, Mr Sants, you were interviewed for
the File on Four programme. You gave the opposite
answer and said it was the FSA that initiated
that contact.
Mr Sants: Sorry, I have got a very bad cold. I
actually could not hear the question.
Q1523 Mr Brady: Who first contacted whom
regarding the liquidity problems at Northern
Rock? Was it the FSA contacting Northern Rock
or vice versa?
Mr Sants: My understanding of the events—I
think, as always in these things, it is a question of
how you perceive them—from our point of view,
we contacted them first in the sense that, just to be
clear, we always understood the funding model of
Northern Rock, as I think I have explained before,
so from the moment that market conditions
deteriorated and we set up our special process from
10 August and so forth, if you remember the earlier
discussion, we were proactively engaging with the
firms that we perceived as carrying risk and that
includes Northern Rock. Northern Rock may have
been answering the question in the sense that
clearly, as the company, it would be their judgment
as to when they had a serious problem, so in that
sense they might have rung us and said, “We now
do oYcially think we have a serious problem”, but
from our perspective we were contacting and
proactive with Northern Rock as an at risk firm
once market conditions had deteriorated from 9
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August. I believe, as I said on the programme, that
we were proactively engaging with Northern Rock
and that was the case.
Q1524 Mr Brady: That dated from 9 August?
Mr Sants: I think from 10 August actually.
Sir Callum McCarthy: Could I make a distinction
between after the events crystallised on 9 August
and before I think it would be a misleading
impression to suggest that the first time we had ever
discussed liquidity, those issues, stress testing, was
9 August.
Mr Sants: Yes, I did not think that was the
question. I think I made clear earlier that in July
we had already started to point out to the firm,
recognising that we could have been doing this
before, that we were very unhappy with their stress
testing scenarios and asked them to do “further
distinct liquidity tests and scenario tests” and give
greater consideration to the impact of accelerated
cash flows from a trigger event in a liquidity crisis,
so that communication was already taking place
with them in July and that was proactively initiated
by us.
Q1525 Mr Brady: What advice did the FSA give
to the Chancellor about the need for an immediate
depositor guarantee after the lender of last resort
operation was leaked?
Sir Callum McCarthy: The announcement was
made on the Friday and, as you say, it was leaked
on the Thursday night. Over the weekend there was
a series of conversations with various Treasury
oYcials and the Chancellor in which the need to
give an explicit government guarantee was
discussed and the decision was taken on the
Monday afternoon.
Q1526 Mr Brady: What advice did you give?
Sir Callum McCarthy: The advice was that if the
run that was taking place continued, the only way
of stopping it was an explicit government
guarantee.
Q1527 Mr Brady: Could I also then ask about the
advice that was given prior to the leak or the
announcement being made. The Governor has
pointed out there was no easy way to predict the
response of the customer, but is it not really
common sense that in those circumstances without
100% guarantee there would be a state of panic
created?
Sir Callum McCarthy: No, I do not think it was
obvious. I think that a whole series of things
conspired. It was extremely unfortunate that the
information leaked because it meant that instead of
this being put in place as, “This is a solvent
institution which has a cash flow problem and the
Government is stepping in to make sure that it is
saved”, it became a panic measure or a response to
something that was already in the making. Panic
was how it was seen. I think that it was unfortunate
that the administrative arrangements within
Northern Rock were not better developed, both in
terms of the Internet access which was inadequate
and something which very little could be done
about at all, which was the physical layout of the
branches. One of the problems in these
circumstances is because of anti-money laundering
requirements, if somebody comes in and says, “I
wish to withdraw £20,000”, it takes something like
a quarter of an hour to go through all the necessary
steps. If you have a small branch with two
counters, you only need ten people and you have
a queue. There was a whole series of things that
were diYcult, some of which with more favourable
timing we could have overcome; some of which we
could not. Also, I think in retrospect it would have
been better to have emphasised the positive aspects
rather than the negative aspects of lender of last
resort.
Q1528 Mr Brady: Did the FSA advise the
Chancellor that there should be the guarantee put
in place at the same time as the lender of last resort?
Sir Callum McCarthy: No, we did not, nor did
anybody else, nor would I have wished to have
given that advice because it would clearly have been
better if the lender of last resort facility had been
put in place and had worked without a general
guarantee.
Q1529 Mr Brady: Again, I think I am quoting
correctly from the File on Four programme, Mr
Sants, on this subject you said—I think this refers
to the FSA and the Chancellor collectively—“We
obviously had made the judgment that it wasn’t an
announcement we wanted to make at the same time
as the facility”. That implies this was at least
discussed.
Mr Sants: To be fair, I think this particular
programme is an edited programme, not a live
programme, so I am not sure I can particularly
recall the question to which I was responding or,
indeed, can be sure from the transcript what the
question was I was responding to. I was not
involved in everyday conversations with the
Chancellor but I concur with the analysis the
Chairman has given. I do not think we specifically
gave any advice with regard to the 100% guarantee
prior to the news breaking.
Q1530 Mr Brady: As you say, the programme is
edited but in the transcript I have got in front of
me, your actual words in response to this point
were: “We certainly discussed the possibility, but
we obviously made the judgment that it wasn’t an
announcement we wanted to make at the same time
as the facility”, so it was the possibility of it.
Mr Sants: My recollection of the discussions, I
have to say these were not specifically with the
Chancellor, was that they were about alerting the
FSCS i.e. we were talking about the way in which
this announcement would interact with the
compensation scheme. We were, of course, aware
of the limitations of the scheme and, indeed, as we
said before in our consultation paper, which was a
precursor to the changes we have announced, and
the Chairman mentioned at the beginning, we made
clear the scheme was not structured to address a
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large scale failure in the banking system. This is the
point we had already made in public. What I was
seeking to reflect in that comment, I believe, from
memory, was the fact that we had been talking
about those issues, but we had not given specific
advice as to whether the matter should be
addressed prior to the announcement.
Q1531 Mr Brady: You did not give advice one way
or the other?
Mr Sants: Not personally to my recollection, none
of us did.
Sir Callum McCarthy: My recollection is that the
question of the guarantee only arose after the
queues began to develop.
Q1532 Mr Brady: Yet it was discussed before that?
Sir Callum McCarthy: Hector has explained the
context in which he made that remark.
Mr Sants: The compensation scheme was discussed
beforehand. The issue of 100% guarantee was
certainly not discussed at the principals’ level. I
think I may have some vague recollection of it
being mentioned by some working group
discussion, but that is the extent of it.
Q1533 Mr Brady: Do the Tripartite Authorities
have a communication strategy for coping with a
bankrupt?
Sir Callum McCarthy: I would say a better one now
than we did some time ago.
Mr Sants: That was the point we made when we
were here before. We absolutely do think that there
are significant lessons to be learned in terms of the
way the Tripartite Authorities communicate
around these types of issues, both the terminology
and the way we handle the release of the news. We
have already started to learn from those lessons and
continue to so do.
supervising the Bank of England or any subsidiary
of the Bank of England, so if an institution became
a subsidiary of the Bank of England, we would not
supervise it. If it were a freestanding, if I can use
that expression, nationalised bank, we would
supervise it.
Q1536 Jim Cousins: Is this something that has been
discussed by the tripartite committee, how its own
workings would be aVected in the event of the
nationalisation of a bank?
Sir Callum McCarthy: I am not aware of any
discussions. I have not taken part in any
discussions. I am not sure if there have been any.
Mr Sants: I am not aware of it in the way I think
you are asking. The Chairman has already
answered in terms of understanding the supervisory
framework, but in terms of the specific tripartite
question, I am not aware of any discussions.
Q1537 Jim Cousins: You are obviously aware, Sir
Callum, that there is a campaign to downgrade the
value of the assets in Northern Rock and force it
into nationalisation, that campaign has been in
front of the Committee this morning. What
regulatory consequences do you think there would
be if one of the members of the tripartite committee
itself became the owner of a bank?
Sir Callum McCarthy: Sorry, I should make clear
that I do not understand the reference to
downgrading the assets.
Q1538 Jim Cousins: I am not suggesting you have
done that.
Sir Callum McCarthy: I am not sure in terms of the
tripartite arrangements if there were a nationalised
bank whether that would have very great eVects on
the tripartite arrangements overall.
Q1534 Mr Brady: One final point. If I could come
back to Ms Minghella. How involved were you at
the time all of this was going on and how confident,
in particular, were you that the FSCS could cope
with the failure of Northern Rock had that
happened?
Ms Minghella: We were not involved in August
with the discussions with the Tripartite Authorities
when they were going on. We became aware of the
problems of Northern Rock in particular in
September. I think a point that has been made
earlier with Mr Todd was that we were not
designed to deal with a failure of this size, so it was
not a surprise to us that these discussions had been
going on in advance of our being informed. By the
time we found out the lender of last resort facilities
were already in mind and that seemed to us to be
appropriate in the circumstances.
Q1539 Jim Cousins: If a nationalised bank were to
seek to wind up its operation rapidly by selling its
assets in the market in a short time frame, would
that be something that would come before the
tripartite committee?
Sir Callum McCarthy: Were there a nationalised
bank, whoever was running that nationalised bank
would have responsibilities, it would have
responsibilities presumably under the Act of
Parliament that had led to the nationalisation. In
terms of the FSA’s regulatory responsibilities we
would be concerned, as with any institution, about
systems and controls, adequate management, all
those things, but it would not be for us because we
would not be the shareholder—the shareholder
would be the Government in some form or other—
to decide on the commercial strategy of that
institution.
Q1535 Jim Cousins: Sir Callum, if a bank were to
be nationalised, how would that aVect the workings
of the tripartite committee?
Sir Callum McCarthy: I think that it would depend
on who was the owner of any nationalised bank
because we do not have responsibility for
Q1540 Jim Cousins: But in your discussions at the
tripartite committee if you did have concerns, you
would be expressing them in front of other parties
who might themselves be the owners of the
institution whose management you have some
question about.
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
Sir Callum McCarthy: I should make clear that all
of these are hypothetical circumstances, but you
should assume that we would discharge our
responsibilities with the same independence that we
adopt towards any institution for which we have
responsibilities.
Q1541 Jim Cousins: One of the issues, looking back
over the Northern Rock aVair, is the failure to
anticipate things. Now I am not myself going over
that ground, the Committee has gone over that
ground. The issue of nationalisation is not now a
theoretical one, it is something that is being actively
advocated by a large number of influential people.
Are you really telling me that, yet again, we have
a failure to anticipate consequences and that there
has been no discussion either at the FSA or at the
tripartite committee as to how the regulatory
system we have for banks would be aVected in the
event of a bank nationalisation? I find that
extraordinary.
Sir Callum McCarthy: I would say that I do not
find it extraordinary. I do not find it extraordinary
because at the moment we have got two proposals
on the table for private sector solutions and we are
concentrating very hard on discharging our
responsibilities in relation to that. I am yet to be
convinced that were there a nationalised bank what
are the real problems that this would present for
the tripartite arrangements. If there were significant
ones we would deal with them, but I do not think
that I am convinced there would be diYcult
problems.
Mr Sants: To your point, we are clear—the
Chairman has answered the question—what our
regulatory responsibilities as the FSA would be for
that entity and it would be our role to discharge
those in our capacity as an independent agency, so
I think we are clear about our regulatory
responsibilities, there should not be a
misunderstanding about that.
Q1542 Jim Cousins: The Governor and you, Sir
Callum, would look the Chancellor in the eye, if he
were to find himself the owner of a bank, and raise
criticisms about it?
Sir Callum McCarthy: If there were a question, for
example, of inadequate systems and controls within
a nationalised bank over which we had supervisory
responsibilities, I would have absolutely no
diYculty in doing what you suggest.
Q1543 Chairman: Sir Callum, a couple of final
questions. In 2006 Northern Rock appointed
Rosemary RadcliVe, a former partner of PwC, to
their audit committee and their auditors last week
mentioned that they raised concerns about this but
withdrew them following the receipt of what they
called an “explicit clearance” from a regulator.
Were you the regulator involved and, if not, did
you express any views on the matter?
Sir Callum McCarthy: I think no views were
expressed on the matter.
Mr Sants: I think we were the regulator involved,
but I know of no views being expressed on that.
Sir Callum McCarthy: Could we come back?
Q1544 Chairman: Definitely. Karin Forseke, a nonexecutive member of the FSA board, was a CEO of
the Swedish investment bank Carnegie until March
2006. The Swedish regulators found that Carnegie’s
2005 and 2006 annual reports presented incomplete
information and punished the company with the
maximum financial penalty, also insisting on
multiple board changes. In these circumstances,
have you considered whether it is appropriate for
her to remain a non-executive member of the
FSA board?
Sir Callum McCarthy: Yes, Chairman, I have
considered it very carefully. I discussed the matter
extensively with the Swedish financial regulator and
took advice on the report and at rather
considerable expense had the report, which is only
in Swedish, translated into English so we could
look at the evidence in detail and formed a view,
which I formed after consulting the past and future
Deputy Chairman of the FSA, that it was
appropriate for Karin Forseke to remain a
member.
Q1545 Chairman: As a Committee, we visited
Sweden in the last couple of weeks and we read the
regulatory report in English, so it was no problem
for us, but it was quite a censure that the regulator
gave. In the light of your answers, I think for the
public record I would like you to write to us on this
the issue in detail as to why you have confidence
in her as a non-executive director and the reasons
for that.
Sir Callum McCarthy: I would be delighted to,
yes.35
Q1546 Chairman: Last question. Do you think that
either you as the regulator or the market have a
proper understanding of the size of the tail risk in
money or credit markets? I say this in light of the
evidence that we have looked at from Paul
Ormorod and Bridget Rosewell.
Sir Callum McCarthy: I think the analysis of tail
risks is an extraordinarily diYcult issue. By
definition you are saying that you expect events
which happen very infrequently, that is what you
are examining, and anybody who claimed they had
a full understanding of the risks associated with tail
risks would be open to appearing misleading.
Mr Sants: I do not think it is possible to have a
full understanding of tail risks.
Q1547 Chairman: We understand that, but what
they are saying is a gap between the Bank of
England’s base rate and the three-month Libor is
an indication of unusual conditions in the market
and really their conclusion was it should not be
assumed that the historical data on this gap follows
a normal statistical distribution as many have done.
Are you alert to that and, for instance, is there
some justification in suggesting that the tails of the
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11 December 2007 Sir Callum McCarthy, Mr Hector Sants and Ms Loretta Minghella
distribution of spread between the three-month
Libor and the base rate may be fatter than
conventional analysis might suggest?
Sir Callum McCarthy: It is certainly the case that
there has been a very substantial divergence
between the three-month Libor and the bank rate,
that is manifest in the UK, the Eurozone and the
United States. It is exacerbated at the moment by
the year end pressures, so that is undoubtedly the
case.
Mr Sants: It is also undoubtedly the case with
regard to financial markets, as others have said to
you, that relying solely on historical statistical
analysis as a method of predicting the future via
modelling is not a suYcient way to discharge your
responsibilities as a board of directors. You do
need to take into account the likelihood that the
future will not reflect the past and circumstances
will not repeat themselves in the way they have in
the past. That is why we continue to reiterate the
statements we made in the earlier part of the year
which are even more appropriate now than they
were, that firms need to seek to run full scenario
tests, understand the circumstances under which
their business models have come under pressure
regardless of whether or not that type of modelling
looks particularly probable from a tail risk
analysis. They should run their businesses to take
into account those risks and, as we said earlier, we
do not feel that it was the case that all institutions
were taking that approach to risk management in
the early part of the year. We believe that recent
events and supervisory engagement mean that they
are much more focused on this point, but it is still
a key factor that they need to properly focus on.
Chairman: On that technical point, could I thank
you, Sir Callum and colleagues, and wish you a
merry Christmas and a peaceful new year, starting
with your reappearance at this Committee shortly
thereafter.
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Tuesday 18 December 2007
Members present
John McFall, in the Chair
Nick Ainger
Mr Graham Brady
Mr Colin Breed
Jim Cousins
Mr Philip Dunne
Mr Michael Fallon
Ms Sally Keeble
Mr Andrew Love
Mr George Mudie
Mr Mark Todd
Peter Viggers
Witnesses: Ms Angela Knight CBE, Chief Executive, British Bankers’ Association; and Mr Adrian Coles,
Director General, Building Societies Association, gave evidence.
Q1548 Chairman: Good morning and welcome to
the Committee. You are both very familiar with the
Committee, but could you introduce yourselves for
the shorthand writer, please.
Ms Knight: Angela Knight, I am the Chief Executive
of the British Bankers’ Association.
Mr Coles: I am Adrian Coles, I am Director General
of the Building Societies Association.
Q1549 Chairman: As you know, this inquiry is
largely about financial stability, so my first question
to you is: is it possible to design a system where
payouts are made from a failing bank within days or
weeks of a failure rather than months or years as at
present? Is work going on on that? I notice that a
representative from the IMA has suggested plugging
the Bank of England into the ATM network in order
to provide immediate access to funds up to the
£35,000 limit if a bank were to fail.
Ms Knight: Yes, I think it is possible to design a
system, Chairman, whereby payouts can be quicker.
The existing Financial Services Compensation
Scheme has been designed primarily for investment
products and not for deposit protection in terms of
a quick payout scenario. If we look at the various
options that are currently in operation in other
countries, I think that there is there some
information and some models which we could
probably usefully consider here. We made brief
mention of some of those within our submission to
the Treasury on reform of the Deposit Protection
Scheme, a copy of which we sent to yourself.
Q1550 Chairman: Adrian, if you could just take that
and add to the point that if depositors were to receive
immediately their deposits from the FSCS, what
implications would this have on depositors’ status as
creditors? Could creditor status be transferred to
the FSCS?
Mr Coles: Clearly it is possible to design a scheme
where depositors get their money back immediately.
That is exactly what happens in America with the
Federal Deposit Insurance Corporation Scheme.
They normally aim to get deposits in the hands of the
depositors of a failing bank within 24 or 48 hours.
The answer to your first question is absolutely yes,
although it is fair to observe that in the American
system most of the banks that have been saved over
the last ten or so years have been very tiny
institutions with deposits of only $10 million/$20
million/$50 million, much smaller than the sort of
circumstances we are talking about in the UK at the
moment. What tends to happen with the larger
institution in the States is that the depositors do
become creditors of an institution owned and
controlled by FDIC, so again the answer to your
question is, yes, this could be arranged if there was
the desire to do that in the United Kingdom.
Chairman: We hope to finish by half past ten so we
are going to ask brief questions and receive brief
answers so that we will get the maximum out of this
session. Peter?
Q1551 Peter Viggers: In your memorandum36 you
commented on the amount of liquidity made
available by the Bank of England and contrasted
that with the amount of liquidity made available by
the European Central Bank and the Federal Reserve
yet when asked a specific question by us, the
Governor on 29 November said that: “The
European Central Bank has not increased the
amount of liquidity at all since the beginning of
August.” He said: “The Federal Reserve has not
raised the total amount of liquidity very much,” and
then he went on to contrast that with the Bank of
England: “The amount of liquidity that we are
extending to the banking system is almost 30%
higher. Can you explain that apparent conundrum?
Ms Knight: I will try but I think you will have to
redirect most of those questions back to the
Governor of the Bank of England. In eVect, what we
had in the UK was a money market framework
which was more constrained than that of the
European Central Bank or that operated by the Fed.
Thus for a UK bank accessing liquidity there were
collateral rules which were much tighter and there
was the so-called penal rate, which was not levied
elsewhere. Whereas technically liquidity might have
been available, it was unattractive to take it because
of the costs involved and because of the lack of
ability to oVer up the broader range of collateral. It
is interesting to note that now—in fact today—the
market operation that is going to be undertaken by
the Bank of England actually does adopt the
collateral arrangements that we proposed and
reduces the penal rate; it is now as we asked. I think
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
perhaps one last thing to say is this: the BBA has had
discussions with our fellow trade associations both
in Europe and also in the US because of the
diVerences that were operating in respective money
markets and we too were aware that somehow the
statistics at the bottom seemed to imply a diVerent
story than we were experiencing. We asked the
question: what did it look like and how did it feel like
for you? The answer that we got from all of them is
that it looked like their central banks were standing
behind the industry ready to provide liquidity as and
when it was needed in a broader way that the UK
which was more in line with that which the industry
was requesting.
Q1552 Mr Todd: The FSCS compensation scheme is
designed primarily not to deal with the failure of a
very large firm. How do we define the limits of what
it is supposed to deal with and the apparent liabilities
that the state presumably bears for firms that are so
large that it cannot cope?
Mr Coles: The current arrangements are quite clear.
The scheme is designed to deal with the loss of up to
about £4 billion because that is the maximum
amount of money that will be available to be paid
out to the depositors of a failing bank after the
reforms that have been agreed earlier this year are
implemented on 1 April 2008. So anything above £4
billion the Financial Services Compensation Scheme
cannot help with. In fact, the current figure would be
about £2.5 billion. How do we define how big an
institution we want to save beyond that is very much
more diYcult. If you are looking at Northern Rock
that is an institution that has clearly been defined as
‘too big to fail’. If you are looking at some of the
smaller banks or smaller building societies, the
actual dividing line becomes very diYcult.
Q1553 Mr Todd: Do you think there is an argument
for transparency about where that line lies?
Mr Coles: Think there are two issues regarding
transparency. First of all, should there be an
indication to depositors about the size of the
guarantee—£25,000 or, as we have in the UK now,
£35,000—and the second issue is should there be an
indication of the size of the fund that is available to
support in the event of a bank failure in relation to
the size of the bank. I think that would also be
important information for a depositor to know.
Q1554 Mr Todd: The protection scheme was clearly
largely unknown to depositors themselves. Do you
think that banks have a clear obligation to display
on their products exactly where the guarantee lies
and to what extent it is?
Ms Knight: I think you can actually express that
question rather more widely: is there a well-known
explanation of the various protections given by the
Financial Services Compensation Scheme to the
broad range of individuals who engage in a variety
of ways with the financial services industry? The
answer is that, whilst it is no secret, I do not think
that there is necessarily the sort of pulsating clarity
which we needed look at now. Certainly so far as the
banks are concerned, we have, not surprisingly, had
a significant amount of discussion on this and have
said to the FSA that we want to engage on this point
of explanation. What I also would say though is that
the attention has been paid on prevention and I
think in this instance we should be looking at
prevention. The question is often asked “did
individuals understand that there was some deposit
protection or not?” Certainly they got the hang of
that relatively quickly with the Northern Rock, as
we are all well aware.
Q1555 Mr Todd: I think awareness will be wider
now!
Ms Knight: There is greater awareness now and in
one respect that is a good thing because it means that
we can play into that awareness with providing
knowledge. As I say, we have said to the FSA quite
clearly that the banks want to engage on this. We do
not just think it is for one part of the industry. We
think that there is a broad question that needs to be
asked and answered and that is: how do we describe
to the individuals how they are protected?
Q1556 Mr Todd: You listed four elements of a
protection scheme that you felt were required. Do
you think the scheme does actually meet those four
elements of requirement?
Ms Knight: I think the key to all this is actually speed
of payout and I think it is the speed of payout that
we need to address. That might require a mixture of
scheme rule changes but also might require some
legislative changes to allow earlier intervention with
a deposit taker that has got into diYculty.
Mr Coles: I think the speed of payout issue is related
to the size of the institution. As I said, if you look at
America, they pay out within 24 to 48 hours. If you
look at the payments that our own Financial
Services Compensation Scheme has made to
depositors of credit unions, typically those payments
are being made in seven to ten days, so for small
institutions we are almost meeting the standards in
America. For much larger institutions it is much
more diYcult.
Q1557 Mr Todd: Lastly, do you think co-insurance
has no great value because it simply muddies the
water and confuses the customer as to what extent of
risk they are actually bearing?
Ms Knight: I think co-insurance still does have a
place. It is the point at which it start which is worthy
of debate. Interestingly, I think it is the Netherlands
which has just gone through that discussion (because
co-insurance is quite common there) and in so doing
they lifted their deposit protection scheme to the
equivalent of about £25,000 in full and then over
that it was co-insurance up to about the level we are
at the moment in the UK. So there is a role but it is
the point at which it starts.
Q1558 Mr Todd: That means that transparency is all
the more critical so that people clearly understand
what they are buying into.
Ms Knight: I think this is all part of your earlier
question, if I may say, about how we explain.
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
Mr Coles: The complexity of the co-insurance is a
diYcult thing. When we had a limit, apparently, of
£31,700, that was extremely diYcult to explain to the
depositor.
Q1559 Mr Fallon: Ms Knight, the banks have been
extremely profitable in the last few years, yet you
have been hiding behind a scheme that nobody really
understands and that is not really properly funded.
The Chancellor’s guarantee for Northern Rock
depositors would not have been necessary if we had
had a properly funded upfront scheme with notices
in every branch in every bank telling people exactly
how quickly they can get their money out.
Ms Knight: Interestingly of course, there has just
been a full discussion about the whole of the
Financial Services Compensation Scheme and the
Deposit Protection Scheme, undertaken by the FSA
with the assistance of consultants, and they came up
with the current limits and current arrangements
that we have. I think the reality is that it is certainly
possible to be able to use a deposit protection route
for certain sizes of institutions that take deposits, but
over a certain amount—and if we look again
elsewhere around the world—you are into bigger
issues than a protection scheme can properly cater
for. On the question of whether it is properly funded,
one of the things that we have here in the UK is
embedded within the legislation is a requirement, an
obligation if you like, on the FSCS to make demands
for payments into it when it knows the extent of its
liabilities. It is not as if you have a scheme where the
industry is asked to put some money in and then
everybody goes away for 12 months or whatever.
There is a requirement and that is a requirement that
has to be fulfilled for the FSCS to make demands
from the relevant part of the industry if it requires
funds.
Q1560 Mr Fallon: But it is not true to say that the
American scheme simply operates for the very, very
small banks. Continental Illinois which failed was
£40 billion, about half the size of Northern Rock,
and that was 17 years ago, so it is not true to say that
it is small banks. Your evidence to us says that you
want to stick with this post funding model?
Ms Knight: Correct.
Q1561 Mr Fallon: Why not put the money upfront
so everybody can see it is there and have a system
where they can get their money back within a few
days?
Ms Knight: Putting money upfront is not the only
way of making sure that you can get your money
back in a few days. If there is a requirement on the
industry to pay there is a requirement on the
industry to pay. It seems rather diYcult to see why
one should have some large sum of money just
hanging around waiting when actually the issue is
not one of is there money to pay out in a diYcult
circumstance; it is how quickly can a deposition
access their money and what rules changes and what
legislation changes are required in order for that to
come about. If I may say, one of the main concerns
which I think comes out from the memorandum
which we submitted to the Treasury Select
Committee is this: we need to be looking with
considerable attention at prevention, and that is
where we believe the whole issue lies; on the
preventative side. We think that the Deposit
Protection Scheme as it is currently formulated—
100% to £35,000 with a requirement by the industry
to pay quickly—is a workable model. The question
that arises is how does it get from the FSCS to the
individual deposit takers, and that is an area where,
as I say, rules and legislation may be required.
Q1562 Mr Fallon: But what the Governor said was
required was a scheme that did not mean that people
had to wait more than a year to get their money out.
Ms Knight: We would entirely agree.
Q1563 Mr Fallon: Are you not dragging your feet
on this?
Ms Knight: No, we have put forward some
proposals, as you know. We entirely agree that a
scheme that requires a year to pay out is not good
enough. As Adrian Coles has just said, where the
scheme has been used has been with failed credit
unions, there the payout is quick, and indeed has
been getting quicker. If one is looking at large
numbers of individuals, there are systemic issues and
there is panic hanging around there as well. I do not
think that one should just say that it is the
responsibility of an independent or quasi
independent scheme to address that situation.
Q1564 Chairman: Last week, Mr Fallon and I were
talking to your equivalent, the American Bankers
Association, in Washington and they were very clear
that an upfront funded scheme was essential for the
confidence in the system in the first place and,
secondly, that when a situation arises where payout
has to be made, it is probably not the best time
economically so you have a fund there that is
available. That was their unequivocal view to us.
Mr Coles: Could I add a point there. I think the
crucial diVerence between the British scheme and the
American scheme is not the upfront funding; the
crucial diVerence is that the FDIC is backed by the
full faith and credit of the US Government, and I
think that is what gives the confidence to depositors
in the United States.
Q1565 Chairman: No, no, no, but they were very
clear on this upfront funding.
Mr Coles: I know that is a diVerence but this is
another important diVerence.
Chairman: You are missing the point. They were
very, very clear on that and they were saying why not
get the money in the fat years so that when the lean
years come there is no problem getting money out of
people? That was the issue. I just put that as public
evidence. Nick?
Q1566 Nick Ainger: The Financial Services
Authority in their Financial Risk Outlook in
January and the Bank of England in their Financial
Stability Report in April both gave clear warnings of
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
problems of weakened credit risk assessment and
impaired market liquidity. Why did the banks not
listen to those warnings?
Ms Knight: The banks did.
Q1567 Nick Ainger: What action did they take?
Ms Knight: As far as the banks themselves
individually are concerned, they did, as I am
informed, take full notice of the points that were
made to them and the issues that were raised. Clearly
we have one bank that may have taken a diVerent
view and I know that you have had a discussion with
them. I think also, though, the one thing that neither
authority nor indeed the industry, wherever it was in
the world, expected was the way in which the
housing problems of the US unfolded as rapidly as
they did and as widespread as they did. Nevertheless,
I think one of the comforts that we can take in the
UK is not only do we have a strong banking industry
but they do heed the documents, the consultations,
and the other communication that are issued from
our various authorities.
Q1568 Nick Ainger: So everything in the garden is
rosy, there is no problem? Surely our experience
from August onwards is that there have been serious
problems and warnings were not heeded?
Ms Knight: I do not know why you say that. Quite
clearly there are some very diYcult market
situations taking place, but you cannot necessarily
cure a market situation that has arisen nor can you
do anything other than handle something well as it
arises. We have well-capitalised banks, they are
handling the situation that has arisen, but what you
cannot expect them to do is suddenly manage to
rectify a problem that has arisen in America. What
can be expected them is to look at their credit
assessment and look at how they are handling their
own aVairs, and I think that is something that we
have seen.
Mr Coles: Can I oVer an observation from the
building society point of view there. On the day the
Financial Risk Outlook was published by the FSA,
we sent out a circular to our members strongly
advising them to read the FRO. We gave them full
details of the relevant pages for building societies,
the relevant developments in the mortgage and
savings market that would be most important for
building societies to read, and our evidence is that
building societies read that carefully and were fully
expecting a slowdown in the housing market this
year. They were not expecting the closedown of
markets in August but they were expecting a
slowdown and we encouraged them to read the
relevant documents.
Q1569 Nick Ainger: Can I follow on from that and
ask you if Northern Rock had still been a building
society, would it have experienced what it
experienced this summer?
Mr Coles: If Northern Rock had still been a building
society it would not have been able, by law, to fund
itself 75% from the wholesale markets. A building
society can fund itself to a maximum of 50% in the
wholesale markets under the Building Societies Act
1986 and, typically, building societies fund
themselves 70% retail and 30% wholesale. Had
Northern Rock stayed a building society, it may or
may not have been a successful institution but it
would not have come to the sticky end that it appears
to have come to in the way that it has.
Q1570 Nick Ainger: Ms Knight, do you think
perhaps there is a lesson here to be learnt for the
banks in that if they adopted the same requirements
that the building societies have, that would actually
give greater protection and security and stability?
Ms Knight: The Northern Rock had a particular
business model, as you know. If you are looking at
the banking industry generally of course, it is much
broader based in what it does in terms of its
operation, how it funds itself and its various
activities. If you have any institution of any sort
which has a very narrow focus, in terms of both its
business model in what it does and indeed how it
funds itself, then clearly it is far more hostage to
fortune than would otherwise be the case. I think one
of the issues as well in all this, though, comes back
to your earlier point about the FSA’s
communications on risk, and that is that the
challenge process that the regulators undertake with
various institutions in respect of risk and exposure.
This is something that certainly we believe warrants
looking at further. Clearly the FSA did have an
engagement earlier this year with the Northern Rock
in terms of stress-testing and risk and so forth, and
this highlights an area that is something, as far as the
industry is concerned, requires clarification. We
want to see proper stability in the market and proper
stability within the industry.
Q1571 Nick Ainger: Have you got any idea when
these warnings are issued by the Bank and by the
FSA if they are taken note of? You have just told the
Committee that they were and yet we ended up with
the mess that the banking industry got itself into in
August. What measures or what further action do
you think particularly the FSA could be taking to
ensure that when they do issue warnings that action
is taken by the banks?
Ms Knight: If I may say, you are talking about one
bank, not banks in general. There may well be an
institution in any walk of life that does not
necessarily take the appropriate action at the
appropriate time, but in terms of the industry and
banks in general, do they act on warnings, the
answer is yes. Are they considered? We see that
consideration around the various committees that
we operate within the BBA, so we are well aware of
the sorts of actions and the sorts of issues that are
addressed and how the industry in general addresses
them. I think also, though, the question is this: what
is the nature of the follow-up by the various
authorities themselves? Because I agree with you it is
one thing to issue some sort of communication and
quite another to say that they have also put in place
the right tools and the right monitoring process to
see whether those actions have taken place. We do
wonder whether that is another area which warrants
further review.
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Q1572 Mr Love: In the press release that you put out
on behalf of the BBA on 5 December you are quoted
as saying: “The operation of the Tripartite was
found wanting when the Northern Rock problem
arose.” What changes would you like to see to make
it work better in the future?
Ms Knight: First of all, we do support the Tripartite;
we think that the problem is more in execution than
in structure. The piece of work that we want to see
done and, as far as I am aware, has not been done,
and it certainly is not yet in the public domain even
if somebody has looked at it, is this: if the various
authorities had taken action earlier, both regulatory
and in respect of the Bank of England, with the
Northern Rock, would we have had a more orderly
outcome? Certainly the perception is that whilst
issues were raised at certain points in the timetable,
actions by the authorities were far more ‘wait and
see’. For example, no changes took place within the
money market structure, there was no alternative or
Plan B despite many approaches, it appears, put it in
place in respect of Northern Rock. Before we know
exactly what sort of changes need to be made to the
Tripartite, we need to have that piece of work
undertaken by our authorities; what would have
happened if they had taken action rather than wait
and see. Clearly there is a question of leadership
within the Tripartite. There is also a question of
getting the right information reported at the right
time. There is also something about the individuals
involved as to whether it is at the right sort of
seniority. Lastly, I think that there is a lot of work
being undertaken on financial stability within the
FSA but there are not all that many people on that
side within the Bank of England, and as far as
financial services and the Treasury is concerned, we
would like to see that side strengthened as well.
Mr Coles: Could I add one point to that?
Q1573 Mr Love: Just before you do that, Mr Coles,
let me press Ms Knight a second. Is there an implied
criticism in what you have just said about the
Governor’s decision in relation to the provision of
liquidity at the very early stages of this problem?
Ms Knight: Certainly as far as the industry were
concerned, they were looking for changes to the
money market in July in some degree of urgency and
the question about wider collateral and the penal
rate had been on-going with the industry for around
12 months. This is not an implied criticism—I am
just stating the facts—and I do not want to have that
terminology used. But there were certainly
diVerences of view of how the money market should
operate and particularly when there were what were
referred to as ‘stress conditions’.
Q1574 Mr Love: Mr Coles, what was your
Association’s attitude?
Mr Coles: For me, looking at the Memorandum of
Understanding, one of the key issues that is missing
from that is “which of the Tripartite authorities is
responsible for communication once a crisis has
begun?” If you look at the final paragraphs of the
MOU, which is talking about crisis management,
neither the Bank, the Treasury or the FSA is
responsible for communicating with depositors, and
I think that was one of the key weaknesses on 13/14
September. Firstly, it was not clear who was actually
in charge of making that communication and,
secondly, as Hector Sants has said in his evidence to
you, some of the terminology that was used was
inappropriate for the ordinary man in the street.
Who is in charge of communication when you have
got a crisis problem and where there is a crisis of
confidence, which is essentially a communication
issue, is a very important improvement that needs to
be made to the MOU.
Ms Knight: That is right.
Q1575 Mr Dunne: Can I turn to the issue of oV
balance sheet structures and transparency and
disclosure. Hector Sants, when he was here last
week, said that we needed to consider the use of oV
balance sheet financing. Could you comment on
whether you think there are mechanisms to bring
particular types of structures onto banks’ balance
sheet? Would that be welcomed by the industry or
would that be a problem for the industry?
Ms Knight: Of course, some are already being
brought back onto balance sheet, as you know.
Q1576 Mr Dunne: But by default.
Ms Knight: I think the wider question is we are where
we are, but should one be looking at other changes
in the future? Some of the points that we believe
warrant
further
investigation
surround
transparency and they surround some of the way in
which ratings agencies should operate. I do not want
to cast them as the devil in all this, but there are some
issues there. Also some of the accounting standards
help as well. There are some accounting standard
changes which take place in eVect from this year and,
which again give greater clarity in that area. What
we want to do is to see how these operate not park
the issue, but see how those accounting standards
operate and take forward with some degree of
rapidity the whole question of transparency and
whether and what that provides in terms of
furnishing the right sort of information to the
market. There is, dare I say though, a proper role for
confidentiality in everything; it is getting that
balance right.
Q1577 Mr Dunne: Do you think Basle I is the culprit
here in large part by allowing banks to provide
liquidity facilities to oV balance sheet vehicles
without having to provide any capital adequacy?
Ms Knight: I think it is certainly arguable now that
Basle I is not the right tool for the job, but we are up
and running with Basle II. The market does move on
and standards do have to be reviewed frequently to
ensure that they keep up with the market. The whole
question of looking at liquidity is part of Basle II and
that is the part that is underway at the moment. One
of the issues though is that you cannot look at these
things from just one jurisdiction. It is not possible to
say, “The UK is going to do this,” because we
operate in a global market. Therefore I think that
this area has come rapidly up the agenda of Basle II
and the discussions which have been stuck for some
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Ev 174 Treasury Committee: Evidence
18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
time are now likely to be unstuck. I say again
liquidity has got to be looked at internationally and
not just in one jurisdiction.
Mr Coles: I think Basle II is going to be particularly
important because pillar three of Basle II is all about
market transparency. It is about institutions giving
much more information to the market about the
nature and structure of the balance sheet and the
liabilities that they have under particular
circumstances, and that should aid the transparency
issue that you are talking about.
Ms Knight: Yes.
Q1578 Mr Dunne: Do you think the FSA is equipped
to regulate banks properly?
Ms Knight: Yes I do. I do think they are equipped to
do that. I certainly think that they need to review
how they do it. It seems to us in the industry that
there has been very considerable attention paid to
capital and very considerable attention paid to, the
conduct of business rules, but the gap in between has
not had the focus that it should have had. I
appreciate that it almost seems year-by-year
additional requirements are placed upon the FSA to
regulate more or regulate diVerently, and I think we
all understand the diYculty of addressing that
scenario. There is the very real problem now as to
how the FSA should be regulating banks and
whether they do necessarily have the right tools and
the right people in place. That is where they need to
look. We think there is some strengthening that is
required and we would rather strengthen the existing
system than put a new system in place.
Q1579 Mr Dunne: Could I just press you on the
people aspect. Do you think the people within the
FSA have enough knowledge of the financial
instruments currently being used by banks and is
there a retention problem at the FSA of people with
those skills?
Ms Knight: The answer to the first question is clearly
no, because if you are a practitioner in the market,
you see how quickly it is developing; if you are not a
practitioner in the market, you do not. Healthy
regulation is about interchange of people from the
market into the regulator and from the regulator
back into the market. I know the FSA is aware of
this and they have been assuring the industry and the
wider public that they are paying attention to the
quality and calibre of people that they have. I think
the industry does want that to take place as well but I
suppose we are sometimes guilty of buying out good
regulators at the same time. A flow between
regulator and industry and industry and regulator is
important in this, as it is in other areas as well.
Mr Coles: I think there is an issue about consistency
of regulation. I know of one large building society,
for example, that has had its relationship with the
FSA headed by five diVerent people in four years.
That does not give the relevant people very much
time to understand the nature of the institution
which they are supervising. I would like to see
someone doing a minimum of two or three years so
that they properly understand the nature of the
business without being subject possibly to
regulatory capture.
Q1580 Chairman: In a word, Angela, is it a case of
first-tier banks getting first-tier regulators and
second-tier banks getting second-tier regulators?
Ms Knight: I think I could argue that you want firsttier regulators with second-tier institutions—
Q1581 Ms Keeble: I wanted to ask a bit more about
transparency and disclosure following on from what
Philip Dunne asked. Adrian Coles, you mentioned
in particular the third pillar of Basle II. Do you
really think that that would be adequate, given the
problems which have been already encountered with
an organisation which I think you said was already
operating to Basle II standards?
Mr Coles: I think there are two issues about
transparency. The first is what is the nature of the
bits of paper that are being issued by issuing
institutions and are the people buying those bits of
paper well enough informed to understand what
they are buying. I do not think there should be
intervention in that area. I think it is up to the people
who are buying the paper to employ the experts to
properly understand the nature of the financial
arrangement that they are buying into. I think the
more important question is when people invest in
banks, should they know whether or not those banks
have invested in risky bits of paper on the other side
of their balance sheet? Pillar three is certainly going
to give us much more information on that, although
I am not aware whether Northern Rock has made
significant pillar three disclosures since it got its IRB
waiver at the end of June this year.
Q1582 Ms Keeble: Can I just come back on that
point because you said the banks should employ the
people who are able to look into the investments and
to work out—
Mr Coles: —when they buy them.
Q1583 Ms Keeble: That is right and, in a sense, the
people who then invest in the banks are dependent
on the banks doing that first bit properly. One of the
things which has emerged through our discussions is
that the due diligence is not adequate in terms of
people looking into what lies behind the commercial
paper. Do you think there is a real need for the
banking sector to improve its due diligence so that
when it discloses what it has invested in, it does not
just say we have invested in these triple-A star rated
securities but it says what is actually bundled up in
those securities?
Mr Coles: I think personally that would be helpful.
Q1584 Ms Keeble: Could you say a bit more than
just “it would be helpful” because otherwise we do
not know enough about what your thinking is about
what the banks should be doing.
Mr Coles: Building societies typically do not invest
in these pieces of paper anyway, so I think I will defer
to Angela on that one about the nature of the
investigation that should take place in due diligence.
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
Ms Knight: It is a fair point. Firstly, so far as
disclosures generally are concerned, IFRS 7 is one of
the standards that is coming into force. I think that
will certainly help on general disclosures—there are
some others, as I have said earlier. Theses are all
coming into place over a relatively short period of
time. I think it is important to see exactly what
clarity they bring. However, the answer to the point
that you made about whether there has been too
great a reliance on something being called triple A or
triple B rather than a proper investigation behind, is
that is probably the case. Certainly Basle II has
brought the reliance on external ratings agencies
more into the fold than I think was intended, so
more needs to be done in respect of these agencies.
We have put a list, which I hope we sent to you, of
some of the specific issues that we think it is
important to look at in terms of this whole area of
transparency. One is clearer signposting between
mortgage-backed securities based on prime assets
and securitisation based on sub-prime for example.
Another relates to the sort of actions that
programme managers ought to be taking in terms of
regular updating, disclosure of information, and so
on. Are there more things that can be done? The
answer is yes. Some of them do get into rather
arcane-sounding language but the question is is it
going to be more understanding, does it need to be
more understandable, and those are the sorts of
recommendations that the banks are making
because better transparency is where they want to
get to.
Q1585 Ms Keeble: What are your criticisms of the
credit ratings agencies?
Ms Knight: I think they need to monitor their ratings
more; I think they need to articulate why they have
got to the ratings they have; and I think there is
something about the separation of the provision of
ratings from the financing of the agencies that is
important as well.
Q1586 Mr Breed: Is it not abundantly clear now that
banks collectively have been totally irresponsible in
lending vast amounts of money against worthless
bits of paper?
Ms Knight: No.
Q1587 Mr Breed: How can you stack that up?
Ms Knight: There is certainly a problem which has
arisen, but it is by no means distributed evenly right
across the banking industry.
Q1588 Mr Breed: So they all knew exactly what they
were lending against and the value of the pieces of
paper that they were lending against?
Ms Knight: As you will know, the exposure is
diVerent and no doubt the knowledge has been
diVerent as well, because some of these structured
products are far more complicated than others.
Q1589 Mr Breed: Some banks have been able to lend
perfectly satisfactorily against asset-backed
securities of which they knew the total value?
Ms Knight: I think you will find that that is entirely
correct. Some will have said that they want an
exposure where there is a higher return and thus a
higher risk, and that is also a perfectly reasonable
lending decision for them to have taken. What is
important here though is not should banks have a
mixture of diVerent types of lending, diVerent types
of analysis and diVerent types of criteria—of course
they should; it is an assessment of risk. If there was
not that assessment of risk much of the financing of
anything from British industry to industry around
the world would not take place. What we have here,
though, is probably a pretty unique—I sincerely
hope it is unique—occurrence whereby what is, in
eVect, a serious housing problem in one country has,
through the spread of risk, found its way around the
world. Not just in the UK but to other financial
centres as well.
Q1590 Mr Breed: I think that is overly simplistic.
Can I ask two quick questions. Was Northern Rock
a member of the BBA?
Ms Knight: Yes.
Q1591 Mr Breed: And did it discharge all its
responsibilities to the BBA properly?
Ms Knight: As far as we were concerned, yes, it
participated in committees and it took part in
discussions
around
the
committee.
The
responsibilities—
Q1592 Mr Breed: There are a lot more obligations
than that to the BAA.
Ms Knight: The membership relationship with a
trade body is, as you rightly say, something of a twoway street in that we are primarily there to assist our
members, often on regulatory and tax issues, and
lobby on their behalf. There is a two-way flow of
information, but what we would not expect is for one
of our members to talk to us about their business and
commercial decisions; that is for them. We are there
for the generic issues, the market issues and those
things which are common to everybody. The
Northern Rock was, after all, regulated by the FSA.
Q1593 Mr Breed: So the announcement in August
was a complete surprise to the BBA as well, was it?
Ms Knight: The problem with the money market and
the freezing up of the money market, which was 9
August—
Q1594 Mr Breed: No, the problem with Northern
Rock, your member?
Ms Knight: That was in September.
Q1595 Mr Breed: When did you become aware of
the problems with Northern Rock, at the same time
as all of us?
Ms Knight: Yes, the Thursday evening when the leak
occurred about the lender of last resort
arrangements was the first time that we were aware
of the situation.
Q1596 Mr Breed: That one of your members was in
failure essentially?
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Ms Knight: Correct. We were certainly aware of the
concerns in the market and we had read the analysts’
report. We had seen the share price fall and we had
read the statement that the Northern Rock had
made about its own finding issues, which was in
June, so, yes, we were aware of the diYculties and we
were certainly aware of the eVective closure of the
market, but we knew for certain at the same time as
everybody else did.
Q1597 Mr Mudie: If I could get some common
ground between you and my colleague Colin Breed.
Your defence of the banking industry is
understandable by your position, but would it not be
correct to say that some banks acted unwisely and
maybe even irresponsibly in terms of these past
months?
Ms Knight: In which respect? I beg your pardon.
Q1598 Mr Mudie: Are you sticking to the position
that they are all as pure as the driven snow and that
this was something that could not be avoided or are
you agreeing that some of them perhaps now wish
they had not got into certain business?
Ms Knight: I am sure they do. I do not pretend the
industry is perfect. I do think it does a good job but
mistakes can be made. A lot of it is about a judgment
call and I suspect that there are some people who, as
you rightly say George, wish they had not invested
in some of the stuV that they have invested in, yes.
Q1599 Mr Mudie: I have certainly got the
impression from some of the folk that have come
before us that their lack of exposure was more down
to timing; they got in late rather than in at the start
and so their exposure was less, but it was not a
question they were not in it because it was too
profitable not to be in it.
Ms Knight: It also depends on the type of business
that you are running. Whether you are focusing
predominantly at investment banking or are focused
predominantly at the retail market, so that would
also depend upon banks’ exposures to sub-prime.
Q1600 Mr Breed: Angela, in the October Financial
Stability Report, the Bank of England said that the
banks should reflect on their business models and
they gave three scenarios. If I could put the scenarios
as (i) they should redesign the credit structures and
carry on, (ii) carry on as before because it is
profitable and they might regard this as a temporary
setback—which I find amusing—or (iii) that they
should scale down and move back towards a more
traditional model of banking; which one do you
think you would prefer and which direction do you
think the banks will move in?
Ms Knight: I certainly cannot dictate to any bank
what it is that they should do.
Q1601 Mr Mudie: Yes, but your advice is closely
watched.
Ms Knight: One can certainly see from their actions
what it is that they are doing and that is they are
reassessing the credit situation. They are looking at
their activities and their business models and they
are, like I think the rest of us, hopeful that this period
of uncertainty will come through and then they will
be able to use their repriced risk and their review of
their business model to recover in the activities in
which they want to get involved.
Q1602 Mr Mudie: So that is the first one—make
these instruments a bit more transparent and carry
on as before?
Ms Knight: I do not think that just carrying on as
before is exactly the description of what I have just
said. I think, if I may say, that the assessment of the
business model and the business that you want to be
in and what you think is going to happen to that
business is something that is taking place right now
within the industry itself. They are assessing where
they have made losses and they are assessing what is
the situation with some of these complex products.
To decide what the outcome and what changes they
are going to make, I do not think that a) I can tell
you and b) I doubt that they have all come to that
conclusion yet, because at the moment some of the
problems of the sub-prime are still in the process of
unfolding, so there has to be an element of wait and
see, an element of review, as well as an element of
change.
Q1603 Jim Cousins: How damaging has all of this
been to London’s markets?
Ms Knight: I think it has been quite damaging
actually. I went out to Brussels in about the middle
of September for the first time after the Northern
Rock, and I keep going out there, and also because
we are an association where 60% of our members are
from overseas, we get the impressions of the industry
and of authorities around the world, London does
rather look like its authorities dropped the ball, that
when push came to shove and a problem arose other
countries managed to deal with it and the UK
somehow did not. It is partly because so much got
played out in the public domain and queues outside
banks are immensely visual things. I think that we
have to recognise that it has done us damage and
that we have quite a lot of work to do to restore
that damage.
Q1604 Jim Cousins: Who should lead the
international action that is required to bring about
better standards across jurisdictions?
Ms Knight: There is a number, as you know, of big
international entities, IOSCO being an obvious one
and the World Bank another. There are therefore a
number of organisations and institutions already
there. I think that the best way to make those sorts
of global institutions work properly is for countries
which have big financial centres such as ourselves to
fully engage with global standards. You can never be
sure that everybody is going to abide by global
standards because in the end it has got to be locally
administered, but the big centres are the ones that
have the people, they have the products, they have
the broad range of services and have of course the
self-interest of getting the global standards right.
That is the sort of engagement which I sincerely hope
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18 December 2007 Ms Angela Knight CBE and Mr Adrian Coles
we continue to make because I do know the Treasury
and the FSA have both been making proposals over
recent times and no doubt earlier as well.
Q1605 Jim Cousins: Have we not got on the
international level the same slightly chaotic
separation of accounting standards, reserve
requirements and actual regulation that to some
degree you are saying are reflected in our own
national arrangements?
Ms Knight: And of course this is reflected in Europe
as well even before we get out of our region. First of
all, there is an inevitability in the sense that
standards have built up from diVerent bases.
Accounting standards have come up from the
accounting profession, prudential supervision has
tended to come up from central banks, financial
regulation from various financial regulators and so
forth. To co-ordinate them together is, as you rightly
say, absolutely essential. I think that we see a greater
co-ordination taking place right now. We note
particularly, for example, the work of Basle and the
work of the accounting industry and that needs to be
built upon, coupled with proper consultation with
the industry, as the industry knows whether
something is going to do the right thing or not do the
right thing. There will always be diVerences of view
but it is how it works practically that is important.
Bringing a recognition of co-ordination together
into the minds of countries and various authorities
is work which is on-going. I suspect that if the
Northern Rock has done us any good it has actually
brought that recognition very strongly into play in
more than one area—that co-ordination between
authorities is essential, and it is essential locally, it is
essential regionally, and it is essential internationally
as well.
Q1606 Chairman: Just a last question to Angela.
Mention has been made, as George said earlier,
about the warnings that were sent out from the FSA
and the Bank of England, regarding Northern
Rock’s business model, there were comments in the
market about that type of model and about the
growth and the fluctuations in the share price. Why
were these things not picked up? Was it the mentality
of a second-tier financial institution not getting into
trouble and all the focus being on the big
institutions?
Ms Knight: I think there is a number of reasons.
Clearly the big institutions are always there in terms
of the systemic risk that they would create if they get
into diYculties and the sheer numbers of individuals
and consumers in the retail business that they do.
Thus there is an inevitability that they will always be
crawled over by regulators of the highest calibre, and
I think that is right. It does seem to us though,
Chairman, as far as the Northern Rock is concerned
that the regulators maybe only looked at two parts
of the business, they did not look at the business as
a whole, and that the process whereby the regulators
looked at the risk assessments and scenarios that
Northern Rock had been undertaking were not
strong enough. I do not have any particular
additional information, but this is how we see it
externally. Also that maybe steps could have been
taken when there was a realisation of the impact of
the Northern Rock’s total exposure to the wholesale
market that. Instead action was not taken; rather the
situation was left as one of wait and see. Wait and see
can bring problems and that is why we believe that,
as part of either your inquiry or a further inquiry, it
is essential to do an exercise to show what would
have been the results if action had been taken earlier
by the regulators. If perhaps they had followed
through on the general warnings that they gave to
the market, and if changes had therefore been made
in advance of the problems of late August and
September.
Q1607 Chairman: Adrian, do you want to add
anything before we finish?
Mr Coles: The only thing I would add to what
Angela has said is going back to a question that
George Mudie was asking, where will banks go and
is there likely to be a retreat into the more traditional
banking model. I think one of the conclusions that
building societies have reached over the last three
months is an absolute vindication of their decision to
retain the traditional model that has worked very
well for them over the last 100 years or so and will
continue to work well for them into the future.
Chairman: Thank you very much for your evidence,
it is very helpful to us. Thank you for coming.
Witnesses: Mr Mervyn King, Governor, and Sir John Gieve, Deputy Governor for Financial Stability, Bank
of England, gave evidence.
Q1608 Chairman: Mr King, Sir John, welcome to the
Committee. I believe that you have an opening
statement. Could you first introduce yourselves for
the shorthand writer, please.
Mr King: Thank you, Chairman. On my left is John
Gieve, Deputy Governor for Financial Stability. If I
may Chairman, I would like to read a short opening
statement. As you and the Committee will be aware,
the problems in the financial sector remain with us.
A painful adjustment faces the global banking sector
over the next few months as losses are revealed and
new capital is raised to repair bank balance sheets.
Uncertainty about the possible scale and
distribution of losses means that interbank lending
rates have risen further relative to expected oYcial
interest rates. The behaviour of those spreads has
been very similar in the sterling, dollar and euro
markets, exacerbating concerns about a ‘credit
crunch’ in the major industrialised countries. That
remains the concern not only of the Bank of England
but of all the major central banks, and I will return in
a minute to our market operations. But we are also
thinking about the changes needed to prevent the
crisis that befell Northern Rock from happening in
the future. There are, as I said in my speech in Belfast
in October, three main lessons from the recent
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Mr Mervyn King and Sir John Gieve
turmoil for the UK’s framework for managing the
financial system. First, the UK authorities are alone
in G7 in being unable to deal with a distressed bank
under a special resolution regime. We rely instead on
normal corporate insolvency laws. But if a bank
enters administration depositors may have to wait a
considerable time to gain access to their funds.
Knowing that, they have a strong incentive to join a
bank run. So at present we cannot allow a bank to
fail unless it is clearly insolvent. In turn the
expectation that the authorities will try to avoid
insolvency puts a floor under the bank’s share price
and that prevents the authorities from intervening to
implement a reorganisation of the bank. So a special
resolution regime is the most important reform now
and it will require legislation. Second, experience in
other G7 countries suggests that a new regime
should be supported by credible deposit insurance
arrangements. A model for deposit insurance that
draws on international experience would have
permanent 100% coverage up to a limit with
transparent and widely understood prompt payout
commitments. Third, the experience of Northern
Rock demonstrates the importance of regulating the
liquidity position of banks. Northern Rock believed
that its adoption of Basle II meant that it would have
surplus regulatory capital, and in July it proposed to
increase its interim dividend for 2007 by 30%. But its
liquidity position remained extremely vulnerable to
the type of shock that occurred on 9 August. It is
clear that regulation of capital alone is insuYcient.
Tomorrow the FSA will publish a discussion paper
on liquidity regulation, and the Bank fully supports
this initiative. Much has been said about the
operations undertaken by central banks in the
money markets during the recent turmoil. All central
banks have the same primary objective in this area:
to implement monetary policy by keeping interest
rates on overnight borrowing in the money market
in line with the interest rate set by the MPC. After a
short period of volatility in August, we have
achieved that objective. The gap between overnight
interest rates and Bank Rate in the United Kingdom
has, on average, been the same as in the euro area
and smaller than in the United States. I will pass over
a description of our money market operations but
leave it in the text for the record.37 Last week, central
37
The text read as follows: “I would add two important points
about our money market operations that have not been
widely understood. First, a unique feature of our system is
that the total amount we lend to the banking system each
month is determined, at the beginning of each month, by the
banks themselves. We are now supplying £6bn more than
on 1 August—an increase of 37%. Neither the ECB nor the
Federal Reserve has increased their supply of reserves in
this way. Second, central banks can only keep overnight
interest rates in the market close to Bank Rate by lending
to banks just the amount the system requires. If we were to
provide more money than banks are required, or in our case
want, to hold, there would be excess money in the system
and overnight market interest rates would fall. That is why
when the ECB lent more to banks for 3 months it reduced
the amount it lent for other periods—there was no net
injection of money to the system. Similarly, the Bank of
England has extended funds to the banking system through
its lending to Northern Rock—as Northern Rock pays
away the money to its creditors, it adds to the reserves of
other banks. So we too have adjusted our other lending so
that the net injection of liquidity since August is in line with
the extra £6bn requested by banks.”
banks around the world announced a co-ordinated
set of actions in response to increased pressures in
short-term interbank lending markets. The Bank has
raised the amount on oVer, and widened the range
of high-quality collateral eligible, in its regular threemonth lending operations that had already been
scheduled for both today and for 15 January. Our
lending in other operations will be correspondingly
reduced. The actions announced last week
demonstrate that central banks are working together
to try to forestall any prospective sharp tightening of
credit conditions that might lead to a downturn in
the world economy. A key lesson that central banks
around the world have taken from the recent turmoil
is that, in stressed conditions, any bank that is seen
to come to the central bank to borrow—whether in
regular standing facilities against high-quality
collateral or against wider collateral in a discount
window or support operation—can become
‘stigmatised’ in the market. It important that, in
future, banks have a means of accessing the central
bank when necessary. So over the next year, and in
consultation with the banks, the other tripartite
authorities and other central banks, we will be
reviewing this element of our money market
operations. In due course we shall publish a revised
‘Red Book’ that describes our operations in the
sterling money markets. Chairman, I am grateful for
the opportunity to make that statement this morning
and John and I stand ready to answer your
questions.
Q1609 Chairman: Fine, thank you very much,
Governor. Regarding last week’s actions by the
central banks, the markets appear to have taken the
recent joint action, not as a sign of strength, but as a
sign of things being worse than people thought. How
would you respond to that suggestion?
Mr King: I do not think I would fully share that
view. There was always a risk that any intervention
by a central bank could be interpreted as a sign that
the central bank has seen something that others have
not, but I think the fact that this was an international
co-ordinated action which we at the bank were
extremely keen on making international did achieve
two objectives. One was to demonstrate that the
central banks were working together—perhaps that
had not been as evident as it might have been since
August, and, secondly, it was a clear recognition that
all the central banks were saying to the market,
“Yes, we do understand the deterioration in
sentiment in credit markets”, which had been very
evident over the previous four weeks, “and we are
conscious of the concerns that you have and we are
determined to take whatever set of policy action is
necessary to ensure that we do not see a serious
downturn in the world economy.”
Q1610 Chairman: There is a view held by some that
this is not just a crisis of liquidity but of solvency
and, as a result, the concerted actions of the central
banks may not help.
Mr King: It is certainly true that the reason for the
rise in spreads in inter-bank markets in the past
month is not due to a shortage of cash. That was the
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case in August and September when the banks were
trying to accumulate as many liquid assets as
possible and the rise in the inter-bank spreads in that
period did represent an attempt to accumulate
liquidity, but the large banks are now awash with
cash. The issue is not whether they have enough
cash; the issue is whether they are willing to lend, and
in recent weeks (and this was the reason for the coordinated action and the concern shared by all
central banks) what has become evident is that
banks are concerned about the capital position of
other banks. They do not know where the losses
resulting from the array of derivative financial
instruments will finally come to rest, and, I think, in
the last four weeks we have also seen a more
disturbing development, which is that the banks
themselves are worried that the impact of their
reluctance to lend collectively will lead to a sharper
downturn in the United States and perhaps
elsewhere, thus generating further losses outside the
housing and financial sector which will feed back
onto bank balance sheets and reinforce their
reluctance to lend because of the need to generate
more capital. That concern is a serious one, because
it does hold out the prospect that, if banks behave in
that way, there will be a self-reinforcing downturn in
credit and activity. That is not necessary by any
means, and, provided we can help to dispel that
sense of fear (and that was one of the reasons for the
actions last week—a demonstration that the central
banks are clearly aware of these concerns and
problems and we will take the appropriate actions to
respond to it) then, in fact, we will be back again in
the position where, I think, after the end year banks
will gradually realise that, once all the losses have
been revealed and once they have taken steps to
rebuild the capital of their balance sheets, which
several big banks have already done, then conditions
will return to a more sustainable position.
Q1611 Chairman: It has been suggested that your
own position, Governor, is characterised by a Uturn. In the summer you were saying that if you were
lending to banks at a penalty rate and there were
certain conditions in the collateral you were
accepting, now there is not a penalty rate and you
have widened the collateral which you will accept.
You also mentioned on Radio 4 and other places that
you were not here to bail out banks, that “the role of
the Bank of England is not to do with what the banks
ask us to do”. People would suggest now that what
you have done is the opposite of what you said you
were not going to do in August and, as a result, you
have done a perfect U-turn.
Mr King: It is not my view of what I have done. What
we did in September when oVering a term tender was
to say we are willing, given the concern about the
British banking system, to oVer money at a very wide
spectrum of collateral, including raw mortgages, and
if we were going to lend against that kind of
collateral—the European Central Bank, for example,
would not lend against that kind of collateral—then
we felt it appropriate to put in place a penalty rate
which was fixed ex ante so that any money would be
lent at the clear penalty rate. What we are doing now
in the co-ordinated action is to lend against a
narrower range of collateral only marketable
instruments. The money will be auctioned oV and, in
that process I fully expect that the rate which people
who get the money will have pay for it will turn out to
constitute a significant premium over bank rate. So,
in that sense, there is a penalty rate built in through
the auction process itself.
Q1612 Chairman: Why do you think you have been so
widely understood then?
Mr King: Misunderstood, I think.
Q1613 Chairman: Misunderstood.
Mr King: I wish I had been widely understood.
Q1614 Chairman: I think we all would!
Mr King: There are two reasons for that. One is that
I failed to speak out in August to explain how money
market operations worked, and I wish I had done,
and by the time it became possible to do so in
September, we were right in the throws of the
problems with Northern Rock and it was an
extremely diYcult environment against which to
explain the arcane details of money market
operations. The second reason is that very few people,
in fact, do understand money market operations.
Even now I find it very hard to explain, and I make big
eVorts to see people to explain it to them. Very few
people seem to understand the basic point that, in
order to implement monetary policy—to keep
interest rates in the market, overnight interest rates,
in line with the policy rates set by the Monetary Policy
Committee in our case, the Governing Council in the
case of the ECB—once the month has started, the
amount of liquidity which can be injected into the
system is completely fixed. If you try to inject any
more in than the banks are told to hold as their reserve
targets or, in our case, choose to hold as reserves, then
the banks will have surplus reserves, will try and lend
it out and that will push the overnight rate down. If
you do not inject enough, then people will be
scrabbling around to get liquidity and that will bid the
interest rate up. So, whatever liquidity is injected (and
often it attracts great headlines), what central banks
then do is to oVset that. What they give in one hand
they take away with another within the same
maintenance period, not the same day or even
necessarily the same week, but within the same
maintenance period you have to do it. That is why I
have been trying to explain to people since the
beginning of August that the European Central Bank
has, in net terms, injected hardly any extra liquidity at
all, the Federal Reserve four or 5%, I think, and the
Bank of England 37% more. Why is that? It is because
we allow our own banks to set their own reserve
targets, and, if they choose to hold more reserves, they
can do so and we supply the increased amount
correspondingly.
Q1615 Chairman: You mentioned that you failed to
speak out. In our inquiry we are looking at the issue
of communication strategy of the tripartite
arrangement. Would you consider that is an
important area for us to focus on?
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Mr King: Yes, it is, and particularly in the case where
there is a problem of a failed bank. I would say,
though, that one of the problems that the tripartite
arrangements faced in September was that, although
the processes for making recommendations on a
lender of last resort operation—the decision of the
Chancellor—worked extremely smoothly in my
view, we were still hoping, even on the Thursday, the
day before the facility was oVered, that it would be
made on Monday—that was the plan—and it was
only during the course of the Thursday, when
rumours started to spread in the market, that it was
felt necessary to accelerate that to the Friday
morning, and that put a lot of pressure on the
communication strategy, but, clearly, we need to
think further about that.
Q1616 Chairman: On the deposit protection scheme,
you have mentioned in your public statements that
it is inadequate. How long have you held that view
and did you communicate that view to the Treasury
in the past?
Mr King: I think all the Tripartite Authorities have
been aware of this and thinking about it. One of the
things which Callum McCarthy and I initiated when
we both started at around the same time was to
pursue regular crisis management exercises, and out
of those exercises in 2005–06 came the very clear
understanding that we had no adequate tools for
dealing with a failing bank. The Treasury completely
agreed with that and, indeed, work was going on in
the Treasury to think about how best to handle that
right the way through 2007. So these issues, I think,
were understood and, as I say, the Treasury was
working on it, but when we had the exercise in 2006,
I did not say to the Chancellor afterwards, “I have a
great crystal ball here. I can see that in 18 months’
time Northern Rock is going to get into trouble.
Therefore, we’d better rush this legislation through
in the next few months.” This was not something, I
think, that we felt had to be done overnight, this was
something that needed careful thought and
attention.
Q1617 Chairman: Did you advise or provide
information to the Treasury, say when the
emergency money facility was announced to
Northern Rock, that there would be a risk of a run
given your views of the deposit protection scheme?
Mr King: I will ask Sir John, because most of the
discussions of that took place at the deputies level.
What I will say is that I do not think that on the
Thursday, when we suddenly had to advance the
date of the operation, that we thought that a run was
inevitable. The nature of a bank run is that it is a
knife edge: it might happen, it might not. That is
exactly why a bank run is so diYcult to handle.
Q1618 Chairman: But you have described the
reaction of customers as being rational. Do you
think it is rational?
Mr King: Once the run had started, once other
people had started to run, then it was, indeed,
rational, given the system we had, to join the bank
run, but it was not necessarily rational to be the first
person in the queue, because if other people had not
gone and started the run, then it might have been
perfectly acceptable for it not to have happened. I do
not think there was any inevitability in that.
Q1619 Chairman: The reason I am asking that,
Governor, is that you consider the deposit
protection scheme inadequate. You know that it is
not 100% guaranteed, so you know that when people
find this out (and it was not evident to everyone) they
say, “Goodness, I am only going to get 90% of the
money I put in.”
Mr King: Absolutely.
Q1620 Chairman: Surely somebody must have
thought about that during that period.
Mr King: Indeed, but that does not mean to say that
it was inevitable that a bank run would occur. Let me
ask John to talk about the deputies’ discussions.
Sir John Gieve: When we were planning the lender of
last resort support we knew that it might not work
and, if it did not, there would then be a choice
between either, in a sense, guaranteeing all the
deposits of the bank or, alternatively, allowing
Northern Rock to go into administration. But we
took the view that it was worth trying a classic
lending operation first, because that oVered the
chance that Northern Rock would be able to get
through the liquidity diYculties in the short-run and
then resume normal operations after that.
Mr King: Could I just add that one of the ways we
hoped to deal with this was by having a covert
operation. That might or might not have worked,
but that was the reason we were arguing for a covert
operation, and that was ruled out only on the
Tuesday, two days before the Thursday of the
decision.
Q1621 Chairman: John, you say you were aware it
might not work. We have got these missing four
days, or these four days of inaction. Surely there had
to be a bit of forward thinking in that.
Sir John Gieve: Which four days are those?
Q1622 Chairman: From the Thursday to the
Monday, the emergency, when the Chancellor
guaranteed everything. You are sitting down
thinking this thing might not work because people
are only getting 90% guaranteed. Why was that not
done straightaway?
Sir John Gieve: We did realise that oVering a limited
collateralised facility was not guaranteed to save
Northern Rock. We hoped that it would restore
confidence. I think that was a reasonable judgment
at the time, and other people commenting on it at the
time thought so too. But I think we did not do
enough to reassure the retail depositors, and that
became clear on the Friday. I think the deposit
protection scheme was one element in that, but one
feature of Northern Rock was that it had a large
number of very big depositors who had deposits well
above the 35,000, and those are always more
slippery, if you like—they tend to move on the basis
of relatively small changes in interest rates—and so
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even taking the measures we have subsequently
taken on deposit insurance to make it 100% up to
35,000 would not have helped them.
Q1623 Chairman: Governor, you mentioned the
deficiencies in the system and the concerns you had
for a number of years. Had you written to the
Chancellor with your prescription for the way
forward?
Mr King: We had after the crisis management
exercises involving the pricipals, the note, the record
of that, and the standing committee deputies that
followed it made it clear that all three Tripartite
Authorities felt that an urgent work programme on
how to resolve the problems of a failing bank was
necessary, and that work was carried out.
Q1624 Chairman: But did you as Governor write to
the Chancellor?
Mr King: I did not write to the Chancellor because
there was no need. It was in the minute agreed by all
three Tripartite Authorities.
Q1625 Chairman: If you felt it was such a pressing
need with four pieces of legislation required and the
system never really worked, as I say, would it not
have been wise to have written to the Chancellor and
put your prescription for the way forward on record?
Mr King: We did not want to force a prescription at
a point when all three authorities agreed that
measures needed to be taken to find a mechanism for
resolving a failing bank and to improve deposit
insurance. That was something which, it was agreed,
the Treasury would work on. There was no dispute
about that.
Q1626 Chairman: Okay, we will follow that up.
Governor, the issue of nationalisation has been
mentioned, whether we are talking about
nationalisation or public administration, or
whatever. I had the opportunity to the speak to the
FDIC last week in Washington and, as a result of
that, I would ask you: what would your preferred
process of nationalisation be if it took place? Would
it be a long-term public sector commitment or
something similar to what the FDIC has with the
bridge bank authority where, if it took place under
FDIC, Northern Rock would be immediately
passed to private sector managers to run it, not by
FDIC but private sector managers, so that it is
prepared for sale? Can you envisage a system like
this in the United Kingdom?
Mr King: I certainly can, but I think it would require
legislation to achieve it. That is the first point that I
made. If we were to get to nationalisation (and I
stress “if”), then I think it would be better if it could
be used as a means of breaking the log-jam and going
into an arrangement which would pass very quickly
to a new management team and, ultimately, to a new
ownership team. I do not see anyone is attracted by
the idea of having on an indefinite—
Q1627 Chairman: No, but you could have assisted
them by identifying a management team.
Mr King: Indeed.
Q1628 Chairman: And you could pass the necessary
legislation in the House of Commons to eVect that
change quickly?
Mr King: You could indeed.
Q1629 Chairman: Would that be a system which is
worthy of consideration, do you think?
Mr King: It is not a permanent system I would
recommend. I think it is much better to have an
equivalent of the FDIC with that ability to intervene
early. This is now very late in the day. The right
system to have had would have been one which would
have intervened in the case of Northern Rock well
before 9 August.
Q1630 Chairman: But given our own Committee is
looking at this issue, this is an issue which should be
on the agenda, you think, in the future?
Mr King: As I said, I do think that legislation to give
the authorities the power to intervene early in the case
of a failing bank is very important. Banks are not like
other companies.
Q1631 Chairman: So it should be on the agenda. The
Government has said that it will wait for our report
before finalising any legislative proposals for
handling banks in distress. We hope to produce that
by the mid to the end of January. Do you think the
Government is correct to wait for that?
Mr King: Yes; absolutely. Indeed, even that is rather
a quick timetable. What matters is that we get the
proposals right and we get the details sorted out, and,
as I said to you when I came in September, I very
much hope that the Treasury Committee will take the
lead in all this because, in my view, this is something
which deserves cross-party support. This not a party
political issue, this is an issue in which, as I said, we are
the only G7 country that does not have the power to
deal with a failing bank in this way.
Chairman: Okay. We hope to get that out by mid
January. Michael.
Q1632 Mr Fallon: Governor, just to be absolutely
clear, it was as a result of the stress tests in 2005 that it
was minuted that the improved legislative framework
needed was now urgent?
Mr King: 2005 was the deputies meeting and crisis
management exercises. The principals, that is Sir
Callum McCarthy, the Minister and myself, first got
involved in the crisis management exercise in 2006,
and at the end of that exercise Callum McCarthy,
myself, Ed Balls as Government Minister and
Treasury oYcials, all agreed that a key part of the
future work programme was to work on these issues,
and that programme was indeed put in place.
Q1633 Mr Fallon: What was the date of that?
Mr King: That was late in 2006.
Q1634 Mr Fallon: So that was a year ago?
Mr King: From now, yes, and work on this was
indeed going on in the Treasury at the point when
Northern Rock got into trouble and it seemed to be
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perfectly reasonable. I did not say to anyone, “You
have to do this by the end of July otherwise we will
not be able to deal with Northern Rock.” No-one
anticipated that, but the work was going on.
Q1635 Mr Fallon: No, but it was identified as
urgently needed a year ago?
Mr King: It was important, yes.
Q1636 Mr Fallon: You said “urgent” in answering
the Chairman.
Mr King: Yes, but that requires designing and
thinking about legislation, and that is not a simple,
straightforward matter.
Q1637 Mr Fallon: So the Treasury has not been
dragging its feet on that?
Mr King: I do not believe it has been dragging its
feet, no. I could perfectly well have written in June
and said, “Look, what is going on with this?”, and
we asked about it, but I think this is a matter where
it was important to persuade people, including you,
to look at the experience of other countries and
recognise that maybe this is one case where we can
learn something from the rest of the world. But; to
win opinion over and to get new legislation through
is not an easy or quick matter and it may not be
sensible to rush it. There did not seem at the time any
obvious reason for this to be urgent in 2007 as
opposed to 2008.
Q1638 Mr Fallon: But it promotes the position now,
without this legislation, that for any one of the ten
big retail banks which ran into similar trouble to
Northern Rock, the Treasury would have to do
exactly the same, guarantee all the deposits all over
again and, if necessary, underwrite a lender of last
resort facility.
Mr King: I very much hope we will not get into that
position, but the reason and the need for new
legislation and the reason I am stressing it now is
that we do not have a means of dealing with this
absent the new legislation.
Q1639 Mr Fallon: The Sunday Times reported a
senior bank oYcial as saying that the Prime Minister
and Chancellor were “unable to focus because
morale throughout the Government is so low”.
Were you that senior bank oYcial?
Mr King: I can assure you, they are not my words
and I do not share those views at all. I have meetings
from time to time with senior economic
commentators. One of those was, indeed, with Mr
Stelzer, but the discussion was about economics. I
explained to him how our money market operations
worked. I am always trying to find people who do
not understand how it works and point out to them
how it does, and I explained to him the three points
in my October speech, which, again, I mentioned this
morning, but the conversation was about
economics, not about politics. None of the
comments in the article I recognise at all, and they
are certainly neither my views or my words.
Q1640 Mr Fallon: Is it the case, do you think, that
the Government can now move quickly enough?
Mr King: Yes, but it is important to get it right. I
think that is why it is sensible to wait for your report,
for the Chancellor to have time to see the
recommendations from the Bank of England and
from the Financial Services Authority, then it will
probably be sensible to have a period in which
people can discuss and debate the proposals and
then you in Parliament will have the responsibility of
taking through this legislation. That is not a quick
process either.
Q1641 Mr Fallon: I understand that, but if this was
a need identified a year ago, it might seem to our
constituents that this is all taking rather a long time
and we are very exposed to another Northern Rock.
Mr King: That is why I think it is important now to
move quickly but not so quickly that we get the
detail wrong. At the end of 2006 I certainly did not
anticipate that it was likely that we would be faced
with this problem during 2007, and I quite readily
accept responsibility for that. I did not say you have
to do it by the middle of 2007; I said it is important
that we work on this, not let it just stand on the
shelves gathering dust but work on it, and we made
that point and that was agreed by all the participants
in the tripartite meeting in 2006.
Q1642 Mr Fallon: But the minutes said it was
urgent?
Mr King: Yes, but “urgent” does not mean rushing
it in such a way that you get it wrong.
Q1643 Mr Brady: Can I return to something Sir
John said a little earlier. I think in relation to the
lender of last resort facility you said, “We knew it
might not work and, if it did not work, we had a
choice between guaranteeing all the deposits or
allowing Northern Rock to go into insolvency.”
Who made that choice?
Sir John Gieve: Ultimately the Chancellor made the
choice to oVer the guarantee to depositors.
Q1644 Mr Brady: But I think your comments
referred to the time before the facility had been
granted. You were saying, “We knew in advance
that if it did not work we would have this choice to
make”?
Sir John Gieve: Yes. All three parties agreed that the
next move was for the Bank to oVer a facility to
Northern Rock to see if it could tide it through these
liquidity diYculties. There was no dispute on that.
Q1645 Mr Brady: But this question of whether to
give a 100% guarantee to depositors had been
considered before the lender of last resort facility
was granted and a decision had been taken not to do
it at the same time as the facility was granted.
Sir John Gieve: The form of the guarantee, I do not
think, had been discussed. We were oVering a
secured lending facility and, if that did not work,
then the question was: would we continue to oVer
however much money it needed or not? We knew
that that would require a government guarantee—
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that was not something the Bank could do oV its
own balance sheet—so, in that sense, there was a
further choice beyond the secured facility on
whether to just provide whatever funds were needed
or to let the bank go into administration, but we
thought it was worth, as a first step, having a go at
helping Northern Rock through its problems.
Q1646 Mr Brady: To be very clear, specifically on
the guarantee to retail depositors, that was
something, therefore, that had been considered
before the facility was granted and a decision was
taken not to extend that guarantee at that time?
Sir John Gieve: We decided not to make an explicit
guarantee that all depositors would get their money
come what may, and at the time I still think that was
a reasonable judgment. In retrospect, of course, we
did not reassure the depositors because we did not
oVer that guarantee on the Friday, so we had to oVer
it on the Monday.
Q1647 Mr Brady: Who made that decision at the
time?
Sir John Gieve: On Thursday?
Q1648 Mr Brady: At the time previously. At the time
that you decided not to extend the 100% guarantee
to retail depositors at the same time as—
Sir John Gieve: The decision for us to oVer a secured
facility was the Bank’s decision, authorised by the
Chancellor.
Q1649 Mr Brady: I am asking about the decision.
Sir John Gieve: The decision not to go further than
that was a tripartite decision in which, I think, all
three parties were at one.
Q1650 Mr Brady: Can I move on and ask you,
Governor: when you gave evidence to us in
September you told us very clearly that, “As a result
of the Market Abuses Directive in 2005, we were
unable to carry out a covert lender of last resort
operation in the way that we would have done in
1990s.” It has been reported since that the European
Commission does not agree with that view. Is that
because the text of the directive is diVerent from the
UK legislation that enacts it, or is it matter of
diVering opinions on the same text?
Mr King: There are certainly diVering opinions in
the legal world on that and, I can tell you, the final
resolution of whether there could or could not be a
covert operation was reached on the Tuesday before
the facility was given. It was a decision by the FSA,
supported by the tripartite legal advice, on two
grounds, one under the listing requirement and
Northern Rock’s obligations as a listed company,
which the FSA is responsible for, and secondly,
under the Market Abuses Directive. We were
advised by the FSA that under both it would require
Northern Rock, not the Bank, to make a public
statement to the fact that it had the facility. I should
say that Northern Rock were very keen to make a
public statement that they had the facility. Their
view was that they did not want the covert
operation; they wanted it to be overt because they
believed that the sign of reassurance of having a
facility from the Bank of England would help them
and, in fact, that is what would prevent a retail run
in their view. Obviously, sadly, it did not turn out to
be the case, but the legal advice was clear, though I
gather now that, at least on the Market Abuses
Directive, there is still a diVerence of view between
the interpretations of some in the UK and some in
Brussels. There are also some diVerences in
interpretation between the original advice we had
and the current advice that is being received.
Somehow this still needs to be resolved, but, frankly,
it is not the most important issue, because I think the
Chancellor was absolutely right in saying that the
facility of the size required would almost certainly
become public knowledge, so it was not really an
issue worth pursuing. Nevertheless, that is an issue
to be resolved still on the table. I think, from my
conversations with central bankers from around the
world, they are very conscious of this case and they
recognise that, irrespective of what the law says, in
practice now it may be extremely diYcult for lender
of last resort operations to be conducted in the
covert way that they were even in the early 1990s,
where what happened has still not been revealed. I
think that there is a challenge for central banks to
think about how they intervene, which all of us will
want to think carefully about.
Q1651 Mr Brady: The legal advice on the Market
Abuses Directive, I think you said, came from the
FSA?
Mr King: Yes, it was the FSA’s advice but it was
taken by the lawyers involved in the tripartite
arrangements. There were lawyers from all three
bodies.
Q1652 Mr Brady: Would you be willing to share that
advice with the Committee?
Mr King: I would have to take advice as to whether
the lawyers will allow us to do that. Often this advice
is given as a matter of legal privilege. I think I need
to consult on that. I personally do not feel strongly
about it, but I think I do need to take advice on
that.38
Chairman: I think that is a wise answer, Governor.
Q1653 Mr Love: Is it inevitable that Northern Rock
will be nationalised?
Mr King: I do not know. I do not think anything is
inevitable. I think it is still possible that it may be.
Until January we do not know what the state of the
financial market conditions will be. I do not think
you can rule out the possibility that a management
team will be able to obtain the degree of financing
that will enable it to become the preferred bidder and
for that to lead to a successful bid. I would not want
to speculate on what would happen. It is very
diYcult to do so.
Q1654 Mr Love: We are told that it would need to
raise around £15 billion, mainly to pay back part of
that that has been loaned by the Bank of England.
38
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Is there any possibility that they can do that in the
timescale, especially since quite a lot of the
shareholders, hedge funds in particular, seem to be
briefing against them?
Mr King: I see two aspects to that. The first one is
that, of course, part of the original bids did include
a proposal from the bidders to raise money and pay
back at least the initial Bank of England lender of
last resort facility. That has become more diYcult in
the last couple of weeks because of the deterioration
in sentiment in the financial markets, but if those
were to improve in the New Year, that may come
back onto the table again. The second thing I would
say is that the diYculty of reaching a reorganisation
of Northern Rock, which is absolutely, desperately
needed, is made much more diYcult by the fact that
the shareholders can block what seems to be a
sensible discussion of reorganisation by the people
who are financing the vast bulk of the balance sheet,
and it is precisely that problem to which the idea of
early, prompt, corrective action and having an
agency that can intervene in a failing bank before it
reaches the stage of insolvency which is, in my view,
so important. It is why all the other G7 countries
have introduced a mechanism like that, and the
FDIC is perhaps the best.
Q1655 Mr Love: Turning to the tripartite
arrangement, do you think there is a need for drastic
surgery to the tripartite agreement?
Mr King: No, I do not think there is a need for
drastic surgery. I think the bits of it that were
described explicitly in the Memorandum of
Understanding, which set out the responsibilities of
the three partners, worked pretty well, but what did
not work so well was that there were issues that came
up that were not described in the Memorandum of
Understanding, and the most important ones to me
are the absence of suYcient instruments available to
the authorities to deal with a failing bank. That is
why I put so much weight on the importance of the
three points I made to you at the beginning this
morning. I think if we had the power to intervene
earlier, if somebody had the power to intervene
earlier, and there had been a diVerent deposit
insurance system, then I do not think the problems
with Northern Rock would have led to the outcome
that resulted.
Q1656 Mr Love: Would you accept the criticisms
about lack of co-ordination between the tripartite
partners and, if so, what changes do you think are
necessary to improve co-operation?
Mr King: I think the co-operation worked well. It is
clear that the shock of seeing Northern Rock get into
such diYculty and the television pictures of
depositors on the street really made a big impact on
people, but I do not think that in and of itself means
that the co-ordination of the tripartite authorities
did not work. As I said, when it occurred we simply
did not have the instruments to deal eVectively
with it.
Q1657 Mr Love: I was intrigued by your statement.
You include knowledge of a discussion paper on
liquidity regulation being produced by the FSA. I
wonder whether you would care to comment—I am
assuming that you have been consulted in relation to
this as well—as to whether it addresses issues of coordination between the tripartite partners?
Mr King: Yes, it does, because it makes very clear
that, whatever regulation FSA adopts in an
improved sense to regulate liquidity, it will want to
co-operate and work with the Bank of England,
because the way we conduct our money market
operations will clearly have implications for the way
they choose to measure liquidity and decide how to
regulate it. But there is a very important point that
was made by Professor Charles Goodhart in an
article he wrote on liquidity a month or so ago,
where he said that there is no single number in
measuring liquidity that will tell you the true story.
It is no good just looking at the amount of liquidity
you have got for the next two weeks, or the next four
weeks, you need to look at a range of numbers and
apply a qualitative judgment as to whether or not the
institution has adequate liquidity. I do think it is
important that this be taken much more seriously
because, as I said, the Northern Rock is an
extraordinary example. Here was a bank that
adopted the Basle II method of capital regulation
and, as a result, found that it had one of the highest
capital ratios of any bank in the UK, proposed to
return that to shareholders and yet it was in a very
vulnerable liquidity position. That shows, if
anything does, that capital is not all. That is not a
criticism of Basle II, Basle II is designed only to look
at capital, but it does mean that, in parallel with it,
you do need a proper regime of regulation of
liquidity and the discussion paper the FSA will
publish tomorrow is the first step on the process of
making sure we get one.
Q1658 Mr Love: There have been suggestions and,
indeed, comments made that perhaps the way to
address the tripartite arrangement is to create a new
body that would come into play exactly in the
circumstances that happened in relation Northern
Rock. Would you have any sympathy for that type
of reordering of the way in which the arrangements
operate?
Mr King: What I think is most important is that we
actually create the powers for some authority to
intervene pre-emptively in a failing bank akin to the
FDIC. Where that is located I do not have strong
views on, and that is something that can be
discussed. What is most important is that someone
has got it and can exercise it.
Q1659 Mr Love: You are not minded to suggest that
that should be with the Bank of England?
Mr King: No, because the one principle that I have
pursued absolutely to the limit while I have been
Governor is that we have never fought any turf
battles. I would much rather give up any pretence
that we should be involved in this than for the UK
not to have these powers available to some
authority. It is not my objective to try to acquire or
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Mr Mervyn King and Sir John Gieve
accumulate powers in the Bank, it is my only
objective to make sure that the UK has a system of
resolving failing banks that works, and we do not
have one at present.
Q1660 Mr Love: So you are going to leave it to the
Treasury Select Committee to make up their mind.
Mr King: I think the Treasury Select Committee are
an admirable group of people to recommend where
that power should reside.
Chairman: You are going too far, Governor!
Q1661 Mr Mudie: Does that include me?
Mr King: Absolutely.
Q1662 Mr Mudie: Governor, I would like to follow
up on a question Mr Fallon put to you in terms of
this leak that was very embarrassing for the
Chancellor, Prime Minister and yourself. I accept
that you are nothing to do with it, but The Sunday
Times did say it was a senior Bank of England
oYcial. I would be interested to know what you have
done since The Sunday Times came out. Have you
had your senior people in? Have you checked
diaries? Have you asked which ones put you in this
embarrassing position a few days before this
hearing?
Mr King: I do not believe that anybody in the Bank
would make comments of that kind. I know my
colleagues well and I would not dream of saying,
“Who had lunch with whom and when?” That is not
the kind of comment that anyone in the Bank makes.
Q1663 Mr Mudie: Do you think it is a type of
reporting that The Sunday Times gets up to, using a
source in the Bank, a senior source in the Bank of
England?
Mr King: I do not believe for a minute that those
words in quotes corresponded to anything that a
Bank of England oYcial actually said.
Q1664 Mr Mudie: So The Sunday Times were just
bolstering their story by the lazy use of a Bank of
England senior source?
Mr King: You might think that, I could not possibly
comment. I have learnt over the years not to believe
a lot of what is in the newspapers.
Q1665 Mr Mudie: The press are after the
Chancellor, and yesterday’s Financial Times made
three assertions about Northern Rock, and I would
like to go through them with you. One of them I
raised with you last time, but I will be specific. Was
there a rescue bid from Lloyd’s TSB on the table the
weekend before the run? That is the first part of that
question. Was it specifically put to the Chancellor as
either advisable or acceptable, and did he reject that
advice, if given?
Mr King: There was no firm bid on the table at all.
There was one pretty vague telephone call,
originating in FSA, which came to Bank oYcials and
then passed to me, saying that there might be a
bidder but they wanted to know first, before putting
a bid on the table, whether it would be possible for
them to borrow about £30 billion without a penalty
rate for two years, and I said, well, the Bank of
England does not normally lend £30 billion to a
going concern. In any event, our balance sheet is not
big enough for us to make that kind of decision, and
it was absolutely clear, whatever way you looked at
it, it was clearly state aid. It was for a takeover bid
to pay a positive share price to another company; so
it was clearly state aid. So I said to the Chancellor
that this was not something which the Bank of
England would do. My advice, clearly, was that this
was not an operation which either central banks or
governments normally did. If it were to go ahead it
would require an indemnity for the Bank of England
from the Treasury. Our legal advice was that this was
clearly state aid and (and this was perhaps most
important oV all) it would be quite impossible to
make an oVer of a loan of that kind to one bank to
buy Northern Rock without making it quite clear to
other potential bidders that they too would have
access to it, and I think, as the Chancellor said when
he came to you before, the idea that if he stood up
and said, “I am willing to lend £30 billion to any
bank that will take over Northern Rock”—that is
not the kind of statement that would have helped
Northern Rock one jot or tiddle. It would have been
a disaster for Northern Rock to have said that. So,
I do not think it was ever a practical proposition,
but, in any event, no formal bid was tabled as far as
we were concerned.
Q1666 Mr Mudie: Mr Brady pressed you on this and
I would like to come back to it. Did the Chancellor
get specific Bank of England advice to give the retail
depositors a guarantee at the same time as the
announcement of lender of last resort?
Mr King: No. I have said that before. No, he did not.
Q1667 Mr Mudie: Absolutely not?
Mr King: Absolutely not. There was no discussion,
in fact, among the principals until the Sunday. On
the Saturday I spoke with the Permanent Secretary
of the Treasury and I met the Chancellor in person
on the Sunday morning, and that is when I made my
clear advice, as he pointed out to you when he gave
evidence to you earlier this year.
Q1668 Mr Mudie: Let us be clear: which day did the
lender of last resort leak out and become public?
Mr King: It leaked out late on the Thursday.
Rumours in the market started on the Thursday
afternoon which led to a meeting at four o’clock of
the standing committee of deputies, and at that
meeting it was decided that, because of the concern
about leaks in the market, not the television leak
later on but rumours in the market, that the facility
should be announced at seven o’clock the next
morning. That is when the decision was taken, on the
Thursday afternoon. There were television reports
later that evening.
Q1669 Mr Mudie: Against that timetable you did
not give advice to the Chancellor that when he made
that announcement he should also announce the
guarantee for the retail depositors?
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Mr King: No, we did not.
Q1670 Mr Mudie: The third thing was that the
Chancellor was advised to use the full leverage of the
Bank facility to push the shareholders and
management to accept an immediate private sale.
Did the Bank give advice to the Chancellor to use
that leverage at that sensitive time or, to your
knowledge, did the FSA give the advice?
Mr King: Can you repeat the proposition. I do not
recall anything like this. This is a proposal for—
Q1671 Mr Mudie: On the back of being so helpful to
Northern Rock. You have said yourself, Governor,
one of the things that is going to be a problem, if the
negotiations went well and you were prepared to
think there was an oVer acceptable, the shareholders
are going to have a say.
Mr King: Indeed.
Q1672 Mr Mudie: And I think the proposition is that
at the time you were putting the money in and there
was disarray and panic, et cetera, you had leverage
to say to the shareholders, “We want an immediate
private sale.” Those are the exact words.
Mr King: Well, there was no proposition like that on
the table, and my understanding and our legal advice
was that it would not have been possible, because
whatever accelerated deal one tries to bring about,
the shareholders must be given proper time to
consider a bid and others must be given a chance to
make their counter bids. So, there was no advice at
all to do that. It was not possible.
Q1673 Mr Mudie: Can I ask your deputy, because he
has been getting a rough press and this is an
opportunity. Do you think you have operated well
the link between the FSA and yourself in the area
you are in? Has it worked well or have there been
deficiencies, and have you contributed to the
deficiencies?
Sir John Gieve: I think the links between the Bank
and the FSA have worked well in terms of exchange
of information and communication. They do not
just depend on me. I am on the Board of the FSA,
Callum McCarthy is on our Board, but we have put
in place daily calls about market developments, the
FSA are represented on my Financial Stability
Board and I think those did ensure that we shared
the information we had and we discussed the issues.
It does not mean we always agreed, of course.
Chairman: Thank you very much.
Q1674 Peter Viggers: A central ingredient of our
present diYculties is securitisation, the banks have
it, of originating and distributing loans and other
assets, and in your October Financial Stability
Report you stated that this model has been shown to
have significant flaws. Would you calibrate those
for us?
Mr King: Let me make a brief comment and then ask
John, because he is in charge of the Financial
Stability Report. The securitisation model, I think,
will return, but not in the way in which it has been
operating in the last few years in which an enormous
superstructure of derivative instruments has been
built on top of securitised assets, the whole complex
structure of CDOs and CDOs of CDOs, and so on,..
I suspect there may be less demand for it. I think they
will still exist for those people who genuinely believe
they really understand the instruments, and there are
those in specialised financial institutions who do
that, but I rather think that pension funds and others
may come to recognise that securitisation is fine but
just follow the basic maxim: only invest in what you
understand. John.
Sir John Gieve: I think the key thing that the FSR
has shown up is that some unintended incentives
were set up in the originate and distribute model as
it applied to credit products. So you find the
originators of mortgages had a strong incentive to
go for volume rather than quality and an awful lot
of bad loans were made; I think the rating agencies
had an incentive to take on as many ratings for as
many products as they could; I think the investors
had an incentive, because of the diVerent yields, not
to look at the fine print of what those ratings actually
oVered and, instead, just to go on the label; and,
finally, I think the banks had an incentive to use oVbalance-sheet vehicles for a lot of their operations.
The market will correct some of these and the role of
the authorities will be to step in where oYcial action
is also necessary to correct them.
Q1675 Peter Viggers: Yes. Banks do not trust other
financial institutions, and you, Governor, said that
part of your role is to “dispel that sense of fear”, but
is not the problem that that fear is justified?
Mr King: Certainly at present it is justified to be
cautious about where the losses on many of these
complex and opaque instruments will ultimately
come to reside. That is why I think we need a little
bit of patience to get through the period, perhaps the
end of February, March, when financial institutions
will have had to reveal most of those losses marked
to market and take whatever resulting steps are
necessary to rebuild their balance sheets, and at that
point I would hope that we will have made a big step
forward. But, as I said in August and when I came to
see you in September, the most important step that is
required here is that the private sector (and it can
only be the private sector) needs gradually to
restructure and re-price many of those complex
instruments which people are now very reluctant to
lend against or buy, and that will take time, but the
process is slowly beginning. There are risks to the
world economy in the meanwhile if it results in a
banking system that is reluctant to lend to industry,
and it is our job to try and take steps to minimise
that, but the resolution of the problems in the
financial sector will hinge on the restructuring and
re-pricing of instruments and the revelation of losses
and the rebuilding of balance sheets. At that point,
and at that point only, will you see inter-bank
spreads, these LIBOR spreads, return to normal
levels, and it is very instructive that, whatever view
you take on how central banks have conducted their
money market operations, there may be room for
disagreement, but whatever central banks did, these
three-month LIBOR spreads are absolutely
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Treasury Committee: Evidence
18 December 2007
Ev 187
Mr Mervyn King and Sir John Gieve
identical now in the euro area, sterling and dollar,
and that tells you that it does not have a lot to do
with the provision of liquidity and money market
operations, it has a great deal to do with the factors
that you mentioned.
Q1676 Peter Viggers: The weapon available to you,
of course, is credit, and it is rather like pushing on a
piece of string, whereas what we need is someone to
sort out the rotten apples?
Mr King: Yes, and that will gradually happen, and I
think the regulators and, indeed, the banks
themselves have a very strong incentive to see this
happen, but it does require auditors to go through a
careful process of working out and validating the
valuations which banks themselves put on their
assets, and this will gradually happen over the next
few months.
Sir John Gieve: I think the fear consists of two things.
One is that we do not know yet what the price is of
what has already happened, the subprime crisis, and,
if you like, where the losses lie and whether it will
require recapitalisation. But there is also a fear
about the future of the economy, particularly in the
US, and the possibility that if that goes into
recession there will be a further round of losses. I
think that part of the central banks’ job is to provide
some confidence that the economy will be managed
in a responsive way going forward. We may not be
able to do much about the subprime losses, which
are in a sense still being worked out, in the past.
Q1677 Peter Viggers: No doubt the situation will
shake down, but should there be a role for leadership
here and who should take it?
Mr King: Central banks have discussed this a great
deal amongst themselves, and I think the conclusion
we have all reached is that actually the resolution of
the re-pricing of instruments is something which has
to be conducted in the private sector, and the
accounting bodies and the regulators have their
important role to play in trying to make sure that the
banks, as soon as is feasible, reveal the size of the
losses and take steps to rebuild their balance sheets,
and you can see that beginning to happen, and I
think we just need a little bit of patience to see that
process through. Meanwhile, as John says, the
challenge facing central banks, and one of the
reasons for our co-ordinated action last week, was to
try to ensure that the sense of confidence in how the
future policy will be conducted is suYcient not to
add this further fear that there will be a layer of extra
losses coming down the road.
Q1678 Mr Breed: Teasing out a little bit more what
you said about these asset-backed securities, is it not
now clear that far too many banks were
irresponsible in lending vast sums of money against
so-called asset-backed securities where they had no
idea whatsoever of the underlying value of that
asset?
Mr King: I do not want to make generalisations
about what banks did or did not do. I think what is
very clear is that in the United States there was some
pretty extraordinary lending in the subprime
mortgage market where people, without a great deal
of sophistication, were encouraged to take on loans
that perhaps they could just about aVord to buy a
home that they never thought they would ever be
able to aVord and they were encouraged to think
that they could aVord it, but only when the policy
rate set by the Fed was 1%, and once interest rates
got back to a more normal level of 5%, they clearly
could not aVord it.
Q1679 Mr Breed: That might have been the genesis
of the problem; that does not absolve our banks
from lending vast amounts of money against assetbacked securities the underlying value of which they
had no idea or ability to calculate.
Mr King: I think a wide range of purchasers of those
assets should ask themselves questions about
whether they really did understand what they were
buying, but they are accountable to their
shareholders, their trustees, whoever, and I think
those people will have a lot to say about the decisions
that were made to take on board these ass